The Sole Proprietor is one of the most popular forms of business entity that is used in the United States. Of the business tax returns that were filed with the Internal Revenue Service for tax year 2012, 71.85% of those returns were Sole Proprietors. So why is this form of business so popular?
The Sole Proprietor is one of the easiest entities to form and to dissolve. A Sole Proprietor involves only one person. There are no legal formalities that have to take place, no assets to transfer, and no excessive paperwork is required. This is because the Sole Proprietor is considered the same as the business owner. One of the major disadvantages of this type of entity is that there is unlimited liability. This means that the business owner is responsible for the business debts and creditors of the business can personally attach the personal assets of the business owner if not paid. In fact in most cases, the business owner is required to personally sign or personally guarantee the liability. This disadvantage can be minimized by electing to be a single member LLC which will not be discussed in this article.
For tax purposes, the Sole Proprietor is not a separate taxable entity. The Sole Proprietor is also not considered to be an employee of the business. He may hire other employees to assist him in his business and deduct their salary as a business expense but he cannot deduct any income paid to him. However, the business owner is allowed to withdraw cash from the business. There is no deduction for withdrawing funds from the business since the Sole Proprietorship and the business owner are considered as one. The business income and expenses are reported on the sole proprietor’s individual tax return on Form 1040 Schedule C. The net income earned on the business is also considered self employment income and the self employment tax is computed and reported on Form 1040 Schedule SE. This means that the business owner will not only pay federal income tax on the net income of the business at the tax bracket the owner’s income falls into, but will also have to pay self employment tax on the net income of the business. To illustrate this point, let us look at the following example.
John Doe has decided to open his own business. He is a taxpayer who is filing single. At the end of the tax year ending 2015 he has earned $75,000 net income from his business.
Since he is considered self employed, he will have to pay self employment tax on the $75,000 net income that his business has earned. The self employment tax is composed of two components: Social Security and Medicare. The Social Security component requires that you pay 12.4% (6.2% employee portion and 6.2% employer portion) on the net income up to a maximum amount. For 2015 the maximum amount of earnings that Social Security tax is paid on is $118,500. The Medicare component does not have a maximum amount; you pay 2.90% (1.45% employee portion and 1.45% employer portion) on the net income your business earns. The self employment tax that John Doe will pay on his earnings from his business is computed below:
In addition to the Self Employment Tax, John Doe will need to pay Federal Income Tax on his earnings. Since he is considered self employed, one-half of the Total Self Employment Tax will be subtracted from his total income in order to arrive at his Adjusted Gross Income. His Federal Income Tax that he will have to pay based on 2015 tax rates is as follows:
To summarize, John Doe's total tax liability for 2015 would be:
When considering the Sole Proprietorship as a business entity it is advisable to work with a tax professional to take advantage of opportunities available such as deducting 100% of health insurance premiums or establishing a SEP retirement plan.
In the next article we will explore the Partnership entity form.
Zebee Levet is a CPA with Roy L. Cress CPA, Inc. in Charlottesville, VA. With 30 years of
experience she has specialized in the area of tax and tax resolution. She has also been a Quickbooks Proadvisor since 1997. She and her husband currently live on a 10 acre farm located in Troy, VA.