Chapter 11: Sole proprietorships.
A sole proprietorship is the simplest form of business entity--simply an individual taxpayer operating a business--and, for that reason, many small businesses start out as sole proprietorships. There are no legal prerequisites to formation. Other than state or local business license laws, there is nothing necessary to operate a sole proprietorship other than to be in business. Self-employed individuals such as freelance writers or photographers are automatically sole proprietors. Because there is no separate legal entity, sole proprietors are personally and fully liable for the debts and obligations of the business.
For tax purposes, a sole proprietorship is not a separate entity from the taxpayer. At the federal level, all business income or losses are reported on Form 1040 with Schedule C attached. Sole proprietors generally must also pay the self-employment tax and file Schedule SE with their Form 1040.
A limited liability company (see Chapter 15) with a single owner may choose to be taxed as either a sole proprietorship or as a C Corporation (see Chapter 13).
WHEN IS IT INDICATED?
1. When a single business owner desires the simplest tax treatment and does not want to incur the legal expense and deal with the formalities of forming a business under state law, a sole proprietorship may be appropriate.
2. Where a single individual is operating a business without significant liability concerns, a sole proprietorship may be appropriate.
1. A sole proprietorship is the simplest form of business entity to start. A sole proprietorship requires no formal steps for formation.
2. A sole proprietorship is the simplest form of business to operate. Because there is a single owner, there are no complications regarding management decisions or the division of profits. Although a sole proprietor must keep separate business records, the taxpayer need only file a single tax return, Form 1040 with Schedules C and SE.
3. A sole proprietorship avoids the double taxation that occurs with C Corporations. A sole proprietor may even be able to deduct losses from the business on the individual tax return to offset income received from other sources.
1. A sole proprietorship provides no liability protection for the business owner. The sole proprietor is liable for all business debts and expenses. In the event of a judgment against the business, the personal assets of the business owner are available to the creditor. For this reason, it is typically difficult to raise cash for such businesses since few investors will want to place their funds at such risk.
2. A sole proprietorship is personal to the business owner. A sole proprietor cannot admit another owner without legally ending the sole proprietorship and forming a new business such as a partnership.
3. The sole proprietorship generally dies (or becomes "disabled") at the death (or disability) of its owner. Thus in most cases, little of the value of a sole proprietorship can be transferred at the owner's death.
4. The sole proprietorship is a poor estate planning tool since it is impossible to fractionalize or create layers of interests that can be transferred during lifetime or at death to others.
WHAT ARE THE REQUIREMENTS?
There is generally nothing required to start a business as a sole proprietorship except to start the business. A single-owner business that is not incorporated or organized as a limited liability company is automatically a sole proprietorship. There may, however, be state and local requirements for permits or business licenses. Most states require a filing and a formal public notification when a business is operated in a fictional name.
A sole proprietor must keep records for business income and expenses separate from records for personal income and expenses. The business income and expenses must be reported on Schedule C and filed with the taxpayer's Form 1040. The net income on Schedule C is reported on the Form 1040 and is taxed to the taxpayer along with the taxpayer's other income.
Sole proprietors must also pay self-employment taxes (see below) to fund the Social Security and Medicare systems. The self-employment taxes are the equivalent of the payroll taxes deducted from employee paychecks and matched by their employers. Sole proprietors must pay the entire amount themselves. The self-employment tax is calculated on Schedule SE and filed with the taxpayer's Form 1040.
1. Individuals having net earnings of $400 or more from self-employment are required to complete Schedule SE and compute the self-employment tax due. (1)
2. There are two separate components to the self-employment tax. The first component is designed to fund the old-age, survivors, and disability insurance (OASDI) component of Social Security. For self-employed individuals, it is set at 12.4% of net income up to a ceiling ($106,800 in 2009, indexed for average national wage levels, $102,000 in 2008). (2) The second component funds the Medicare program, and is set at 2.9% of net income, with no ceiling amount. (3) This means that self-employment income up to the OASDI ceiling is subject to 15.3% self-employment tax.
3. Net earnings from self-employment are calculated by multiplying self-employment income (as reported on Schedule C) by 0.9235 (1-.0765%).4 This is equivalent to self-employment income minus one-half of the self-employment tax, reflecting a deduction from self-employment income of roughly one-half of the self-employment tax.
4. Self-employed individuals are also entitled to a deduction (reported on page 1 of the Form 1040) of one half of the self-employment tax paid. (5)
HOW IS IT DONE--AN EXAMPLE
Joseph decides to open up a computer consulting business. Initially, Joseph incurs $5,000 in startup costs for advertising, equipment, office supplies, and other necessities. During the rest of the first year, Joseph incurs an additional $5,000 in expenses. During that first year, Joseph receives $20,000 in consulting fees, the only revenue generated by the business.
At tax time, Joseph reports his $20,000 in income and $10,000 in expenses on his Schedule C, showing a net income of $10,000. That $10,000 is reported on his Form 1040 and added with his other income. Joseph also reflects the $10,000 net income on his Schedule SE and calculates the self-employment tax due [($10,000 x 0.9235) x 0.153) = $1,412.96]. The self-employment tax due is then also reported on his Form 1040. On page 1 of his Form 1040, Joseph takes a deduction for one-half of the self-employment tax due [$1,413 x 0.5 = $706.50].
WHERE CAN I FIND OUT MORE ABOUT IT?
1. IRS Publication 334, Tax Guide for Small Businesses (revised annually).
2. IRS Publication 535, Business Expenses (revised annually).
QUESTIONS AND ANSWERS
Question--How is the self-employment tax due calculated if a sole proprietor also has employment income?
Answer--In most respects, employment income is disregarded in calculating self-employment taxes, because the employee and employer are already paying the equivalent payroll taxes. If, however, a sole proprietor has combined net earnings from self-employment and employment income in excess of the OASDI ceiling, the sole proprietor must take the employment income into account in determining how much of the net earnings from self-employment are subject to the 12.4% OASDI tax.
For example, assume Joseph, a sole proprietor has net earnings from self-employment of $70,000, and also has earnings from employment of $50,000, all in 2009. Because his total income [$70,000 + $50,000 = $120,000] exceeds the $106,800 ceiling for the OASDI tax, only the first $56,800 of net earnings from self-employment will be subject to the OASDI tax [$106,800-$50,000 = $56,800].
(1.) IRC Sec. 1402(b)(2).
(2.) IRC Secs. 1401(a), 1402(b)(1).
(3.) IRC Sec. 1401(b).
(4.) IRC Sec. 1402(a).
(5.) IRC Sec. 164(f).