The sole proprietorship is taxed at the individual tax level. Basically, the income earned during the calendar year is calculated on Schedule C of Form 1040. The final number is transferred to the front page of Form 1040 to line 12. Schedule C is divided into three major sections. Below is an explanation of each section and how the preparer calculates the final number. Once the number is calculated, I illustrate how the taxes are calculated and what to expect in regards to the Internal Revenue Service regulations.
At the top of Schedule C is an area related to explaining the business. Prior to conducting business you would have applied via SS-4 ( https://businessecon.org/resources/ ) for an identification number or what is commonly referred to as the Employer Identification Number. This is a nine digit number similar to your Social Security Number. The section is straight forward, where is it located, and what do you do for a living. There is a requirement to indicate your business type via a 6 digit code. Just follow the code groupings to find your particular code.
In reality, this section has both income and cost of goods sold associated with calculating the gross margin (revenue less direct costs of products or services rendered). You should include any Form 1099 revenue reported plus any revenue you receive that is not reported via the Form 1099-M. Subtract any money paid back such as returns of products or actual amounts paid back to customers. This adjusted number is referred to as adjusted gross receipts on Line 3 of Schedule C.
From adjusted gross receipts you should subtract any payroll, direct material costs, supplies purchased to provide the goods, equipment rental costs to produce or deliver the goods. All of these costs are referred to as Cost of Goods Sold. They are detailed in Part III of the schedule on page 2.
You now have what the IRS calls Gross Income. In accounting we refer to this as Margin or Gross Margin. But it means the same thing.
The third section is called expenses. These are typical expenses incurred by most businesses in conducting operations. The most complicated lines are depreciation and auto operations. Please see https://businessecon.org/2012/12/mileage-deduction-new-rate-for-2013/ for an explanation of how to handle the auto expenses. Auto expenses are detailed slightly on page 2 of Schedule C. You can keep depreciation simple by utilizing Section 179 and deduct the full amount paid for the assets you purchase. See https://businessecon.org/2012/12/small-business-tax-depreciation-section-179/ for more information. Again, this is detailed with an attached worksheet or Form 4562. The rest is relatively self-explanatory.
I caution you to not include personal expenses here in the expense section. Some common ones that I have seen include health insurance (any of the medical insurances on you or your family); health insurance is deducted on page one of Form 1040. Others include deducting life or disability insurance. Again this is not allowed. For meals and entertainment, you need to be reasonable. If your job is a salesman, then there should be a low dollar value in this expense line. If you are an auto mechanic; the IRS should see something near a zero or less than $100 for an entire year. Think about it; what is an auto mechanic doing entertaining customers? This expense line is not some open ended deduction for you. I can pretty much guarantee there will be questions if the number is unreasonable. Just because you talked with your wife about business at a dinner out, doesn’t make it deductible. Use your common sense.
There is a section on page 2 of Schedule C to identify some oddball types of expenses. I have seen the following in this section:
- Communications (cell phone, internet connection)
- Fuel costs associated with operating machines and motors
- Some one time fees
From this number you may subtract your home office deduction. This is strictly for those individuals that dedicate a single room to the business operation. The formula for this deduction is basically the total square footage of this space in comparison to the whole house (everything including the garage). The percentage of the utilities and the taxes can be deducted here. There is a form for you to fill out to calculate this dollar amount. Remember to adjust your taxes on Schedule A for real estate if you use the home deduction. If you rent, there is no real estate tax adjustment necessary. I suggest NOT using depreciation on the house in the calculation because you will most likely sell your home one day and you will have to add back this depreciation dollar value as taxable income. It may not be worth the depreciation adjustment or going through the documentation process to do this. Sometimes it is not worth saving $30 to $40 dollars in taxes just to pay those taxes in a later year. Trust me, the paperwork isn’t worth the frustration associated with doing that step.
From your calculated net income is deducted the home expense and you end up with income that will be recorded on Page 1 of Form 1040.
Now the hard is part is done. Next, you need to fill out Schedule SE which is the self-employment tax. See https://businessecon.org/2012/11/self-employment-tax-you-can-stop-staring-at-me-now/ for an explanation of this tax. The net income from your business is recorded on Line 12 of the Form 1040, one half of your self-employment tax is deducted on the front page on Line 27. All sources of income and adjustments are combined to determine total Adjusted Gross Income. At this point your business income is included. From here, the typical itemized and standard deductions are subtracted and you end up with taxable income. Income tax is calculated on page 2 of Form 1040 and you have your tax amount. From this you should subtract your credits and deposits to determine any remaining balance due.
The IRS regulations require you send in estimated tax payments related to your business operations four times a year. If you follow the guidelines, you basically calculate the net income from the business every quarter and pay about 30% of your net income from that quarter to the IRS to cover your tax obligation. This covers both the income and self-employment tax.
If you have any questions, send me an e-mail and I’ll be glad to follow up with you. Act on Knowledge.