The goal of most small businesses is to grow and that usually means recruiting new team members to help manage the increased volume. Even sole proprietorships can hire employees, albeit with some risks. Sole proprietors that are expanding may eventually want to restructure their business for liability protection.

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What is a sole proprietorship?

Before exploring the answer to “can a sole proprietor have employees?”, it helps to first understand the business model. A sole proprietorship is unincorporated and owned and operated by one person, making it one of the simplest ways to structure a business. In the eyes of the IRS, the owner and the organization are the same entity. This means that a sole proprietor not only receives all of the business’s profits, but is also responsible for its debts, losses and liabilities.

Can a sole proprietor have employees?

Sole proprietors can and do employ people. Many start with family members, but hiring people, whether the person is a relative or not, adds another layer of complexity to business management. Sole proprietors will need to pay their employees, file and remit payroll taxes, and comply with employment regulations. Different tax requirements may apply, however, if the employee is a spouse or a child.

Hiring a spouse

If a spouse is a bona fide employee and not a business partner, the sole proprietor doesn’t have to pay federal unemployment tax (FUTA) on their spouse’s income. Spouses are still subject to federal income tax and federal insurance contribution act (FICA) taxes, though.

Hiring children

Sole proprietors who hire their children withhold taxes differently, depending on the child’s age. Basic guidelines are as follows:

  • Children under the age of 18 are not subject to FICA taxes
  • Children under the age of 21 are not subject to FUTA taxes
  • All children, regardless of age, are subject to federal income tax

What is needed when hiring?

Now that we know the answer to “can sole proprietors have employees?”, the next step is to actually hire some. To do that, sole proprietors generally must fulfill these compliance-related responsibilities:

  • Apply for an employer identification number (EIN)
    The federal government issues EINs to businesses for tax administration purposes.
  • Gather employee documentation
    Employees are required to complete Form W-4, Individual Withholding Certificate, so that their employer can determine the correct amount of income tax to withhold from their wages. They also need to certify that they are legally authorized to work in the United States by filling out Form I-9, Employment Eligibility Authorization.
  • Document employee policies and procedures
    Even the smallest of businesses should have official policies or an employee handbook. Such documentation typically covers at-will employment status, pay schedules, benefits eligibility, equal employment opportunities and certain other notifications required by law.
  • Obtain workers’ compensation insurance
    Most states require businesses with one or more employees to carry workers’ compensation insurance. It pays for the rehabilitation, recovery or medical bills of employees’ work-related injuries, as well as the resulting lost time.
  • Display workplace posters
    The Department of Labor (DOL) and state and local labor departments require businesses to display certain workplace posters. Failure to display the correct information can result in a citation and/or a penalty.
  • Set up a recordkeeping system
    Anyone who is hiring and paying people must keep certain information about each employee on file for specific lengths of time. Examples of mandatory payroll records include, but are not limited to name, date of birth, regular pay rate, hours worked, overtime pay, deductions from wages, pay dates, etc.
  • Choose a payroll method
    Sole proprietors may be tempted with manual approaches to running payroll and filing taxes, but the process can be complicated and carries a high level of risk if there are errors. Alternatively, outsourcing payroll and tax administration to an experienced provider, like ADP, can help save both time and money.

How do sole proprietors pay employees?

Sole proprietors pay employees much like larger businesses, just on a smaller scale. Here are the basic steps:

  1. Calculate gross pay
    For non-exempt, hourly workers, employers multiply the total hours worked by the hourly rate. If any overtime is incurred, then the employer would also have to multiply the number of overtime hours worked by the applicable overtime rate and add it to the base pay. For exempt employees who earn a salary, employers divide the annual salary by the number of pay periods.
  2. Withhold pretax deductions
    If the employer sponsors a health care or retirement savings plan that is funded on a pretax basis, they deduct employee contributions to those benefits.
  3. Withhold statutory deductions
    Employers are required to withhold federal income tax, FICA taxes and any other applicable state or local taxes.
  4. Withhold post-tax deductions
    Post-tax deductions apply to some types of voluntary benefits and wage garnishments, if necessary.
  5. Pay employees
    Employers can pay employees via direct deposit to their bank accounts or depending on state law, may use another electronic method, such as paycards. Traditional paychecks are also permissible in all jurisdictions.

What forms does a small business need to have for its employees?

In addition to the previously mentioned Form W-4 and Form I-9, sole proprietors may need their employees to supply any of the following paperwork:

  • Completed job application and signed offer letter
  • State withholding certificates, if different than the federal Form W-4
  • Bank account information for purposes of direct deposit
  • Signed recognition of the employee handbook or company policy
  • Authorization forms for participation in health care or retirement savings plans

The actual documentation required will depend on the individual business and state of employment.

Sole proprietorship vs self-employed and freelance

It’s not uncommon for a sole proprietor to also be a freelancer. Both pay self-employment taxes and report their income to the IRS using Schedule C (Form 1040), Profit or Loss from Business. The primary distinction between the two roles lies in the nature of their work.

When self-employed individuals sell goods or services directly to a consumer, they’re acting as sole proprietors. If another business outsources a project to a sole proprietor, then that person is an independent contractor. Freelance work also requires the payor to issue a Form 1099-NEC, Nonemployee Compensation, which reports payments made to independent contractors.

Do employers have to carry workers’ compensation insurance on independent contractors?

Workers’ compensation only covers the bona fide employees of a business. Sole proprietors and independent contractors who work in potentially hazardous environments may need to purchase their own insurance policy to protect themselves.

At what point should a business upgrade from a sole proprietorship?

The decision to restructure a sole proprietorship depends on individual circumstances and should be carefully weighed with a knowledgeable attorney and/or tax professional. On one hand, sole proprietors avoid double taxation and enjoy lower tax rates than other types of business. On the other hand, there is no separation between personal and business assets, which means that property, vehicles, savings accounts, etc. could be jeopardized in a lawsuit or claim.

Changing business structure

Restructuring a sole proprietorship as a limited liability company (LLC) provides liability protection against the actions of employees. Other benefits include pass-through taxes and financial credibility with lenders. If business owners decide that this structure is the best choice for them, the general steps are to:

  1. Choose a name that’s not already in use
  2. File articles of organization with the state
  3. Document operating procedures
  4. Pay the requisite fees to the state
  5. Publicly announce the LLC

Frequently asked questions about sole proprietorships

How many employees can a sole proprietor have?

There is no right or wrong number of sole proprietorship employees. However, because sole proprietors are personally liable for the actions of their employees, many restructure their business as it grows. LLCs, in particular, are popular options because of the liability protections they afford.

Can a sole proprietor have employees who receive a Form W-2?

Sole proprietors, like other businesses, have the option of hiring bona fide employees or outsourcing work to independent contractors. In either case, they must be careful to avoid misclassifications, which can result in costly penalties.

Can a sole proprietor pay themselves a salary?

Sole proprietors are not employees and, thus, cannot earn a salary. Instead, they receive payment via an owner’s draw from their business equity.

This article is intended to be used as a starting point in analyzing sole proprietorships and is not a comprehensive resource of requirements. It offers practical information concerning the subject matter and is provided with the understanding that ADP is not rendering legal or tax advice or other professional services.