Tax Aspects of Sole Proprietorships

A sole proprietorship can be defined as any unincorporated business with a single owner. It's the most commonly used form for new small businesses. 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, the business is not a taxable entity. Instead, 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 one of the owner's Form 1040, U.S. Individual Income Tax Return. There is no separate tax rate schedule that applies to a sole proprietorship. The business owner's individual tax rate (with a maximum rate of 35 percent for 2012 and 39.6 percent in 2013) 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, the accounting rules are much easier to understand and to use. Also, a business owner may transfer money in or out of the business with no tax effects to keep track of. 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.

Self-employment tax. While a sole proprietor does not have to worry about "withholding" on money that he, or she, withdraws from the business, he or she still faces payroll tax liability in the form of the Self-employment Tax. Sole proprietors are required to pay self-employment taxes on all of the business's net profits, provided the net earnings are more than $400 in a year. Schedule SE of the annual income tax return must be used to compute and report these taxes.

Among the Business Tools are Form 1040, Schedule C, Schedule C-EZ and Schedule SE. They are in Adobe Portable Document Format (.pdf), and you will need the free Acrobat Reader to view and print the file.

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

Sales of business assets or business. 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 separate gain or loss is computed on 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 husband and wife businesses can use sole-proprietorship status.