Self-Employed or Sole Proprietor: Tax and Business Basics

The Tax and Business Basics for Self-Employed or Sole Proprietors

Many businesses begin unincorporated. Such sole proprietorship or self-employed are not aware of the many tax implications and tax cost involved in such operations.

In addition, they are not aware of certain legal liability exposure that they subject themselves to by operating as an unincorporated enterprise.

The following highlights some of the basic tax and business considerations and risks involved in operating as a self-employed individual.

What is Self-Employment Income and Is It Subject to Income Tax?

A sole proprietor is one who operates a business as an individual without the use of a corporation or partnership.

Self-employment activity can also include work in addition to your regular full-time business activities, such as part-time work you do at home or in addition to your regular job.

Remember that under IRS rules income is taxable from whatever source derived, so you must report this income to the IRS.  Of course, this income must also be reported at the state level and oftentimes at the local level. For example, Philadelphia has two taxes for the self-employed: BIRT and the NPT.

Earnings Are Subject to Social Security Tax As Well As Income Tax

In addition to the income tax that must be paid on your earnings, if you are self-employed you generally have to pay a self-employment tax. Self-employment tax is a social security and Medicare tax primarily for individuals who work for themselves. It is similar to the social security and Medicare taxes withheld from the pay of most wage earners. However, as a self-employed individual you pay both the employer and employee portion of this SE tax. You figure SE tax yourself using a Form 1040 Schedule SE.

Pay As You Go: You Must Make Estimated Tax Payments

If you are self-employed you generally have to make estimated tax payments. This applies even if you also have a full-time or part-time job and your employer withholds taxes from your wages. Estimated tax is the method used to pay tax on income that is not subject to withholding. If you don’t make quarterly payments you may be subject to an underpayment penalty.

Deducting Cost of Running Your Business

You can deduct the costs of running your business. These costs are known as business expenses. These are costs you do not have to capitalize or include in the cost of goods sold but can deduct in the current year.

Capitalized costs for the acquisition of property, plant and equipment, real estate and other large expenditures for capital assets are deducted over time based upon various depreciation methods.

Start up expenses may be eligible for an expense election and/or may be amortized under applicable federal income tax rules. For an overview of the primary rules in this area of tax law please see Start-up Costs For New Ventures

Note also that if your business requires an inventory you must use appropriate accounting methods to account for such inventory and to be able to ascertain the difference between costs of goods sold and ending inventory.

Expenses Must Be Ordinary and Necessary

To be deductible, a business expense must be both ordinary and necessary.

An ordinary expense is one that is common and accepted in your field of business.

A necessary expense is one that is helpful and appropriate for your business. An expense does not have to be indispensable to be considered necessary.

The Achilles Heel of Operating As a Sole Proprietor: Personal Exposure for Business Debts

Remember that if any liabilities arise from these business operations you are personally liable for such debt. This is why many businesses operate in the corporate form, be it a C corporation, an S corporation, or an LLC. For more on these other entities please see Choice of Business Entity For Your Business, S Corporations: The Basics and LLCs: The Basics.

It is recommended then that you consult with a corporate or tax attorney before starting any business to limit your personal liability and to set up the most tax advantageous business entity for your particular operations.

Warning

This is an extremely basic and general discussion of the tax considerations involved when operating as a self-employed individual. Each business situation should be explored and discussed with a tax or business attorney before starting a business to avoid unpleasant surprises and tax risks that put personal wealth at risk. Please feel free to contact our office for support and guidance.

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