Tax Savvy for Small Businesses:

Sole Proprietorships

“The most enlightened judicial policy is to let people manage their own business in their own way.”

— Oliver Wendell Holmes, Jr.,
U.S. Supreme Court Justice

For tax purposes, the term “sole proprietor” is an individual (or husband and wife) who owns a business. A business is any enterprise operated with a profit motive. Sole proprietors are also folks who, acting as independent contractors, provide services to other businesses.

There are 15 to 20 million sole proprietorships in the U.S., comprising over 80% of all businesses. Most folks choose this way because it is the easiest, fastest and cheapest way to go into business.

For most legal purposes, a sole proprietor and her business are indistinguishable. Business profits and losses are reported on the owner’s personal tax return every year. The sole proprietor is personally responsible for business debts, including all taxes. And when the owner dies, a sole proprietorship terminates by law—unlike a corporation or limited liability company.

Sole proprietorships may offer any type of goods or services, have multiple employees, lose or make millions. In most parts of the country you can start a sole proprietorship by simply putting up a sign offering your goods or services. You may also need a local business license and possibly a sales tax permit as well, but that’s about it—you are a sole proprietorship.

Taxes and Sole Proprietorships in a Nutshell

1. The tax code does not consider a sole proprietorship a separate entity from its owner, so the business does not file its own tax return. Its income or loss is reported on a schedule filed with the owner’s tax return.

2. Sole proprietors, as self-employed individuals, must pay quarterly estimated income taxes, as well as self-employment tax for Social Security and Medicare contributions.

3. The great majority of small businesses begin as sole proprietorships, but many eventually convert to a partnership, limited liability company or corporation.

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A. Business Expenses

All legitimate business expenses can be tax-deducted no matter what form your business takes—sole proprietorship to major corporation.

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B. Profits Left in the Business

The following bit of tax news comes as a shock to most sole proprietors: You are taxed on all profits in the year they are earned—whether you take the money out of the business or not. Any profits remaining in a business bank account at the end of the year are taxed as if you had put them in your pocket. Remember, under the tax code a sole proprietor and the business are one.

For retailers and manufacturers, this rule means if you put profits into building your inventory—which is usually the case—you first will be taxed on them. In other words, you will have to use “after-tax” dollars to expand your business.

Example: Jose made a net profit of $85,000 in his magic and novelty shop last year. He took $50,000 out of the business bank account for living expenses and spent the remaining $35,000 on inventory. Jose pays income and self-employment tax on the full $85,000.

If your small business is incorporated, you may pay less tax on profits put into inventory. This is because owners of C corporations do not report profits left in the business on their personal tax returns. Although profits left in a corporation are taxable to the corporation, initial rates of taxation are lower than for most individuals, producing a tax saving for most small businesses.

Start-Up Permits

Although it is easy to start a sole proprietorship, certain businesses and professions (restaurants and attorneys, for example) need state or local licenses before beginning operation. For more information, see The Small Business Start-Up Kit, by Peri Paknoo (Nolo), and Small-Time Operator, by Bernard Kamoroff (Bell Springs).

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C. How Sole Proprietors Tax-Report

As far as the IRS is concerned, a sole proprietorship starts the day an individual begins taking in income for goods or services. No IRS licensing or even form-filing is required to start off. A sole proprietorship and its owner (or married couple filing a joint tax return) are one and the same for tax purposes. Here are the tax reporting forms you will have to deal with.

1. Schedule C (or Schedule F, for Farming)

Business income is reported on a separate “schedule” (form) attached to the proprietor’s annual Form 1040 individual tax return. You’ll use either Schedule C or C-EZ, Profit or Loss From Business (Sole Proprietorship), or Schedule F if your business is farming.

You must file Schedule C if your net income (after deducting expenses) from all sole proprietorship ventures exceeds $400. But you should file one even if you make less than $400 or even lose money. One reason for filing is that if you have a loss, it may produce a tax benefit. Also, filing starts the statute of limitations (the period during which the IRS legally can audit you) running. If you don’t report, the IRS has forever to audit you for the business operation.

Example: In December 2000, Sam and Jeannie Smith open Smith’s Computer Sales and Service as a sole proprietorship. The Smiths just about break even that year. Even though they didn’t make or lose money, prudence dictates that by April 15, 2002, they should file their 2001 income tax return, including a Schedule C or C-EZ for the business.

2. Schedule C-EZ

If you run a tiny side business, you may use a simplified form, Schedule C-EZ. You are eligible if you:

• have gross receipts under $25,000

• claim less than $2,500 in business expenses

• have no inventory

• have no employees

• use the cash method of accounting

• don’t claim IRC § 179 or depreciation expenses to write off any assets, and

• don’t have an overall loss in operation.

Most businesses worthy of the name can either claim much more than $2,500 in business expenses or will not otherwise qualify for Schedule C-EZ. Since it is only a little more effort to fill out a regular Schedule C form, I recommend it in most cases.

More Than One Sole Proprietorship

If you and your spouse operate more than one sole proprietorship, you must file a different Schedule C, or C-EZ, for each business. You might have any number of Cs filed with one tax return if you have your finger in many pies.

Example: Jeannie and Sam Smith own Smith’s Computer Sales and Service. Besides helping run their business, Jeannie has an Amway distributorship, and Sam buys and sells sports trading cards. The Smiths file one 1040 form, with three Schedule Cs. Since the sports card venture incurs more than $2,500 in expenses, they must use a regular C form, even though the other, smaller, ventures qualify for the EZ form.

3. How Sole Proprietor Income Is Taxed

Schedule C, line 31, shows the bottom line—profit or loss—from your sole proprietorship. This figure is entered on the front page of your Form 1040 tax return and is added to your income (or losses) from all sources—regular jobs, dividends, capital gains and so on.

After deducting your personal exemptions and itemized or standard personal deductions, the combined income is taxed at your tax bracket range, from 10% to 38.6% (2002). You are also subject to self-employment taxes of 15.3% of the first $84,900 of your total self-employment income and 2.9% of everything over $84,900 (2002 rate).

If your business loses money, you can use the loss to offset your other earnings in that year—say from a regular job. Or, if you don’t have enough other earnings, you may carry the loss over to the following year’s tax return. If the business makes a profit in a future year, you can use the previous unclaimed business losses to offset it and reduce your taxes.

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D. Estimated Tax Payments

Wage-earners have their income taxes siphoned off by their employer every paycheck. It’s not so simple for a sole proprietor who is required by law to make income tax payments, called estimated taxes, four times a year. If you wait until April 15 to pay your taxes, you will incur a penalty for failing to make estimated tax payments. You must make estimated tax payments if you expect to owe at least $1,000, and any tax withheld will be less than:

• 90% of the tax you’ll owe, or

• 100% of last year’s tax bill.

To make the quarterly estimated tax payments, use IRS Form 1040-ES. The four equal payments are due on April 15, June 15, September 15 and January 15 (of the following year). Estimated tax payments cover self-employment taxes (better known as SE or Social Security and Medicare taxes) as well as plain old income taxes.

The chief difficulty for most people with estimated taxes is knowing how much to pay. In effect, you must predict how much you will earn for the whole year ahead of time or pay a penalty. To avoid the estimated tax penalty, you should make payments equal to your tax liability for the previous year. For example, if you paid $5,000 in income taxes in 2000, you should make four estimated tax payments of $1,250 each during 2001. Tax-preparation software will also tell you how much you should pay each quarter.

Spouse’s Self-Employment Taxes

Spouses who co-own a sole proprietorship are taxed as one on income of the business. However, they are treated as two individuals for purposes of self-employment tax (SE). (IRC § 1402 (a)(5)(A), Reg. 1.1402(a)(8).) So a separate SE tax form must be filed—and taxes paid—based on an allocation of each spouse’s share of the net income. The allocation should be based on how much each spouse contributed to the operation. Beware: This rule has more significance than just filing another form. Listing your spouse as a co-worker in a sole proprietorship can cost you extra taxes if the business profit exceeds $84,900 (2002). To save this expense, you might list only one spouse as an owner. The other spouse can be treated as an unpaid “volunteer.”

If estimated tax payments are too small or aren’t made on time, the IRS will assess an underpayment of estimated taxes penalty. Skipping quarterly ES payments, waiting to pay in one lump sum with your annual Form 1040 income tax return, may be a costly mistake. You may not have the funds by tax time. And if you don’t catch up by paying all the estimated taxes by April 15, the IRS will tack on another tax penalty and interest for paying late.

Most states also require quarterly estimated income tax payments. Get forms and information from your state’s tax agency.

Excerpted from “Tax Savvy for Small Business”, by Frederick W. Daily