What Is Sole Proprietorship and How Does It Affect Your Taxes?

One of the decisions that must be made when you’re starting a business is what business formation works best for your needs. In the event you are going it alone or joined by a spouse, chances are you’ve elected for a sole proprietorship. When you and a spouse join together to run a business and elect for a sole proprietorship, you’ve agreed to basically be counted as one person.

Entrepreneur Magazine defines a sole proprietorship as “A business that legally has no separate existence from its owner. Income and losses are taxed on the individual’s personal income tax return.” Remember, even a sole proprietorship may operate under a business name, either as the name of the person or as a “DBA” (“doing business as”) name.

Types of Business Ventures

Some entrepreneurs are surprised at the range of business ventures that can be run effectively as a sole proprietorship. For example, you may be aware that many home-based businesses are run as sole proprietorships, but sole proprietorships don’t have to be a one-person operation. Many businesses with employees elect to form as sole proprietorships, including consulting businesses, direct mail businesses, and retail trade businesses.

Sole Proprietorship and the IRS

The Internal Revenue Service (IRS) allows sole proprietors to deduct business losses on their personal tax returns which may help reduce the amount of self-employment tax owed. However, there is a caveat to this: You must be operating the business in order to make a profit. Now this may make you wonder — why else would someone operate a business? The IRS is clear: If you do not make a profit in three years out of five, you have a hobby and not a business, and your losses are not deductible.

Taxes: Filing, Paying, and Burden

Unlike most other business entities, a sole proprietorship is not a taxable entity in and of itself. Income, expenses, debts, and other obligations are the sole responsibility of the owner of the business. This means that you will file your standard Form 1040 but you will also be required to file a Schedule C to claim your income, expenses, and gain/loss. But it doesn’t end there: There are other taxes that you will be responsible for, including Social Security and Medicaid. To calculate these taxes, you will have to file Form SE with your other forms when you file your federal tax returns.

Social Security and Medicaid Taxes

When you work for someone else, you pay one-half of these taxes through automatic payroll deduction and your employer pays the other half. When you are a sole proprietor or any self-employed person, you are responsible for 100 percent of the taxes due for both. Keep in mind, you will pay these taxes regardless of your age, how much you make, and even if you are already collecting social security benefits. The combined amount (for earnings in 2014) is 15.3%, which is 12.4% for Social Security and 2.9% for Medicaid. This amount applies anytime your net earnings exceed $400.

Paying Quarterly Taxes

For most sole proprietorships, filing quarterly taxes will be a requirement. The Internal Revenue Service requires any sole proprietorship who anticipates owing a minimum of $1,000 in taxes for the year to file an estimated quarterly return. There are specific due dates for quarterly taxes and even if you wind up paying the full amount owed over the  course of the year, you could still be penalized and forced to pay penalties if you underpay your quarterly tax filing. Keeping accurate records is imperative when you are self-employed and earning regular income.

Sole Proprietors and State Taxes

In addition to your federal tax burden you will also have to review the requirements for your state income tax filing. Many states also require sole proprietors to file a quarterly return. Keep in mind, you are filing taxes as an individual but your tax burden will not be the same as if you were not running a business.

Reducing Your Tax Burden

Accurate record keeping will be very important to ensuring you are taking full advantage of the business tax deductions you are entitled to claim. For example, if you work from your home and you have a dedicated phone line, dedicated office space, and you use your automobile partially for business purposes, you may use these expenses to reduce your tax burden. It is also important to note there may be taxes you’ve paid that may be partially deductible on your returns.

There are other common deductions such as health insurance, a separate liability policy for your business, and contributions to a retirement plan which may also help reduce your tax burden as a sole proprietor. If you are not familiar with all of the deductions that you may be entitled to take, it is a good idea to review the rules set out by the Internal Revenue Service and your state’s taxing authority. If you are still uncertain, it could be worth paying a tax preparer (which is also a deductible expense) to handle your tax returns on your behalf.

A sole proprietorship is one of the most common business entities used by those who are working for themselves and have no employees. However, this does not mean you don’t have to follow the rules set out by the Internal Revenue Service and your state taxing authority. In fact, the rules may be even more stringent as there is a higher burden of proof that you are running a business and not involved in a hobby.