Tax Aspects of Sole Proprietorships

A sole proprietorship is an unincorporated business with a single owner. It's the most commonly used form for new small businesses, and the easiest form to operate from a tax and recordkeeping perspective. If your business has only one owner, the IRS will presume that it's a sole proprietorship unless you incorporate under state law.

From the IRS's perspective, a sole proprietorship is not a separate taxable entity from the owner. All of the business's assets and liabilities are treated as belonging directly to the business owner. When tax time rolls around, all income and expenses generated by the business are reflected on either Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business. Whichever of these forms you use, it must be included as part of your annual individual tax return (Form 1040).

To give you a handle on how this form works, your gross revenue from sales and other business income items are reported on the top of the Schedule C or C-EZ. Expenses of the business are subtracted from income to arrive at the net profit (or loss) figure at the bottom of the form.

The net profit, or loss, is then carried over from the Schedule C or C-EZ and reported on page 1 of the owner's 1040. This means that there is no separate tax rate schedule that applies to a sole proprietorship — the business owner's individual tax rate will determine the amount of tax paid on the earnings of the sole proprietorship.

The main advantage of a sole proprietorship is simplicity. Because there is only one owner, it's easy to understand and comply with the accounting rules. Also, a business owner may transfer money in or out of the business without concern about tax effects.

Tip For example, when you pay yourself as a sole proprietor, you simply withdraw money from your business checking account — you don't have to issue yourself a paycheck and make payroll tax deductions. Similarly, if you decide to contribute some personal money to the business, you can simply add it to your checking account — you don't have to formally make (and keep track of) your capital contribution as you would with a partnership or a corporation, at least as far as the IRS is concerned.

Sole proprietors are generally required to pay self-employment taxes on all of the business's net profits, as computed on Schedule C or C-EZ. You must use Schedule SE of the annual income tax return to compute and report these taxes.

For each quarter, a sole proprietor generally needs to make an estimated tax payment that includes income tax and self-employment taxes.

A sole proprietor who sells a business asset or even the business itself is treated as if he or she sold each individual item that was included in the sale, and gain or loss on each item must be computed separately. Intangible assets, such as patents and copyrights, are considered assets of the business, and gain or loss is computed separately for them as well.

Beyond these basic issues, sole proprietors may face some notable distinctions in their tax situations.

• Some very small businesses may not need to file a tax form at all.
• Some businesses can file Schedule C-EZ, Net Profit from Business.
• Some huband-and-wife-owned businesses can use sole-proprietorship status.
• Statutory employees use Schedule C or C-EZ to report income and expenses.

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