The Financial Structure of a Sole Proprietorship

When you start a sole proprietorship, you must separate your personal finances from your business. This helps you prepare financial statements (so you know whether you're making or losing money) and prepare tax returns. Weltman suggests establishing the following to set up business finances:

A business bank account. Use this account only to deposit business income and pay business expenses.
A business credit card. Use this card only for business expenses.
Business recordkeeping. Software or online solutions can simplify recordkeeping.

"Keep business finances and records separate from your personal activities to show the IRS that you are conducting the activity with the intent to make a profit, so that losses, which often occur during start-up years, will be deductible," Weltman adds.

"If you start co-mingling personal and business finances it can get messy in terms of taxes and family," Osteryoung adds.

Be prepared for paying taxes. As a sole proprietor you must file an annual return with the IRS to report your business income and expenses; use Schedule C (or, if eligible, a simplified Schedule C-EZ), which is part of Form 1040. If you do not have employees, then the business can operate under your Social Security number, Weltman says. However, once you hire staff or set up a retirement plan, you'll need a federal employer identification number (EIN), which you can obtain online at no cost from the IRS.

"If the business is profitable, you will owe self-employment taxes," Weltman says. "These taxes cover the employer and employee share of Social Security and Medicare taxes."

Because you are self-employed, you do not have withholding from a paycheck to cover your tax obligations. Instead, you pay income and self-employment taxes through quarterly estimated tax payments (you should set aside money on a regular basis to cover these payments). "When you file your return for the year, you will then pay any shortage or receive a refund if you've overestimated your quarterly payments," Weltman says.

Check with your locality to learn about sales tax collections. You may be required to collect sales taxes on the goods and services you sell and to turn over your collections to the state, as well as to report on collections on sales tax returns.