Running a business as a sole proprietorship rather than a formal legal entity, such as a corporation, can greatly simplify your annual tax return filings. One reason for this is that the IRS doesn’t treat your business as a distinct taxpayer for which a separate tax return must be filed. Additionally, since payments that you make to yourself can only be classified in one way, it is one less issue for you need to deal with at tax time.
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Sole Proprietor Payments
Whenever you take a payment from the earnings of your sole proprietorship, classifying its treatment for tax purposes is straightforward. The IRS treats sole proprietors as self-employed persons for tax purposes. This means you cannot treat yourself as an employee of your business, and you cannot issue yourself a W-2 or deduct your wages. In fact, the IRS doesn’t even consider the payments or withdrawals you make from your business accounts. This is because net earnings from your sole proprietorship are fully taxable, regardless of whether you take a payment or not.
Repayments of Capital
Sole proprietors usually have no choice but to finance startup costs with personal funds. If you make a contribution and consider it a loan to the business, you can’t classify a future payment you take to repay yourself for the loan as a tax-free return of capital; this payment is treated in the same manner as withdrawals you periodically make from profits to compensate yourself for the work you perform. This contrasts with how payments to shareholders of a corporation are handled: a payment may be a taxable dividend from corporate earnings or a tax-free return of capital, which is the amount a shareholder initially invests to purchase stock.
Filing Schedule C
The IRS requires sole proprietors to file a Schedule C (or Schedule C-EZ if eligible) with their personal income tax returns. All earnings and deductions for the taxpayer’s business are reported on this form. Schedule C does not have a line to report payments you make to yourself. Instead, you report your total revenue and then subtract your deductible business expenses to arrive at the taxable amount of your earnings from the sole proprietorship. The profit is then combined with the other income that you report on Form 1040 and it is taxed at your personal income tax rate. This means your sole proprietor tax bill will be the same whether you take every dollar of profit out of your account or reinvest it in your business.
Other Payment Considerations
As a sole proprietor, it is important that you understand your obligation to make payments for estimated income tax and self-employment tax, which covers Social Security and Medicare. The IRS requires that you make quarterly deposits to pay these taxes rather than making a lump sum payment at the end of the year. To avoid a situation where you don’t have the funds to make an estimated payment and you incur penalty charges as a result, you should be mindful of these tax obligations before taking a payment of profits from your sole proprietorship.