If you’re making money on your own and aren’t sure how the IRS is going to classify your income, chances are you’re a sole proprietor and didn’t even know it. A sole proprietorship is a business that is owned by a single person. You can either be running an unincorporated business or an LLC that you haven’t elected to treat as a corporation (check out our sole proprietorship vs. LLC article for additional reading).
Since a sole proprietorship is the simplest business structure out there, it might be difficult to differentiate between a business activity or a hobby. However, it’s important to know the difference because the IRS allows you to deduct business expenses but not money spent on a hobby.
If you’re not making much money and aren’t sure if your activity is business-like enough to be a sole proprietorship, the IRS “Business vs. Hobby” guide can help you figure out whether or not it’s a business.
Here are a couple ways to tell if you have a business or a hobby. If you can answer “yes” to either one of these questions, then you’re probably running a business:
The IRS also assumes that you are a business if you have made a profit in three of the last five years.
Once you’re sure that you’re a sole proprietorship, you can deduct business expenses from your taxes accordingly. In some states, your line of business might be regulated and require a license or permit even you opt to forgo the legal protection of an LLC.
If you need more information, the Small Business Association can tell you more about the business licenses and requirements for starting a business.
Many entrepreneurs choose to run their business as a sole proprietorship because it keeps things simple. When you’re a single owner you have the right to make any decision affecting the business without consulting others.
If you bring on a business partner, your business can no longer be classified as a sole proprietorship. It would now be considered a general partnership and would require a separate tax filing.
Business losses and earnings for a sole proprietorship can be reported directly on a personal income tax return, so filing taxes is pretty simple compared to the tax requirements of other kinds of businesses.
To make things simpler come tax season, remember to file 1099s and W2s when tracking business earnings. Identify and report potential deductions, which may require tracking before tax season to be completely accurate. When paying quarterly taxes, smart sole proprietors will also apply for any small business tax credits that may apply to their business.
Sole proprietors must accept full responsibility for all business debts and obligations.That responsibility, also known as full liability, is even extended to the business owner’s personal assets.
Unless you take the additional step of creating a limited liability corporation, or LLC, there’s no distinction between the individual and the business, which means personal assets can be seized to cover business debts, including homes, cars, retirement funds, savings accounts and any other asset belonging to the business owner.
Sole proprietors should take liability into careful consideration before making business decisions that could adversely affect his or her personal life.
While sole proprietorship keeps taxes simple, it can also mean that you pay more taxes than other kinds of businesses.
As a sole proprietor, you are required to pay self-employment taxes, whereas other types of business can be arranged to avoid those taxes.
Jenny is a content writer for ZipBooks and a graduate student at Brigham Young University.