Those seeking to turn a hobby into a business or who want to do some side work in Alabama should consider starting a sole proprietorship business. Alabama is full of opportunities for those seeking to supplement their income or launch a startup.
That decision could be affected by the rules and regulations of the state. Before you head to the heart of Dixie, it’s best to understand all the requirements that sole proprietors face in the state of Alabama.
What is a sole proprietorship?
A sole proprietorship is a form of business. It’s considered an unincorporated business since it doesn’t need to be registered with the state, which has a single owner. For tax and legal purposes, the business and the owner are considered the same entity. This is the simplest version of a business that one can form, and many people who freelance or sell goods are operating as a sole proprietor without realizing it. Because there is no separation between the business and the owner, the owner is personally responsible for all of the business’s debts and litigation that the business is named in.
Who is a sole proprietorship best for?
By definition, a sole proprietorship is a business with a single owner. Anyone looking to form a partnership or have multiple owners should choose a different structure. A sole proprietorship will be a good fit for someone looking to maintain total ownership of their business who is willing to take on the liability associated.
Because a sole proprietorship is simple to start and requires no fees or paperwork, it can be a good option for anyone who needs to get a business up and running quickly. It can also offer a good test case for a business idea without any upfront requirements.
It can be more difficult to get funding and credit in a sole proprietorship, so if investments are required, having capital at the start can make this structure easier.
How to set up a sole proprietorship in Alabama
1. Choose your business name
Alabama law allows you to operate a sole proprietorship under a name other than your own. While you can use your name, most people choose a specific business name. If you want to do this, you should first search the Alabama Department of State’s website to see if the name you chose is taken or if something similar exists.
In Alabama, a business name must not:
- Match any company doing business in the state
- Be misleading
- Use any certain government agency terms or abbreviations like FBI or EPA
2. File a trade name
First, you need to make sure your trade name is unique and original. You can do that by going to the state legal entity records website and list some words you want to use in the search engine to see what comes up.
Once you pick a name, you need to start using it even before you register it. Alabama law requires at least three acceptable business items with the name on them in order for you to claim it and for you to be protected by your doing-business-as (DBA) name.
Acceptable items are business cards, flyers, decals, labels, and brochures. You must also pick the classification of your business according to the state schedule.
You can then file for it with the State of Alabama either online or by mail. Trade names are considered trademarks. The total cost of filing a trade name is $31.20 online and $30 if applying by mail. Renewals are $10 yearly.
3. Obtain licenses, permits, and zoning clearance if needed
Depending on the industry of your business, you may need to obtain a variety of business licenses or permits. This is managed by the Alabama Department of Business and Professional Regulation (DBPR), though some areas like health care are licensed by independent areas.
You should also explore local regulations like building permits and zoning clearances where appropriate.
Sole proprietors in Alabama aren’t required to have a general business license from the state. However, they are required to have a privilege license issued by the probate judge in the county where the business is located. The license is good from Oct. 1 through Sept. 30 and must be renewed by Sept. 30 yearly. The fee is subject to local ordinances.
Local municipalities may have other types of fees, depending on your business. They could include contractor fees, zoning fees, and fees for home businesses. Depending on your occupation, you could also face professional licensing requirements. These can be required for people like hair stylists, dentists, nail technicians, and others.
You should check with the local city or county clerk to find out all the licensing and permitting requirements for your business.
4. Obtain an Employer Identification Number (EIN)
If you’re planning a new hire, you need to obtain an EIN. This nine-digit number is issued by the IRS and used for tax purposes when you need to report wages. You can file for an EIN online through the IRS website.
If you do not have employees, you can use your Social Security Number to file taxes and are not required to have an EIN. However, some banks will require new business owners to have an EIN and a business plan to open a business bank account or apply for a business loan.
Once you have these pieces in place, you’re officially a small business owner. You can begin thinking about things like marketing materials, landing your first clients, and how you want to grow over time.
How is a sole proprietorship different from an LLC or freelancing?
Anyone who does work on a freelance basis can technically be considered a sole proprietor of their business. They will pay taxes individually and usually operate under their own name, assuming liability associated with their work. However, there are a number of ways the two can differ.
A sole proprietor is able to hire employees and is responsible for employment taxes, while a freelancer usually cannot do this without filing paperwork and effectively becoming a sole proprietor. Freelancers also do not have to adhere to the same local regulations that a business might and cannot purchase the same types of insurance. A freelancer is considered somebody who has a relationship with external clients, while a sole proprietorship operates as a small business.
In contrast, an LLC is another possible business structure for small businesses. An LLC, or limited liability company, must file articles of organization and register with their state. This also protects the owner (or owners, as an LLC can have multiple) from personal liability, and the business is treated separately for tax purposes. Because of this separation, LLCs are often given larger lines of credit or more likely to attract future investments in times of growth.
What are the advantages of a sole proprietorship?
Fast and inexpensive startup
Unlike other business structures, a sole proprietorship does not have to register with the state or pay the associated fees. If a fictitious name is being used, there may be a registration process for the trade name, but it is optional. This lack of paperwork and cost means that you can start a sole proprietorship almost immediately and without bureaucracy.
In a sole proprietorship, all profits and losses for the business are included in the owner’s individual tax returns. This leaves the owner responsible for state, local, and federal taxes that include their business, but they are not subject to corporate tax rates or specific business taxes. Additionally, being self-employed offers tax credits and benefits to the owner.
Complete control over your business
The sole proprietor of a business has complete control and is responsible for all decision-making within the business. With no partners or shareholders, you are free to run your business as you choose and take risks without implicating others.
What are the cons of a sole proprietorship?
Because the owner and the business are the same in a sole proprietorship, it can leave the owner vulnerable in multiple ways. Any business debts that the business owes are also considered personal debt, and any lawsuits against the business also implicate the owner. If these result in collections or seizures, the owner’s personal property can be taken in order to meet the obligations of the business.
Difficulty with funding
If a sole proprietor wants to raise capital, they may have fewer options to do so. Without stock in the business to sell, investors are less likely to get involved. Banks may also be less inclined to offer credit because the owner will be responsible for the loans in the end.
Risks of hiring employees
As long as they have a valid Employer Identification Number, a sole proprietor is able to hire employees as needed. However, if any legal issues arise related to an employee, it could put a strain on the owner as their own assets are on the line for lawsuits and other costs.
How are sole proprietors taxed in Alabama?
With this type of business, taxes are a part of the personal tax return of each owner. Business profit is calculated and reported on a Schedule C form which is for Profit or Loss from Small Business.
A Schedule C will calculate the income of the business, including all income and expenses, along with the costs of goods sold and costs for home-based businesses. The rest of the calculation is the net income, which is the amount of taxable business income.
This net income is entered on the Schedule C and included with other income and losses the owner (and their spouse) report for the purpose of income taxes.
The owner then pays income tax on all of the income listed on their personal income tax return, including income from business activity at the applicable rate for the year.
Alabama doesn’t have a specific or unique tax rate for sole proprietorships. Those operating a sole proprietorship are expected to report their income on the federal and state income tax returns, both of which are due April 15.
The State of Alabama will follow the federal government in allowing extensions. Those granted an extension by the federal government will be given one by the state.
Alabama tax rates fall into three categories, 2%, 4%, and 5%. The state Constitution stipulates it can never exceed 5 percent. The rate individuals pay depends on two things and they are your adjusted gross income and which filing status you choose.
As a self-employed individual, there are additional tax payments the sole proprietorship is obligated to pay. Based on the business’ income, the sole proprietor must pay Social Security and Medicare taxes. If your own business operates at a loss, the tax is not payable, but you will not receive benefit credits for that year.
There may be other employment taxes and property taxes that are applicable.
Alabama, like every state, has an array of taxes that could apply to a sole proprietorship, depending on the business. The general consumer’s use and a general rental tax are 4% each, but the rental tax on linens and garments is only 2%. The sales tax for vending is 4%.
Alabama’s median real property tax rate is 3.33 per every $1,000, making it one of the lowest of all 50 states. It has long been low with a .50 percent rate in 2019. Property taxes are due between Oct. 1 and Dec. 31. They are late after Dec. 31.
Those in a sole proprietorship don’t pay themselves a salary. Any profit after paying business expenses is your pay. Alabamans can’t deduct their pay on tax forms as a business expense either.
You report them on your individual tax return. The federal and state tax returns should have a listing of all losses or profits. The business isn’t taxed separately as the Internal Revenue Service (IRS) calls it a pass-through tax.
No, those who are self-employed are a sole proprietor even if they don’t register for a trade name or set up a formal business. Their name is their business name.
Both have advantages. A sole proprietorship is easy to start and doesn’t require a lot of annual reporting. An LLC has an advantage in that you don’t assume any liability as you do in a sole proprietorship, so it protects your personal assets.
Those who are sole proprietors can get tax refunds if they have paid more taxes than their tax liability.
An Alabama sole proprietor doesn’t need to submit any 1099 forms unless they hire subcontractors or contractors. They don’t have any employees but can hire contracted workers.
You can deduct the entire cost of a vehicle if you only use it for business. Otherwise, you can deduct the mileage and a portion of other things for business use.
You can choose how you pay taxes but most advise to pay quarterly. Otherwise, you will pay for the full year when you file your individual taxes.