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Does a small company that operates as a sole proprietorship need an employer identification number (EIN)?

Friday, January 10, 2014

How to know if your business needs an EIN

When it comes to starting and running a small business, there are a lot of questions that will come up. From running the day to day operations to knowing how to file your taxes correctly, there can be a big learning curve. So, in this article, we’ll take a look at sole proprietorships and lay out the scenarios when sole proprietors need to obtain an Employer Identification Number (EIN). To start, let’s first define a sole proprietorship.

What’s a sole proprietorship?

If you’re just starting out as a business, you’ve probably already heard terms like sole proprietorship, limited liability company, corporation, and others. But what do those terms mean for you, the business owner? In this section, we’ll focus just on sole proprietorship.

Sole proprietorship is a type of unincorporated business entity with a single owner. If you’re already operating your business by yourself, chances are you are a sole proprietor. It’s the simplest and least expensive type of business, and you’re considered a sole proprietorship unless you’ve formally adopted another business structure.

The biggest characteristic of a sole proprietorship is that there is no legal separation between the business and business owner. That means that the owner is personally liable for business debt and personally responsible for all business income. You’ve probably already interacted with sole proprietors without knowing – a photographer, a craftsman, or a person selling goods online are all self-employed sole proprietors. Now that you know about sole proprietorship, let’s define EINs.

What’s an EIN?

An EIN is a nine-digit number that identifies your business for tax purposes. You’ll use this identification number for many business activities. From filing taxes to applying for a business bank account or taking out a business loan, obtaining an EIN is an important step for a business owner like you. The EIN, sometimes referred to as a federal tax identification number, gets issued to your business by the Internal Revenue Service (IRS).

It may be helpful to think of the EIN as your business’s equivalent to a Social Security Number (SSN). While you’ll use your SSN for many different purposes, it’s a way to confirm your identity to the IRS. Similarly, if you have a business EIN, that number helps to identify your business as a unique entity. So, if you’re running your business as a sole proprietorship, do you need an EIN?

Does a sole proprietor need an EIN number?

Most of the time, if you’re a sole proprietor and you have no employees, you don’t need to obtain an EIN. Because there’s no separation between the business and business owner, you can use your SSN in place of an EIN. However, there are a few exceptions for when you may need an EIN as a sole proprietor:

  • You are subject to a bankruptcy proceeding.
  • You change your business to a corporation.
  • You take on partners and form a partnership.
  • You change your business to a multiple-member Limited Liability Company (LLC).
  • You change your LLC to be taxed as a corporation or S corporation.
  • You buy or inherit an existing business that you operate as a sole proprietorship.

As you can see, these are not common scenarios for many small businesses. So, generally speaking, your business as a sole proprietorship does not need to obtain an EIN. However, if you operate a different business that isn’t a sole proprietorship, here are the circumstances in which you do need an EIN:

  • You have employees.
  • You are operating your business as a corporation or partnership.
  • You have an LLC taxed as a corporation or S corporation.
  • You file an employment tax return, excise tax return, or alcohol, tobacco and firearms return.
  • You withhold taxes on income paid to a non-resident alien.
  • You have a Keogh plan (a tax-deferred pension plan).
  • You administer an estate or trust.
  • You are involved with non-profit organizations, farmers' cooperatives, real estate mortgage investment conduits, or plan administrators.

If your business doesn’t fall into any of these requirements but you’d still like to obtain an EIN, you can. In fact, there are some benefits of an EIN that go beyond the legal requirements. Let’s look at some of the biggest benefits.

The benefits of an EIN

Although you may not deem it necessary to obtain an EIN as a sole proprietor, it can be beneficial for a number of reasons. Let’s look at some of the most common advantages of obtaining an EIN.

Filing business taxes

While it’s not required to have an EIN as a sole proprietorship, it can help you when it comes tax time. That’s because an EIN provides you with credibility. In cases where you’re looking to deduct business expenses (like a business home office), an EIN can help lower the chances of an IRS audit.

Protecting against identity theft

Because an EIN helps you keep your business finances separate from your personal finances, it’s a great way to help you prevent identity theft. Once you have an EIN, you’ll provide that number to business clients or vendors instead of your personal SSN. This helps shield your SSN from being exposed since it’s on fewer documents. In turn, that lowers the chances of a thief stealing something as valuable as your SSN.

Lending credibility to freelancers and independent contractors

One way to help your credibility with freelance clients is to make sure you have an EIN. Once you secure the project, you’ll provide them with your EIN number instead of your SSN. This helps you by adding credibility to your name and signifying that the work you’re performing is more than just a side gig – it’s a serious business. An EIN can signify to those around you that your business is not just a hobby.

An EIN is also less often confused with a SSN, so that helps to prove that you’re an independent contractor and not a W-2 employee.

Opening a business bank account

Although some banks allow sole proprietors to open a business bank account without an EIN, others require it. Therefore, if you’re looking to keep your business and personal finances separate, you’ll most likely need to get an EIN. Not only will you have to show your EIN, but you’ll also have to provide other documentation such as your business license.

Building trust with vendors

If you’re a small business owner, you know how hard it is to do everything yourself. But having an EIN makes it easier since third party businesses are more likely to work with a business who has an EIN. That’s because they may want to check your business credit or require you to have an EIN before doing business with you. Again, an EIN shows that you’re a credible business who will pay vendors on time.

Establishing business credit

One key piece to establishing your business credit is an EIN. Like your personal credit history, a business credit history measures your trustworthiness. This credit history is an evaluation of your company’s history of bill payment and financial responsibility.

As a business, you’ll have a commercial credit report that contains a summary of your business’s credit accounts and payment history. This is a full record of your credits – loans, business credit cards, and vendor and supplier payment history. Therefore, paying on time and in full (just like with personal credit cards) is key to establishing and maintaining good business credit. A higher credit score indicates more trustworthiness and can help you get lower rates on business loans.

Now that you’ve seen why a sole proprietorship would choose to get an EIN, how do you obtain one?

How do I get an EIN?

As a small business owner, the process to obtain an EIN is easier than you might think. First, it’s important to note that obtaining an EIN is free. If the applicant has a SSN or other tax identification number (such as an ITIN), any business in the U.S. or U.S. territories can qualify. The person who submits the EIN application doesn’t even need to be the business owner. The IRS allows the applicant to be any “responsible party,” which means anyone who manages the company’s finances. Obviously, if you’re a sole proprietorship, this would be you.

When you’re applying, you’ll need to have a few documents to complete the application process.

To start, make sure you have the following:

  • Business details, such as your business name and address.
  • The name of the principal owner or controller of the business.
  • Taxpayer identification number (TIN) of the responsible party.
  • Type of entity (sole proprietor, partnership, corporation, etc.).
  • Date the business started or was acquired.
  • The highest number of employees expected in the next 12 months.
  • Reason for applying for an EIN.
  • Principal activity or line of merchandise for the business.
  • Whether or not the entity has applied for an EIN before.

Then, you have a few ways to submit your application: Online using the IRS website, by filling out IRS Form SS-4, Application for Employer Identification Number, and mailing or faxing this form, by phone, or with the help of a qualified accountant. For those who want an EIN immediately, submitting online is the fastest way to obtain one. After you complete the online application form and your information gets verified, the IRS will issue you an EIN. And once you receive it, you can start using your EIN.

As we mentioned earlier, obtaining an EIN is free, regardless of how you apply for one. Having said that, be wary of companies who try to charge you to get one. It’s best to go directly to the IRS website and complete the application.

In this article, we’ve discussed EINs for sole proprietors. While not a legal requirement, there are some instances where you may be required to have an EIN. But, even if you’re not required to have one, they can provide your business with benefits that can help your business keep moving forward.

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