Sole proprietorships are businesses owned and typically operated by a single individual. While sole proprietorships are the most common form of business entity and the simplest to establish, an important distinction between sole proprietorships and other entity forms is that the legal liability for all debts and obligations of the business lies with the owner. This has important consequences when a sole proprietorship hires employees.
In the United States, sole proprietorships may hire employees. In practice, very few sole proprietorships actually do so, and those that do typically hire employees for very limited functions. This largely relates to liability protection, because as the business grows and hires employees, the external liability risks increase. In a sole proprietorship, the obligation to satisfy the debts of the business rests with both the business and the owner. Since liability protection that will shield the business owner from many of the debts and obligations of the business is readily obtainable in the U.S., most businesses that grow large enough to hire employees will get this protection, although it is not legally required.
Liability protection is generally available in the U.S. to businesses that incorporate or register as a limited liability company (LLC). Both incorporation or LLC registration allows many of the debts and obligations to remain within the business. Business creditors may not pursue the business owners for repayment of business debts from personal funds. This limitation on liability is far from absolute, however. It does not, for example, extend to business owners' criminal acts or to instances where business and personal funds are largely co-mingled.
Registration or Incorporation
In the U.S., registration or incorporation is governed by the individual states. As a result, each state has a different set of registration and incorporation standards. Typically, registration as an LLC is more simplified than incorporation, and while both involve the payment of fees and completion of forms, neither method tends to be overly onerous. Different taxation rules usually apply to corporations, although LLCs may generally continue the same tax-accounting methods used by a sole proprietorship.
A sole proprietorship wishing to hire employees will typically need to file for an employer identification number, or EIN, with the Internal Revenue Service. The EIN is used to identify the business when the employer files federal payroll tax returns and issues year-end tax documentation. The IRS does not charge a fee to obtain an EIN.
Employee vs. Independent Contractor
Hiring employees requires significant documentation and record keeping by the employer. This includes numerous periodic tax filings to the federal and state government and compliance with federal and state employment law. Hiring employees also involves the payment of Social Security, Medicare and unemployment taxes.
As a result, many sole proprietorships will initially seek to classify employees as independent contractors, to whom most employment requirements do not apply. Classification as an employee or an independent contractor is based on numerous factors, primarily involving the way tasks are assigned and performed.