When choosing to operate your business as a sole proprietorship, no legal entity exists that separates your business and personal activities – which is why you need to operate the business in your personal name. For tax purposes, the Internal Revenue Service treats your sole proprietor earnings as self-employment income, reportable on your personal tax return and for which you’re solely responsible to pay tax on as your income. However, self-employed taxpayers are never entitled to deduct their own “salary” payments.
Taxation of Sole Proprietorships
Due to the lack of separation between your personal and business affairs, you must ultimately combine your sole proprietor net earnings with all other income you earn that isn’t tax-exempt on a 1040 form. You do, however, separately report your business earnings and expenses on a Schedule C -- or if your business expenses aren’t more than $5,000, on a Schedule C-EZ. The purpose of the schedules is to calculate your net earnings (or loss) – which is essentially total revenue minus all business expenses. This net amount is then transferred to the income section of your 1040.
Why Salaries Are Nondeductible
Since your sole proprietorship isn’t a separate business entity, it’s impossible to consider yourself as an employee and take a deduction for wages on Schedule C. Take, for example, a sole proprietor who uses a business bank account and only uses it to pay business expenses and deposit earnings. If the sole proprietor decides to take a monthly “salary” of $2,000 for himself, this resembles more of a draw or advance of earnings than it does employment wages. Ultimately, the sole proprietor’s net profit is his nondeductible self-employment income. Also consider that even if the IRS did allow the sole proprietor to deduct wages paid to himself, those wages are subject to the same income tax treatment that self-employment income is subject to, so the end result would be the same, whether wages are deducted or not.
Paying Self-Employment Taxes
Your sole proprietor profits are, however, similar to employment wages in that Social Security and Medicare taxes must be paid on it. Employees have both taxes withheld from their paychecks by their employers. However, as a sole proprietor, you need to make these tax payments yourself. The amount of self-employment tax you owe is calculated on Schedule SE, which uses the net earnings figure reported on your Schedule C or C-EZ. The full amount of your net earnings is subject to Medicare taxes, but a maximum amount is subject to the Social Security tax.
Deducting Self-Employment Taxes
After you calculate the self-employment tax on your sole proprietor earnings, Schedule SE requires a second calculation to arrive at the amount you can deduct. Half of the self-employment tax you pay is deductible as the “employer-equivalent” portion, since - in an employment context - employers are responsible for approximately half (depending on the tax year) of the tax and employees pay the remaining amount through withholding. Although you still aren’t an employer who can deduct the wages you pay to yourself, the deduction for self-employment tax you report on the first page of your 1040, will reduce your overall income tax bill.