Sole Proprietorship Tax Primer
A schedule C is a business that is a sole proprietorship. A sole proprietorship is the simplest business form under which one can operate a business. Other business forms include corporation, partnership or LLC. The sole proprietorship is not a legal entity, but is a person who owns the business and is personally responsible for its debts of the business, including tax debts. A sole proprietorship does not offer any legal protection for the owner.
How does a sole proprietorship report its income and expenses?
A sole proprietorship reports its income and expenses on the schedule C of the owner’s 1040 tax return. The taxpayer will need to tally up gross receipts for the sole proprietorship and the expenses broken out by category. It is advisable to keep receipts for at least three years for all deductions. In addition, a 1099 must be issued if your business paid a service provider $600 or more unless the service provided is a corporation.
Net income of the sole proprietorship is arrived at by subtracting cost of goods and all other expenses from gross receipts. Gross receipts means all income from the trade or business. The IRS may check the amount you report as gross receipts against bank statements and other financial documents to confirm that the figure reported as gross receipts is accurate. Self employment tax is applied to the business’ net income, not gross receipts.
Business expenses reduce gross receipts in arriving at net income. To be deductible a business expense must be customary, ordinary, necessary and required for your type of business in order to carry out your trade or business. Some types of expenses that are customary, ordinary, required and necessary are car and truck, travel for business purposes, meals and entertainment, and the home office deduction.
Deduction for car and truck
Using your car for business purposes is very common. You can either deduct the standard IRS rate applied to your business mileage or actual expenses. You must choose one or the other. Often, it is helpful to keep track of all business miles and actual expenses during the year so that you can make an informed decision as to which one is best at the end of the tax year. The standard rate tends to be simpler as you will keep track of all miles and apply the rate to the total business miles driven at the end of the year. The standard rate supposedly builds in costs such as gas, depreciation, registration fees, and maintenance. For example, the standard rate in 2016 is 54 cents per business mile driven. Parking fees and tolls generally may be added to your standard mileage rate. If you choose to deduct actual expenses instead of the using business mileage, you will add up all actual auto expenses for your business vehicle during the tax year and deduct them. This includes: depreciation, lease payments, registration fees, licenses, gas, insurance, repairs, oil, garage rent, tires, tolls, and parking fees. You may only deduct the portion of actual expenses that relate to your business usage of the vehicle. Please refer to this useful IRS guide to the car and truck deduction.
Deduction for travel
Travel is a common business deduction. For a travel expense to be a legitimate deduction, you must travel outside of your geographic tax home and the travel must be business in nature. Generally, your tax home is the entire city or general area where your main place of business or work is located, regardless of where you maintain your family home. For example, you live with your family in San Luis Obispo but work in Los Angeles where you stay in a hotel and eat in restaurants. You return to San Luis Obispo every weekend. You may not deduct any of your travel to, or meals or lodging in Los Angeles because that’s your tax home. Your travel on weekends to your family home in San Luis Obispo isn’t for your work, so these expenses are also not deductible.
If you regularly work in more than one location, your tax home is the general area where your main place of business or work is located. In determining your main place of business, factors include the length of time you normally need to spend at each location for business purposes, the degree of business activity in each area, and the relative significance of the financial return from each area. However, the most important factor is the length of time you spend at each location.
Deductible travel expenses while away from home include, but aren’t limited to, the costs of:
- Travel by airplane, train, bus or car between your home and your business destination. (If you’re provided with a ticket or you’re riding free as a result of a frequent traveler or similar program, your cost is zero.)
- Fares for taxis or other types of transportation between the airport or train station and your hotel, the hotel and the work location, and from one customer to another, or from one place of business to another.
- Shipping of baggage, and sample or display material between your regular and temporary work locations.
- Using your car while at your business destination. You can deduct actual expenses or the standard mileage rate, as well as business-related tolls and parking fees. If you rent a car, you can deduct only the business-use portion for the expenses.
- Meals and lodging. A deduction for meals is typically limited to half of the total cost of the meal.
- Dry cleaning and laundry.
- Business calls while on your business trip. (This includes business communications by fax machine or other communication devices.)
- Tips you pay for services related to any of these expenses.
- Other similar ordinary and necessary expenses related to your business travel. (These expenses might include transportation to and from a business meal, public stenographer’s fees, computer rental fees, and operating and maintaining a house trailer.)
You must keep meticulous records of your travel expenses, including receipts, dates of travel, business purpose of travel, and the destination of travel.
Deduction for meals and entertainment
Expenses for meals and entertainment are deductible if associated with travel as mentioned above, or in connection with entertaining a business client or potential client, a customer, or an employee. An expense for meals and entertainment must meet either the directly related test or the associated test. Only fifty percent of the expense may be deducted for business meals. You must keep meticulous records of your expenses for meals and entertainment, including receipts, the person you met with, and the business purpose of the meal or entertainment.
To meet the directly-related test for entertainment expenses (including entertainment-related meals), you must show that: 1) the main purpose of the combined business and entertainment was the active conduct of business, 2) you did engage in business with the person during the entertainment period, and 3) you had more than a general expectation of getting income or some other specific business benefit at some future time. Even if your expenses don’t meet the directly-related test, they may meet the associated test. To meet the associated test for entertainment expenses (including entertainment-related meals), you must show that the entertainment is: Associated with the active conduct of your trade or business, and Directly before or after a substantial business discussion.
Deduction for home office
If you use part of your home for business, you may be able to deduct expenses for the business use of your home. The home office deduction is available for homeowners and renters, and applies to all types of homes. If you don’t use the simplified option (refer to this helpful IRS publication for more information on the IRS simplified method for the home office deduction), you must determine the actual expenses related to your home office. These expenses may include mortgage interest, insurance, utilities, repairs, and depreciation. Generally, deductions for a home office are based on the percentage of your home devoted to business use. So, if you use a whole room or part of a room for conducting your business, you need to figure out the percentage of your home devoted to your business activities.
Regardless of whether you use the simplified or regular method for calculating your home office deduction, there are two basic requirements for your home to qualify as a deduction:
- Regular and Exclusive Use. You must regularly use part of your home exclusively for conducting business. For example, if you use an extra room to run your business, you can take a home office deduction for that extra room. You cannot use the room or area for any other purpose other than business. This means that, for example, you cannot store personal items in the home office.
- Principal Place of Your Business. You must show that you use your home as your principal place of business. Your home office will qualify as your principal place of business if you use it exclusively and regularly for administrative or management activities of your trade or business or if you have no other fixed location where you conduct substantial administrative or management activities of your trade or business. To determine whether your home office is your principal place of business, consider the relative importance of the activities performed at each place where you conduct business, and the amount of time spent at each place where you conduct business. If you conduct business at a location outside of your home, but also use your home substantially and regularly to conduct business, you may qualify for a home office deduction. For example, if you have in-person meetings with patients, clients, or customers in your home in the normal course of your business, you can deduct your expenses for the part of your home used exclusively and regularly for business, even though you also carry on business at another location. You can also deduct expenses for a separate free-standing structure located within your home property, such as a studio, garage, or barn, if you use it exclusively and regularly for your business. For a separate free standing structure, it does not have to be your principal place of business or the only place where you meet patients, clients, or customers.
How Does the IRS Tax A Sole Proprietorship?
Sole proprietorships are commonly used and can provide businesses with unique tax deduction opportunities. Don’t miss out on deductions that you are entitled to, including car and truck, travel for business purposes, meals and entertainment, and the home office deduction. Always keep meticulous records for at least three years of your receipts, proof of payment of expenses, invoices, and records indicating business purpose for travel, meals and entertainment. If the IRS were to audit your income sole proprietorship’s income and expenses, your records will greatly help substantiate your business deductions and make the audit process much smoother. An IRS audit can be a stressful experience, but it doesn’t have to be if you are prepared. If you have questions about tax deductions for your sole proprietorship, contact a Los Angeles tax attorney today for a free consultation.