Businesses often start out as sole proprietorships simply because it is the simplest entity type with the easiest setup. Unlike other business structures, no formal set up is involved. An individual who begins to operate a business is a sole proprietor by default. However, sole proprietorships only work if there is one owner. If there are two or more owners, the business must be a partnership or some form of corporation.
Sole proprietorships are called pass-through entities because all business income and losses are reported on the business owner’s personal tax return rather than on a separate business return. Profits and losses are reported on Schedule C, which is submitted with Form 1040. Following are specific rules that affect the taxation of sole proprietorships:
- All business profits are taxed, even if they are not withdrawn.
- There is no distinction between the personal assets of the owner and the business, so the business owner is personally liable for all business debts and liabilities.
- Subject to certain income and other restrictions, sole proprietors may be able to qualify for the 20% pass-through tax deduction mandated by the Tax Cut and Jobs Act of 2017 (the TCJA). This deduction is set to expire in 2025, however, unless it is extended by Congress.
- Unlike other business models, which are taxed at the company rate, sole proprietors are taxed at their individual rate.
- Business records should be kept separate from personal information, but there is no requirement. Only business expenses may be deducted for tax purposes.
- Quarterly estimated taxes must be paid in lieu of income tax withholding.
- Self-employment taxes must be reported on Schedule SE, which is submitted with Form 1040 and paid when income taxes are paid.
- Sole proprietorships may hire employees, but the sole proprietor is responsible for filing taxes and properly administering those employees.
- Sole proprietors may also use independent contractors.
Once the business reaches a certain level of profitability, the business owner may choose to restructure the business. The most common way to do so is to set up a Limited Liability Company or LLC for short. LLCs require a formal document to set up, and provide the owner with personal liability protection. However, LLCs do come with additional rules. For example, personal and business assets cannot be co-mingled in an LLC, or personal asset protection may be lost. Becoming an LLC does not change tax filing as long as there is only one owner. There are additional considerations when setting up an LLC or other entity for your business, so be sure to contact a legal professional.
