Kenneth Gibbons LLC a full service CPA Firm located in Northern, NJ and NYC, NY which has experience with clients who are sole proprietorships and single member LLCs.
A sole proprietorship is one of many different types of entities that under the right circumstances could be the most advantageous to a business owner/ taxpayer. Sole proprietorships are informally structured as compared to other business entities such as corporations, partnerships, etc. These other types of business entities must file certain documentation and register with the state prior to doing business in that state. In addition, corporations, partnerships, etc., must also file paperwork with the state, if they should choose to close the business at some point.
As the name suggests, there is only one sole proprietor (owner) and no partners or any other owners are allowed. The only time when a sole proprietorship may have more than one owner is when the owners are a husband and wife who are considered a qualified joint venture and opt out of a partnership treatment. The sole proprietorship does not file a separate business entity tax return as do corporations and partnerships, etc. It files an additional schedule (e.g., Schedule C) which is part of the owner’s personal IRS 1040 filing.
There are times when an individual would have to be treated as a sole proprietorship and file a schedule C. For example: The taxpayer is working as an independent contractor and there is no payroll tax withholding from his pay. Or if an independent contractor receives more than $600 in pay, he will receive a Form 1099 MISC from the payor.
A sole proprietorship has to pay self employment tax in addition to the income tax paid on the net profits of the business. Since a self-employed individual does not have social security and Medicare payroll taxes withheld from his pay, he still has to pay the equivalent withholdings which is self employment taxes. The self employment tax rate is 15.3% (12.4% for social security and 2.9% for Medicare). This amount represents the combined employee and employer contribution on 92.35% of his net income from self employment. The tax is added to the Form 1040 as an additional tax to his income but the taxpayer is allowed to deduct one-half of his contribution as an adjustment to income.
A self-employed tax individual must choose one of three methods of accounting for his business for tax purposes which are the Cash Method, Accrual Method or the Hybrid Method:
The cash method means that the taxpayer only reports income when cash is received and only reports expenses when cash is paid.
The accrual method differs from the cash method in that cash does not need to be received or paid to have a reportable tax event. An accrual method is usually used by businesses that have inventory. Under this method, if inventory is sold in December of 2011 but the customer does not pay you until January 2012, the sole proprietor reports the income on his tax return in the 2011 year when incurred. This holds true for expenses as well.
The Hybrid Method combines the accrual method for inventory but the cash method for other income and expenses.
Sole proprietorships that have a loss for a year may be able to offset it against other income as long as the owner’s participation is material to the business. For example, let’s say there is a sole proprietor who has a job and earns $50,000 in W2 wages and he also has a business on the side which has a loss of $20,000. He can offset the $20,000 loss against his $50,000 of wages and he then only has a net taxable income of $30,000. However, if a self-employed individual does not meet the material participation requirement, then the $20,000 loss from the business would be considered a passive loss and could only be offset against other passive income. Gross Wages that are W2 income would not be considered passive income since it is ordinary income. In this situation, the $20,000 loss from the business could not be offset against the Gross Wages of $50,000. Contact Kenneth Gibbons LLC to learn more about “the material participation requirements”.
If the IRS determines the business is a hobby and not a sole proprietorship business, then the loss will be disallowed. Hobby income is taxable by the IRS, but hobby losses are disallowed and non-deductible. If a taxpayer who has a job and a business on the side continues to report losses from the side business, he runs the risk of being contacted by the IRS and audited to see if the side business is a hobby or not. Usually, after reporting three straight years’ of losses, the taxpayer will be contacted by the IRS.
The sole proprietorship schedule C which is included with the personal form 1040 has a few different sections:
Business Income includes gross receipts and other income. Gross receipts are income from the operations of the business. Other income includes but is not limited to interest received on receivables and recaptured excess depreciation or Section 179 deductions.
Cost of Goods Sold (COGS) is the expenses a business incurs to produce (as a Manufacturer) or sell its goods (as a Retailer). COGS are calculated as follows:
Beginning Inventory + Purchases = Available for Sale – Ending Inventory = COGS
There are different ways to calculate the cost of inventory based on the flow of goods sold. The business must determine a cost flow to determine the cost of COGS and Ending inventory. The two methods used for tax purposes are “First- In - First- Out” (FIFO) and “Last-In - First-Out” (LIFO).
For example, let’s say that you are in the business of selling air conditioners. In January, 2 air conditioning units cost $100 each but in February, those same units now cost $140 each. No inventory was sold until February at which time you sold 3 units. If you use the FIFO method, the COGS = $340 and if you use the LIFO method the COGS =$380.
There are non- cash expenses such as depreciation of assets that have a useful life over one year. Depreciation is a very complex topic which includes Section 179 expenses. Therefore, please contact Kenneth Gibbons LLC for more information.
Vehicle expense can be computed for tax purposes in one of two ways. The first is the actual expense method and the second is the standard mileage rate. Self- employed taxpayers may deduct $100 of their health insurance premiums for themselves, their spouse and any dependents. The deduction is taken as an adjustment to income on Form 1040 and not as a business expense on the Schedule C.
There are many more areas that can be discussed in detail regarding sole proprietorships. The above information is only meant to give a brief understanding of the subject. If you have any tax or accounting questions, contact Kenneth Gibbons LLC for a free consultation.