Sole Proprietorship

We don’t want to spend too much time on sole proprietorships since most people reading this book don’t want this arrangement. It also behooves us to say that you cannot elect a sole proprietorship to be taxed as an S corporation. The check-the-box regulations only apply to a “business entity” recognized for federal tax purposes (Treas. Reg. 301.7701-2(a)), and a sole proprietorship is not an entity. It is just you.

Therefore, if you have been in business for several years without an underlying entity, such as an LLC, then you must first create one and then file an S Corp election to enjoy the tax savings. The election cannot be effective before the LLC exists, so those sole proprietor years are what they are (although late S Corp election relief under Rev. Proc. 2013-30 can reach back to the LLC’s formation date, which we cover in Chapter 6). What are those mysterious tax savings and other benefits we keep mentioning? Slow down love… we’re getting there!

As a sole proprietor you might still need a state registration or some licensing for your particular line of work (such as real estate agent, massage therapy, family counseling), but it is easy to do without needing to form an LLC. Additional downsides to sole proprietorships include zero liability protection for your personal assets, poor transfer of ownership upon expansion or death, and the ugly self-employment taxes (which a single-member LLC pays too, by the way, since the IRS sees the same Schedule C either way; only the S Corp election changes that math). Income and expenses are generally reported on Schedule C of your Form 1040, self-employment taxes are computed on Schedule SE, and a separate business tax return is not necessary. You might report activities on Schedule E or Schedule F in certain situations.

A quick word on DBAs since we tossed the term around earlier. A DBA, or “doing business as,” is a registration, not an entity. It lets Jane Smith hang a shingle as Smith Bookkeeping and open a bank account in that name, which is why banks and most states want it filed. That is all a DBA does. It provides zero liability protection, does not change how you are taxed, and leaves you a sole proprietor with a nicer name. LLCs and corporations can register DBAs too, handy when one entity runs two brands.

Having said all this, in some cases a sole proprietorship is preferred. For example, California imposes an $800 annual tax on every LLC (temporarily $400 for the first tax year for LLCs formed in the 2027 through 2029 tax years, and nothing for a stub year if you form in the last 15 days of December and do no business). If your business is barely a side gig that might turn into something one day, then even $400 might seem expensive. You can easily use a personal credit card and open another checking account in your name (or in your DBA name) as segregation for the business activities. Done!

Also, be wary of annual Secretary of State filing fees. Nevada is $350 ($150 for the annual list plus $200 for the state business license). Massachusetts is massive at $500. Delaware wants $300. These are annual fees for just having an LLC. The “pleasure to have an LLC in our state” fee, if you will. Other states vary between $15 and $250, and a few remain free after the initial filing fee, like Texas, Arizona, Missouri and Ohio. Keep this in mind when we get to the Nevada and Delaware fallacies later in this chapter.