Can a sole proprietorship have employees?

Perhaps you've been wondering, "Can you hire employees as a sole proprietor?" The answer is yes, but it comes with new responsibilities. The moment you hire your first employee, your legal and tax obligations change.

Because sole proprietors have unlimited personal liability, a workplace injury, lawsuit, or other issue could put your personal assets at risk. That's why following local, state, and federal employment laws, as well as maintaining good insurance coverage, is essential.

Let's break it down so you can understand what's involved in hiring employees as a sole proprietor. We'll also cover how you can protect your business and personal assets.

For legal and tax purposes, hiring employees differs significantly from working with independent contractors. Employees work under your direction and control, while independent contractors operate their own businesses and decide how to complete the work you’ve hired them to do.

Contractors typically handle their own tax requirements, whereas business owners who hire employees are responsible for withholding taxes and complying with labor laws.

You might be wondering, “How many employees can a sole proprietor have?” There’s no legal limit on the number of employees you can have. Your business structure doesn't restrict your ability to grow or expand your operations.

However, once you pay wages to your first employee, you take on federal and state employer responsibilities. These obligations are required by law, and failing to meet them can lead to costly fines and penalties.

Workers’ compensation insurance is required in nearly every state as soon as you hire your first employee. This coverage pays for medical expenses and lost wages if an employee is injured or becomes ill because of their job.

Most policies also include employer’s liability coverage, which provides important protection for you as the employer, since employees who receive workers’ comp benefits typically can’t sue for workplace injuries. The insurance company would then handle the claim and pay the benefits, which protects your business from expensive lawsuits.

As a sole proprietor, your business and personal assets aren't separate, which means coverage is essential. Without workers' compensation insurance, for example, an employee who suffers a serious work-related injury could sue you personally instead of your business. That means your home, savings, vehicle, and other personal assets could be at risk.

As a sole proprietor, the way you pay yourself is very different from how you pay employees. You don't receive a salary. Instead, you take an "owner's draw," where you withdraw money from your business account for personal use. No taxes are withheld from these payments. Instead, your business income is reported on your personal tax return using Schedule C.

Employees are paid regular wages, and you're responsible for withholding federal and state income taxes, as well as their share of FICA taxes for Social Security and Medicare. At the end of the year, you must provide each employee with Form W-2 by January 31, which summarizes their earnings and tax withholdings.

Regardless of whether your business is a sole proprietorship or a limited liability company (LLC), you’ll need to keep employee and financial records to stay compliant.

As an employer, you're legally required to maintain detailed financial records. You must track payroll information, tax withholdings and deposits, insurance payments, hiring documents, tax deductions, and other information. This can be simplified by using bookkeeping software, like QuickBooks or Xero, and working with a payroll service provider.

Maintaining accurate records can also work in your favor. Employee wages are typically tax-deductible as a business expense on your Schedule C. Your financial records also support general liability insurance audits, workers’ compensation insurance audits, and premium audits. It helps demonstrate that you're legally compliant as a small business employer.

A sole proprietorship is the simplest type of business entity. It makes it easy for new business startups to quickly get off the ground, but you could face limitations and liabilities if you remain a sole proprietor after hiring employees.

Here are some things to consider:

As a sole proprietor, there’s no legal separation between you and your business. If an employee is injured on the job or makes a mistake that causes property damage or harms a customer or client, you could be held personally responsible. Your home, savings, and other personal assets could be at risk.

If you need to raise capital to grow your business, it's usually harder as a sole proprietor. Banks and investors tend to view sole proprietors as riskier than other business entities. They may also be concerned about the lack of liability protection separating your business and personal assets.

Bringing on employees adds to your tax burden. You’ll pay self-employment taxes on all business profits and handle payroll taxes for your employees. Other business structures can help reduce self-employment taxes by allowing you to take a salary instead of an owner’s draw. An attorney or tax professional can help you determine which structure is best for your situation.

As a sole proprietor, your business may end if something happens to you. This could cause your employees to be concerned about long-term job security. It could also make it difficult for someone to take over the business.

Some clients, vendors, and potential employees view sole proprietorships as less stable or professional than LLCs or corporations. This perception could affect your ability to land contracts, obtain needed supplies or inventory, or attract the best workers.

When you hire employees, you'll have a lot more to handle to stay legally compliant. You'll have to handle payroll withholding, unemployment insurance, workers' compensation, workplace safety regulations, and ensure you're following all employment laws. These requirements can be time-consuming or expensive if you outsource them.

All these issues are why many sole proprietors consider changing their business structure when they hire employees. In some jurisdictions, businesses can become LLCs just by submitting a form and paying a fee.

Hiring employees increases your exposure to potential liabilities. An employee getting injured on the job, wrecking a company vehicle, injuring another motorist, or damaging customer property could put your personal assets at risk.

A limited liability company legally separates your business and personal assets. If your business is sued, for example, you likely won't lose your personal bank account, home, and other assets if there's a judgment or settlement.

Keep in mind that no business structure offers total protection, and courts sometimes "pierce the corporate veil" if the owner commingles personal and business funds or there are other compliance issues.

An LLC is simple and closely held. It provides much of the protection of a corporation, but it's easier to set up. Although an LLC isn’t required, most business advisors and attorneys strongly recommend making the switch once you begin hiring employees.

Growing a business often means additional responsibility. Yes, you can have employees as a sole proprietor, but that type of business structure puts your personal assets at risk. Forming an LLC is usually quick and easy. It legally separates your personal and business assets and protects them from lawsuits and other liabilities.

Although you can take care of these yourself, using the services of bookkeepers, payroll companies, and other professionals frees up time to run your business. It also ensures your payroll is accurate, taxes are filed on time, and all legal requirements are met.

Bringing on employees also means you'll be handling sensitive employee and payroll information. Don't forget about the importance of cybersecurity in your business operations. A data breach or cyberattack could result in identity theft, a ransomware attack, and other liabilities.

Be sure to enable multi-factor authentication on all accounts and use reputable, encrypted software.

It's easy to get insurance for your small business with Insureon. Just fill out our online application to receive quotes from trusted providers. Our expert insurance agents are available to answer any questions and help you find affordable small business insurance that fits your needs.

Most small business owners can get same-day coverage and easily download a certificate of liability insurance (COI) as soon as they purchase a policy.