Tax Implications for a Sole Proprietorship

by Michael Keenan
You must use IRS Form 1040 if you have a sole proprietorship.

You must use IRS Form 1040 if you have a sole proprietorship.

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When starting your own business, one of the most important decisions is how you want to organize your entity. The choice of a sole proprietorship is one of the easiest to form and easiest to report tax-wise. However, not knowing the forms to use, as well as anticipating your liability for self-employment taxes, can cause headaches come tax time if you don't do your homework.

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Personal Tax Return

Profits and losses from sole proprietors are included on your personal income tax return. To figure the profit or loss, use IRS Schedule C. On this Schedule, you include not only all of your income, but also deductible business expenses, such as costs of goods sold, advertising, business supplies and, if you employ others, the wages and benefits you pay them. Then, the net profit or loss is copied over to your Form 1040 tax return. If you have self-employment income or losses, you also have to use Form 1040; you can't use Form 1040A or Form 1040EZ.

Individual Rates

The income from a sole proprietorship is taxed at your individual income tax rates and you include the entire amount on your taxes, even if you don't take the money out of the sole proprietorship. For example, if you fall in the 28 percent tax bracket, your sole proprietorship income is taxed at 28 percent. In addition, this allows the income to avoid double taxation. If the business were incorporated, it would have to pay the corporate income tax. In addition, you would be taxed on any distributions paid to you as dividend income, thus you would pay double taxes.

Losses Offset Other Income

If your sole proprietorship has a bad year, you can use your sole proprietorship losses to offset other income. For example, if you receive a $60,000 salary for your day job and your sole proprietorship has a loss of $10,000, you can use the loss to offset your salary so you only have $50,000 of taxable income. If your net operating loss exceeds your income for the year, you can carry back the loss up to two years prior. Afterward, any excess can be carried forward for up to 20 years.

Self-Employment Taxes

Sole proprietorship income is also subject to self-employment taxes. Self-employment taxes are equal to employer and employee portions of the federal insurance contributions act, or FICA, taxes imposed on employee income. However, since the sole proprietor is both the employer and employee, the sole proprietor pays both portions. As of 2012, the self-employment tax rates are 2.9 percent for the Medicare portion and 10.4 percent for the Social Security portion. The Social Security portion only applies to a set amount of income. To figure your self-employment tax, use Schedule SE.