Sole proprietorship

A sole proprietorship is a business entity that is owned and operated by a single individual. It is the simplest and most common form of business structure. In this type of business, there is no legal distinction between the owner and the business itself. This means that the owner is directly responsible for all aspects of the business, including its debts and liabilities. This lack of distinction makes a sole proprietorship easy to set up and manage, but it also means that the owner assumes full personal responsibility for the business’s financial obligations.

Can I set up a 401(k) as a sole proprietorship?

Yes, you can set up a 401(k) as a sole proprietorship. You can select a solo 401(k), which is designed for businesses who have no other employees other than a spouse. A solo 401(k) is exempt from the testing and reporting requirements of ERISA. Additionally, solo 401(k) plans allow owners and their spouses to contribute up to the maximum annual additions limit each year ($69,000 to $76,500 for 2024 as indexed) into their retirement plan since the participants can contribute as both participant and employer.

How to start a sole proprietorship

Starting a sole proprietorship involves several straightforward steps:

1. First, the individual must choose a business name that complies with state regulations and is not already in use by another business. 

2. After selecting a name, the next step is to register the business with the appropriate local or state government office, often filing a "Doing Business As" (DBA) name if the business operates under a different name from the owner’s legal name. 

3. Sole proprietors must also obtain any necessary licenses or permits required for their specific type of business. 

4. If they plan to hire employees, obtaining an Employer Identification Number (EIN) from the IRS is required for tax reporting purposes. 

5. Lastly, keeping personal and business expenses separate is essential for accurate financial tracking and tax preparation.

When it comes to retirement savings, sole proprietors need to be mindful that contributions to retirement plans like SEP IRAs or solo 401(k)s are based on earned income reported on Schedule C of their Form 1040, which is recalculated and converted to W-2 income after medicare and social security. You can learn more about it here. Since retirement contributions are calculated on net earnings from self-employment after business expenses and deductions, sole proprietors must accurately report this income to maximize their retirement contributions while maintaining clear records for tax purposes.

Sole proprietor vs. LLC

Several key differences emerge when comparing a sole proprietorship to a Limited Liability Company (LLC). A sole proprietorship is simpler to establish and involves fewer administrative requirements. However, it does not provide the same level of legal protection as an LLC. In a sole proprietorship, the owner is personally liable for all debts and liabilities incurred by the business. Conversely, an LLC offers limited liability protection, meaning the owner’s personal assets are generally protected from business debts and legal claims. However, an LLC may involve higher setup and maintenance costs compared to a sole proprietorship. 

The process of converting a sole proprietorship to an LLC can be relatively straightforward, involving steps such as filing articles of organization with the state and creating an operating agreement that outlines the business's structure and management procedures.