Sole Proprietorships – The Simplest Form of Business Entity

Last week I wrote about the various kinds of business entities available for small businesses, such as sole proprietorships, partnerships, corporations, etc. This week I want to explain more in detail about how a sole proprietorship works.

The simplest form of business entity that an entrepreneur can set up is the sole proprietorship. Simply starting a business forms a sole proprietorship. No legal documents are required to set up the sole proprietorship. However, most local governments require sole proprietorships to register any assumed names or Doing Business As (DBA) names that the sole proprietorship intends to use.

The sole proprietorship is also the most informal and easiest business entity to operate on a day to day basis. With a sole proprietorship, it’s very easy for the money to invest funds in or take money out of the business any time the owner wants. With a corporation, for example, putting money into or taking money out of the corporation can get complicated as to the tax implications.

A sole proprietorship by definition can only have one owner. However, for tax purposes, a husband and wife are considered one owner.

A sole proprietorship does not have an existence apart from its owner. Because of this, the tax return for a sole proprietorship is simply a Schedule C which is filed with the owner’s 1040 form. So, there is no extra tax return to be filed as there is with a corporation.

If a sole proprietor needs to borrow money for his business, he can deduct the interest on his Schedule C as long as he can show the funds were used for a business purpose.

A sole proprietorship can have employees. The owner just needs to make sure that all payroll tax forms are filed and all payroll taxes are timely paid in to the proper state and federal agencies. (Incidentally, failure to do this gets many business owners in a lot of trouble.)

The thing to keep in mind about a sole proprietorship is that the sole proprietorship only pays taxes on its net profit. No matter how much money the sole proprietor puts into or takes out of the business, he is only taxed on the net profit of the business.

The net profit from a sole proprietorship is calculated on Schedule C of the business owner’s 1040. The net profit is then reported on Page 1 of the 1040 along with any other income the business owner may have. If there is a net loss from the sole proprietorship, then this net loss will offset other income the sole proprietor may have.

If there is more than $400 of net profit from the Schedule C, then the business owner must pay self-employment tax on the amount of the net profit. Self-employment tax is essentially the owner’s Social Security taxes. The self-employment tax is 15.3 percent of the net profit the sole proprietor reports on Schedule C. The 15.3 percent is made up of two components: 12.4 percent for Old age, Survivors, and Disability Insurance (OASDI) and 2.9 percent for Medicare. Self-employment taxes are calculated on Schedule SE.

During the next few days, I’ll be taking a more detailed look at the other business entities mentioned in last weeks article.