How Many Employees Can a Sole Proprietorship Have?
For a sole proprietor, the question isn't how many people you can hire, but how you manage the resulting shift in personal liability and legal duties.
As a sole proprietor, you can hire employees to help grow your business. Legally, there is no limit on the number of employees a sole proprietorship can have. However, adding employees introduces significant legal and financial responsibilities. The decision to hire should be weighed against these new obligations, as they can add complexity to your operations.
The Direct Answer and Its Implications
There is no federal law that restricts the number of employees a sole proprietor can hire. The primary implication of hiring as a sole proprietor is the unlimited personal liability inherent in this business structure. Since the law views the owner and the business as a single entity, there is no legal separation between your personal and business assets.
If an employee were to sue the business, your personal assets—such as your home, car, and savings—could be at risk to satisfy business debts or legal judgments. This personal risk extends to liabilities that may arise from the actions of your employees while they are on the job.
Differentiating Employees from Independent Contractors
Before bringing on help, a sole proprietor must correctly classify the worker as either an employee or an independent contractor. Misclassifying a worker can lead to significant tax penalties. The Internal Revenue Service (IRS) provides guidelines to help make this distinction, focusing on three main categories of control.
The first category is Behavioral Control, which examines whether the business has the right to direct and control how the worker does their job. This includes the level of instruction the business gives, such as when and where to work, what tools to use, or how to complete the tasks.
The second category, Financial Control, looks at who controls the economic aspects of the worker’s job. This involves how the worker is paid, whether expenses are reimbursed, and who provides the necessary supplies and equipment.
The final category is the Relationship of the Parties, which considers how the worker and business perceive their relationship. This is evidenced by written contracts, whether the business provides employee-type benefits like insurance or vacation pay, and whether the services performed are a key aspect of the business. An independent contractor has more control over their work, uses their own tools, and may work for multiple clients.
Employer Responsibilities for Hiring
Once you decide to hire an employee, you must obtain an Employer Identification Number (EIN) from the IRS. An EIN is a unique nine-digit number that identifies your business for tax purposes, and it is required if you have employees. You can apply for an EIN for free on the IRS website.
Next, you must manage federal and state payroll taxes. This involves withholding federal income tax, Social Security, and Medicare taxes from your employees’ paychecks. You are also responsible for paying the employer’s share of FICA taxes, paying Federal Unemployment Tax (FUTA), and state unemployment insurance (SUI).
Workers’ compensation insurance is mandated at the state level, and each state has its own laws regarding which employers are required to carry it. This insurance provides benefits to employees who get injured or become ill on the job. You must also complete new hire paperwork for each employee, including Form I-9 to verify their legal right to work and Form W-4 to determine tax withholding.
Considerations for Hiring Family Members
Hiring family members in a sole proprietorship involves unique tax rules that differ from those for other employees. When a sole proprietor hires their spouse, the spouse’s wages are subject to federal income tax withholding, as well as Social Security and Medicare taxes. However, payments to a spouse are exempt from FUTA taxes. It is important that the spouse is a legitimate employee performing necessary job functions for the business.
The rules for hiring a child also have specific tax advantages. If you hire your child who is under 18, their wages are not subject to Social Security and Medicare taxes. Furthermore, wages paid to your child under 21 are exempt from FUTA taxes. Regardless of age, you are still required to withhold federal income tax from your child’s pay. These exemptions only apply if your business is a sole proprietorship or a partnership where each partner is a parent of the child.
When to Consider a Different Business Structure
As your business grows and you hire more employees, the unlimited personal liability of a sole proprietorship becomes a more significant concern. Each new employee increases the potential for business-related risks, such as workplace accidents or legal disputes. At this stage, it may be prudent to consider changing your business structure to one that offers personal liability protection.
The most common alternatives are a Limited Liability Company (LLC) or a corporation. An LLC is a legal entity that is separate from its owner, so your personal assets are generally shielded from business debts and lawsuits. Forming an LLC or corporation involves more administrative requirements and costs, but the liability protection they provide can be a worthwhile trade-off.