Incorporator The Journal of U.S. Formation
Start Free Quiz
Editorial 6 MIN READ

The sole proprietorship in 2017: the default you already are

No filing, no shield, and a 15.3% self-employment tax bill that surprises people every April

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 5 sections
  1. What "sole proprietorship" actually means
  2. The self-employment tax, which is where the real money goes
  3. The EIN question and the DBA question
  4. The liability problem, which is why most sole props should not stay sole props
  5. Sources

f you did freelance work last year and never filed formation papers with any state, you were a sole proprietor. The IRS treated you as one by default, your income hit Schedule C, and you owed self-employment tax at 15.3% on the first $127,200 of net earnings. Most people do not choose to be sole proprietors. They become one because they invoiced somebody and cashed the check.

This is a guide to the form everyone starts in and most people should eventually leave. Written in April 2017, with the 2016 return still fresh and the 2017 quarterlies already running.

What "sole proprietorship" actually means

There is no formation document. An individual conducting business for themselves, without forming an LLC or a corporation, is a sole proprietor for federal tax purposes. The IRS says so directly in Publication 334, its 2017 Tax Guide for Small Business for filers using Schedule C. The same document walks through what counts as a trade or business and what deductions are available against it.

Mechanically, the return looks like this. Your business income and expenses go on Schedule C (Form 1040), Profit or Loss From Business. The net number flows to Schedule 1 of your 1040 and is taxed at your ordinary individual rate. Self-employment tax is computed separately on Schedule SE and attached to the same return. There is no business return. There is no corporate layer. The business and you are the same taxpayer.

That singularity is the point, and it is the problem.

The self-employment tax, which is where the real money goes

The self-employment tax is the self-employed version of FICA. It replaces the split between employer and employee payroll tax, and the self-employed person pays both halves. The rate is 12.4% for Social Security (OASDI) plus 2.9% for Medicare, for a combined 15.3%. For 2017, the Social Security portion applies only to the first $127,200 of covered earnings — that's the contribution and benefit base set by the Social Security Administration for this year, up from $118,500 in 2016. The 2.9% Medicare portion applies to every dollar of net self-employment earnings, with no ceiling.

The base on which you pay SE tax is not your gross. It is 92.35% of your net earnings from self-employment — the rough equivalent of the employer-side FICA deduction a W-2 worker never sees. You then get a deduction for half of the SE tax when computing adjusted gross income, which softens the blow at the margin but does not change the cash you owe on April 15.

Above $200,000 of wages or self-employment income for a single filer ($250,000 for married filing jointly, $125,000 for married filing separately), the Affordable Care Act's Additional Medicare Tax of 0.9% kicks in. It is computed on Form 8959 and layered on top of the regular Medicare portion.

The arithmetic people miss: a sole proprietor netting $100,000 owes roughly $14,130 in self-employment tax before any federal income tax. A sole proprietor netting $150,000 owes the full $127,200 × 12.4% = $15,772.80 on the Social Security side, plus 2.9% of $150,000 × 92.35% on the Medicare side, plus ordinary income tax on top of all of it. The quarterly estimates are not optional. Miss them and you owe a penalty under IRC § 6654.

The EIN question and the DBA question

You can operate a sole proprietorship using your own Social Security number as your taxpayer ID. The IRS does not require a sole proprietor without employees to get an Employer Identification Number. An EIN becomes mandatory the moment you hire someone, the moment you establish a qualified retirement plan, or the moment you file an excise, employment, alcohol, tobacco, or firearms return. Form SS-4 handles the application; the online system issues a number immediately.

The practical advice is to get one anyway. An EIN keeps your SSN off every W-9 you send to a client, which is the single best identity-theft prevention move available to freelancers, and it costs nothing.

The DBA question is a state and county problem, not a federal one. If you operate under your own legal name — "Jane Chen, Consultant" — most jurisdictions do not require a filing. If you operate under a trade name that does not include your surname — "North River Strategy" — you almost certainly need to file a fictitious-name or "doing business as" registration. Thirteen states do not have a state-level filing (Alabama, Alaska, Arizona, Delaware, Florida, Hawaii, Kansas, Maryland, Mississippi, Nebraska, Ohio, Wisconsin, and Wyoming, per Harbor Compliance's state-by-state tracker), but most of those push the requirement down to the county clerk. Florida uses the Division of Corporations directly; California pushes it to the county recorder. Check your state before you print the business cards.

Some states also require a state tax ID separate from the federal EIN — California's Employment Development Department number for employers, New York's withholding registration, Pennsylvania's enterprise registration. These attach to activities (selling taxable goods, paying wages), not to the entity form. A sole proprietor who sells nothing and pays no one often has no state registration obligation at all.

The liability problem, which is why most sole props should not stay sole props

The defining feature of the sole proprietorship is that it is not a separate legal person. If a client sues over your work, they sue you. If a delivery driver you hired rear-ends a minivan, they sue you. If your business defaults on a lease, the landlord comes for your personal bank accounts. There is no corporate veil because there is no corporation.

This is tolerable for a low-risk side practice — a tutor, a writer, a weekend consultant with a handful of repeat clients and a professional liability policy. It stops being tolerable the moment any of three things happens. First employee: now you carry vicarious liability for another human being's conduct, and your personal assets are the backstop. First real contract: the indemnification clause in a serious MSA or SaaS agreement is written assuming you are a corporate entity, and signing it as an individual puts your house on the line. First lease: commercial landlords often demand personal guarantees anyway, but signing a lease in your own name with no entity layer removes even the option of negotiating a limited guarantee.

Any one of those is the signal to form an LLC. The LLC costs somewhere between $50 (Kentucky, New Mexico) and a few hundred dollars to form in most states; it preserves the same pass-through tax treatment if you leave the default classification alone; and it adds the one thing a sole proprietorship structurally cannot provide. There is no tax reason to delay the conversion and several legal reasons not to.

The sole proprietorship is the form you belong in when the business generates less than a full-time income, involves no employees, no physical premises, and no contracts that could trigger meaningful damages. It is the form you outgrow the first time any of those things changes. In 2017, the tax bill alone — that 15.3% hitting every dollar of net earnings with no salary-plus-distribution planning available — is already a reason many single-member practices will look at an S-corp election on top of an LLC before year-end. The liability gap is the reason they should have been in an LLC to begin with.

Sources

Keep reading

More from the journal.