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William Perez

How to Prepare a Tax Return for a Sole Proprietor

By February 21, 2012

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Sole proprietors are people who work for themselves in their own business. They may be called freelancers, independent contractors, or entrepreneurs. Sole proprietors could be working under their own name or through a single-member limited liability company. In either case, a sole proprietor reports his or her income on Schedule C.

There's a number of things to which a sole proprietor should to pay attention. Let's start with an overview of the tax filing obligations. Sole proprietors will need to fill out the long Form 1040, along with Schedule C and Schedule SE. There are other line items on the Form 1040 that are particularly relevant to sole proprietors, such as Line 27 to deduct the "employer" portion of Social Security and Medicare taxes, Line 28 to report contributions to a small business retirement plan, and Line 29 to report health insurance premiums. Along with the Schedule C, these various line items capture most of the income and expenses that a sole proprietor incurs.

Before filling out these Schedules and line items, it's very helpful to have a summary of business income and business expenses. You could do this on paper, or using any number of financial software programs. The important thing is to have a report that summarizes total amounts for each category, such as total business income and totals for various types of expenses. The next step is to map these items to the tax forms. Most business expenses will get reported somewhere on the Schedule C. But expenses for health insurance, the business portion of the self-employment tax, and contributions to the sole proprietor's own retirement plan will be reported directly on the Form 1040.

After seeing where various income and expense items go on the tax forms, you'll be able to navigate the tax forms or your tax software much more effectively.

Now for an overview of the sole proprietor's tax situation. Sole proprietors are taxed on their net income, after related business expenses have been taken into account. On that net income, sole proprietors pay both the income tax and the self-employment tax (both the employee's and the employer's halves of the Social Security and Medicare taxes). Business expenses reportable on the Schedule C reduce both the income tax and the self-employment tax. Expenses shown directly on the Form 1040 (for health insurance and retirement funding) reduce the income tax only and do not reduce the self-employment tax.

Sole proprietors may also need to report some expenses in a separate filing with the IRS by issuing Form 1099-MISC. This reporting is required if a payment of $600 or more was made to a non-corporate service provider (that is, to another sole proprietor for services rendered) during the course of the year. New for 2011, the Schedule C now has questions I and J at the top of the schedule to ask if any 1099s were required and, if so, whether a 1099 was filed.

Also new for 2011, sole proprietors may have received a Form 1099-K to report sales income paid via credit or debit cards. The IRS has added a new line item 1a on Schedule C to report amounts from Form 1099-K. But for 2011 only, the IRS is instructing us to ignore this line item and report total gross revenues directly on line 1b.

More tax tips for sole proprietors:

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