💰Federal Income Tax Accounting Unit 13 – Taxation of Sole Proprietors & Single Owners

Key Concepts and Definitions

• Sole proprietorship simplest form of business ownership operated by a single individual
• Pass-through entity business income and expenses "pass through" to the owner's personal tax return
• Schedule C (Form 1040) used to report income and expenses from a sole proprietorship
• Self-employment tax (SE tax) Social Security and Medicare taxes paid by self-employed individuals
• Ordinary and necessary expenses must be both ordinary (common in the industry) and necessary (helpful for the business) to be deductible
• Depreciation gradual deduction of the cost of long-term assets over their useful life
• Cash method most common accounting method for sole proprietors, recognizing income when received and expenses when paid

Sole Proprietorship Basics

• Sole proprietor has complete control over business decisions and operations
• No legal distinction between the owner and the business for tax and liability purposes
• Sole proprietor reports business income and expenses on Schedule C (Form 1040)
• Net profit or loss from the business is combined with other income on the owner's personal tax return (Form 1040)
• Sole proprietor personally liable for all business debts and obligations
• Relatively low startup costs and minimal legal requirements compared to other business structures
• Sole proprietorship terminates upon the owner's death, disability, or decision to close the business

Income Recognition for Sole Proprietors

• Most sole proprietors use the cash method of accounting
  • Income recognized when payment is received
  • Expenses deducted when paid
• Accrual method recognizes income when earned and expenses when incurred, regardless of when payment is received or made
• Constructive receipt doctrine states that income is taxable when it becomes available to the taxpayer, even if not physically received
• Advance payments for goods or services must be included in income when received, even if the work has not been performed yet
• Bartering exchanging goods or services without money still results in taxable income equal to the fair market value of the goods or services received
• Hobby income must be reported but losses from hobbies are generally not deductible

Deductible Business Expenses

• Ordinary and necessary expenses incurred in carrying on a trade or business are deductible
• Cost of goods sold (COGS) direct costs of producing or acquiring inventory, deductible when the inventory is sold
• Salaries and wages paid to employees deductible, including payroll taxes (FICA, FUTA) and benefits
• Rent, utilities, and other overhead expenses associated with business premises are deductible
• Supplies, equipment, and other items used in the business can be deducted or depreciated
• Travel expenses (transportation, lodging, meals) incurred for business purposes are deductible, subject to certain limitations
• Vehicle expenses can be deducted using actual expenses or the standard mileage rate
• Advertising, professional fees, and other miscellaneous expenses related to the business are generally deductible

Home Office Deductions

• Home office must be used regularly and exclusively for business purposes to qualify for deductions
• Two methods for calculating home office deductions:
  1. Simplified method: $5 per square foot of home office space, up to 300 square feet
  2. Regular method: Allocate a portion of actual home expenses (mortgage interest, property taxes, utilities, etc.) based on the percentage of the home used for business
• Direct expenses (e.g., painting the home office) fully deductible
• Indirect expenses (e.g., utilities) deductible based on the percentage of the home used for business
• Home office deduction limited to net income from the business; excess can be carried forward

Self-Employment Tax

• Self-employment tax (SE tax) consists of Social Security (12.4%) and Medicare (2.9%) taxes for self-employed individuals
• Applies to net earnings from self-employment (NESE) of $400 or more
• NESE calculated on Schedule SE (Form 1040) based on net profit from Schedule C
• Self-employed individuals responsible for both the employer and employee portions of SE tax (combined 15.3% rate)
• Half of the SE tax paid is deductible as an adjustment to income on Form 1040
• SE tax provides Social Security and Medicare coverage for self-employed individuals
• Estimated tax payments may be required to cover income tax and SE tax liability throughout the year

Recordkeeping and Reporting Requirements

• Sole proprietors must maintain accurate records of income and expenses
• Receipts, invoices, bank statements, and other documentation should be kept to support deductions
• Separate business and personal expenses to ensure accurate reporting
• Schedule C (Form 1040) used to report income and expenses from the sole proprietorship
• Schedule SE (Form 1040) used to calculate and report self-employment tax
• Form 1099-MISC issued to contractors and service providers paid $600 or more during the tax year
• Form 1099-K issued by payment settlement entities (e.g., PayPal) for transactions exceeding certain thresholds
• Retain tax records for at least three years from the filing date or due date of the return, whichever is later

Tax Planning Strategies for Sole Proprietors

• Maximize deductions by keeping accurate records and claiming all eligible business expenses
• Consider hiring family members to take advantage of lower tax brackets and shift income
• Establish a retirement plan (e.g., SEP IRA, Solo 401(k)) to save for the future and reduce current tax liability
• Utilize Section 179 expensing and bonus depreciation to deduct the cost of qualifying assets in the year of purchase
• Defer income and accelerate expenses (when using cash method) to reduce taxable income in the current year
• Contribute to a Health Savings Account (HSA) to save for medical expenses and receive tax benefits
• Consider incorporating or forming an LLC to limit personal liability and potentially save on self-employment taxes
• Stay informed about changes in tax laws and regulations that may affect sole proprietors