Filing Taxes as Sole Proprietor

You may be a sole proprietor for tax purposes and not know it.  Many people think they have to own a business in order to be required to file their tax return as a sole proprietor.  The IRS has a very flexible definition of “business.”  For tax purposes, you have a business if you work for money, and you are not considered a “bonafide” employee by your employer.

I.  How can you tell if you have been classified a bonafide employee?

You are a bonafide employee if you filled out and submitted a W-4 to your employer, your employer has been withholding federal and state income tax, as well as FICA (Social Security and Medicare), from every paycheck. You can expect to receive a W-2 early February reporting the total income and withholding for the year.  You would report the income from Box 1 of the W-2 on the first page of your tax return, line 7.  If you have more than one job for which you submitted a W-4, you will receive more than one W-2 for the tax year. Enter the total amount from all W-2s on line 7.

You are not a bonafide employee if you examine a pay stub and find no FICA withholding. In all but a few cases, you will have to file a Sole Proprietor Schedule C or C-EZ on that income.  As a sole proprietor for tax purposes, you may be in for a nasty surprise. 

Our tax system is a pay-in-advance system.  You pay an estimate of your taxes according to the information on the W-4 you submitted to your employer.  The purpose of the tax return is to determine your actual tax liability, and compare it to what you have already paid.  If the total tax you have paid all year through withholding exceeds your actual tax liability, you will get a refund of your money.  If your actual tax liability exceeds your total withholding, you will owe tax.

II.  What if you discover you have self-employment income?

If you were not aware that some of your income was actually self-employment income, you probably have not paid any advance tax on that income.  But wait, it gets worse.  You also have not paid FICA.  With a regular job, you pay one-half of the FICA through withholding and your employer pays the other half out of his business income.  Self-employed persons must pay both halves. 

Both halves of FICA equals 15.3% of your self-employed income.  You will also owe income tax at your tax bracket.  At the lowest tax bracket of 10%, it means that 25.3% of your self-employment income is already spoken for.  But if you did not realize you had self-employment income, the money has probably been spent.

III.  Who might be unaware they have self-employment income?

You may be wondering how it could be possible for a person to not know they have self-employment income.  An example I see all the time are college students working as note-takers or homework graders.  They believe they are employees of the university.  Their first clue that all is not what is seems is when the Form 1099MISC arrives in January instead of a W-2.  Another common case is an employer who tells you that you are considered an independent contractor.  As an independent contractor, you will get a 1099MISC. 

It is against the law for an employer to classify a bonafide employee as an independent contractor.  If you believe you should be getting a W-2 instead of a 1099MISC, the IRS wants to hear about it.

IV.  How do you report self-employment income?

Some people erroneously believe that if they do not receive a 1099MISC, they do not have to report the income.  You must report the income using Schedule C or C-EZ whether you have a received a 1099MISC or not.

Once you have determined that you have any sole proprietor income, you will want to complete a Schedule C or C-EZ.  You report your gross revenue and expenses.  If your revenue exceeds your expenses, the difference is the income on which you will pay income tax and FICA.  If your expenses exceed your revenue, you have a net loss.  You will not owe income tax or FICA on a net loss.  The net loss will also reduce your other income and thus reduce your final tax liability, possibly increasing your refund.

If you have a very simple sole proprietorship, you can find most of the information you need in IRS Publication 17.