A sole proprietorship is an unincorporated business organization that's owned and operated by an individual. Sole proprietors do not run their operations through separate legal entities (such as corporations). They can sell goods or services; they can also be self-employed freelancers, independent contractors (ICs) and consultants who provide their services to other businesses. There are over 17 million sole proprietorships in the United States, comprising well over 70% of all the nation's businesses. This isn't surprising since it's the easiest, fastest and least costly way of going into business.
For tax and most legal purposes, a sole proprietor and his or her business are one and the same, indistinguishable from one another. Business profits (or losses) are reported on the owner's Form 1040 tax return. The sole proprietor is personally responsible for all business debts, including taxes. When the owner of a sole proprietorship dies, the business terminates by law, unlike a corporation or limited liability company (LLC).
Sole proprietorships may have multiple employees or none at all. Solos, as they're often called, can make (or lose) millions of dollars. They're very easy to start; a sole proprietorship can be launched by obtaining a local business license (and possibly a sales tax permit) and simply putting up a sign or using other advertising that offers the operation's goods or services to its market. Certain businesses and professions (such as restaurants and attorneys, for example) may need other additional state or local licenses before beginning operation.
Solos are taxed on all profits in the year that they're earned, whether the owner takes the money out of the business or not. Any profits remaining in the business at the end of the year are taxed as if the owner had taken them as personal income. This is because, as previously stated, under the tax code the sole proprietor and the business are one. For retailers and small manufacturers, this means that if profits are put into building the operation's inventory - which is often the case - the owner will still be taxed on those profits. In other words, after-tax dollars must be used to expand the sole proprietorship business. (Owners of C corporations do not report profits left in the business on their personal tax returns, even in one-shareholder organizations.)
For tax purposes, a sole proprietorship starts when the first dollar of income is received. No IRS forms or licensing are required to start the business. Income taxes are reported on the owner's individual tax return. Business income and expenses are reported on a separate schedule attached to the Form 1040 - either Schedule C or C-EZ, Profit or Loss From Business (Sole Proprietorship), or Schedule F if the business is farming. (A sole proprietor can deduct business expenses under the same rules that apply to a major corporation.) The sole proprietor must enter the principal business code number to designate to the IRS the type of business that's being operated.
The sole proprietor must file Schedule C and Schedule SE, Self-Employment Tax, if the aggregate net income (after deducting expenses) from all of the owner's solo ventures is equal to or greater than $400. (If more than one sole proprietorship is owned, a separate Schedule C must be filed for each business.) However, it's wise to file these forms even if the enterprises make less than that amount or even lose money. This is because if a loss is incurred, it could produce a tax benefit. The loss can be used to offset additional earnings in the same tax year, including earnings from a regular job. If there are no other earnings to offset, the loss can be carried over (known as a net operating loss) to the following year's tax return. If the operation makes a profit in a future year, the previous year's losses can be used to offset those profits and reduce the tax bill. Additionally, the act of filing also starts the statute of limitations (the time period during which the IRS can legally audit returns), and the sooner that this period starts the sooner it will expire.
A very small sole proprietorship may qualify to use the simplified Schedule C-EZ. To utilize this form, the business must carry no inventory and have less than $5,000 in business expenses. It must also have no employees, there can be no prior year disallowed passive activity losses, and cannot claim any deductions for business use of the owner's home. Finally, the operation must use the cash method of accounting, have no depreciation expenses to write off, and cannot claim an overall loss.
Solos pay self-employment taxes - which are a combination of Social Security and Medicare taxes - at the rate of 15.3% of the first $94,200 of net self-employment income and 2.9% of everything over $94,200 (These figures apply to the 2006 tax year, and are accurate at the time of this writing.) These taxes must still be paid on business income even if the sole proprietor is currently drawing Social Security or Medicare benefits. However, paying self-employment taxes produces a tax break on the owner's individual tax return. One-half of the tax is deductible; it's claimed on the front of the Form 1040 as an adjustment to income.
In addition to paying self-employment taxes, sole proprietors are required to make periodic income tax payments, called estimated taxes, four times a year. If the estimated payments aren't made, the IRS can impose a penalty. The penalty is a percentage of the tax due each quarter and is typically equal to around 8% annually, close to the interest rate on a bank loan. By law, the rate can change quarterly.
If the solo hires employees, it must pay federal employment taxes and begin withholding the workers' income taxes, which also means considerably more time spent with recordkeeping. Employment taxes cover Social Security and Medicare for the employees as well as federal unemployment compensation insurance. Sole proprietors (including a husband and wife team, which are looked upon as one entity) are technically not employees of their business, so no payroll taxes are due on their income. Instead, as noted previously, sole proprietors pay quarterly estimated taxes, which include the self-employment taxes for Social Security and Medicare.