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Solo 401(k) Contribution Limit with Another Job

A reader writes in, asking:

“For the first 9 months of 2016, I have been considered a self-employed 1099 contractor at a hospital. As of October 1st, I will be a W-2 employee, but I will be doing the same work at the same hospital.

If I have sufficient earnings as a 1099 contractor for that 9-month period in 2016, will I be able to contribute a full $53,000 to my Solo 401k with that contribution being funded as ’employer’ contributions while also contributing up to $18,000 to my 401k as an employee for the period of October 1, 2016 – December 31, 2016?”

Short answer: Yes.

[Quick note: With what follows, I am assuming that the reader is familiar with the basics of solo 401(k) contribution limits. If you are not, I’d suggest reading up on them before proceeding.]

The employee salary deferral limit for 401(k) plans (i.e., $18,000 for 2016) is a per-person limit. That is, any deferrals that are made to the plan at your job as an employee will be counted against the $18,000 limit for deferrals (i.e., “employee” contributions) to the solo 401(k) — and vice versa.

The $53,000 annual limit works differently though. This limit comes from IRC 415(c). The key point when reading that Code section is to understand that these are the rules for a given plan, rather than for a given person. That is, the plan wouldn’t be a qualified retirement plan if it let a participant contribute more than $53,000, but there’s no rule saying that a given person isn’t allowed to make more than $53,000 of total contributions if they are a participant in multiple plans.

This article from IRS.gov provides a very clear example:

“Greg, 46, is employed by an employer with a 401(k) plan and he also works as an independent contractor for an unrelated business. Greg sets up a solo 401(k) plan for his independent contracting business. Greg contributes the maximum amount to his employer’s 401(k) plan for 2015, $18,000. Greg would also like to contribute the maximum amount to his solo 401(k) plan. He is not able to make further elective deferrals to his solo 401(k) plan because he has already contributed his personal maximum, $18,000. He has enough earned income from his business to contribute the overall maximum for the year, $53,000. Greg can make a nonelective contribution of $53,000 to his solo 401(k) plan. This limit is not reduced by the elective deferrals under his employer’s plan because the limit on annual additions applies to each plan separately.”

Caution: Shared Ownership

While the $53,000 limit is a per-plan limit, it’s important to understand that, in some cases, multiple retirement plans will be aggregated (i.e., considered to be one plan). IRC 415(g) and 415(h) provide the relevant rules.

Specifically, multiple businesses will be aggregated as part of a “brother-sister controlled group” if five or fewer individuals (including people, estates, and trusts) own more than 50% of the stock of each business (measured in terms of voting power or value). Alternatively, two businesses will be aggregated as part of a “parent-subsidiary controlled group” if one business owns more than 50% of the other business (again measured in terms of voting power or value).

For example, if you are the sole owner of two single-member LLCs, those two LLCs will be aggregated for these purposes (and you will not be able to exceed the $53,000 total contribution limit), even if the two LLCs operate in completely different industries.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

Is It Better to Be Taxed as an Employee or Independent Contractor?

A reader writes in, asking:

“I just started a new position and the company is letting me decide whether I want to be taxed as an employee or an independent contractor. What factors should I be considering in order to make this decision?”

Firstly, we need to back up a step, because this question sets off some alarm bells.

It is the facts and circumstances of the work relationship that determine whether a worker is an employee or an independent contractor. Generally speaking, the more control the business has over the worker, the more likely it is that the worker is an employee rather than an independent contractor. (IRS Publication 15-A has more details.)

In other words, if the facts and circumstances of the work suggest that you are an employee, the business cannot simply decide you are an independent contractor and handle everything accordingly. And in fact many employers get in trouble with the IRS every year as a result of having misclassified their employees as independent contractors.

The key point here is that, in the event that you really do have a choice between being an independent contractor or an employee (i.e., it is not simply a case of the business misunderstanding the rules and thinking that they can treat you as either one without any substantial difference in the work relationship), there are going to be factors other than taxation involved.

So What Are the Tax Differences?

From a tax perspective, there are both pros and cons regarding the tax treatment for independent contractors as compared to employees.

As an employee, you are responsible for paying Social Security and Medicare taxes in the amount of 7.65% (2.9% for amounts beyond the current Social Security earnings limit), and your employer pays a matching amount. As an independent contractor, you have no employer, so you get stuck with both halves of the bill (in the form of a 15.3% self-employment tax).

Another disadvantage of being an independent contractor is that it requires somewhat more administrative work. You’ll have to fill out Schedule C along with your Form 1040 every year to calculate the profit or loss from your business. In addition, because nobody will be withholding taxes from your income, it will (in most cases) be necessary for you to make estimated tax payments throughout the year.

On the other hand, one advantage of independent contractor tax treatment is that your work-related expenses will be business expenses, which will save you money on income tax as well as Social Security and Medicare taxes. In contrast, as an employee, unreimbursed work expenses are generally itemized deductions, meaning that you get no value from them if you use the standard deduction each year. In addition, they’re in the category of itemized deductions from which you must subtract 2% of your adjusted gross income before even being allowed to include them as an itemized deduction. (See the instructions to Schedule A for more information.)

An additional advantage of being an independent contractor is that you’ll have additional retirement plan options available to you. Most importantly, you’ll be eligible for a solo 401(k) — alternatively referred to as an individual 401(k) — for which the contribution limits are quite high.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

How to Calculate Self-Employment Tax

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The self-employment tax is a tax that gets added to your normal income tax. The tax is calculated by multiplying your earnings from self-employment by approximately 15%.

Why the Self-Employment Tax Exists

At first glance, it seems unfair that entrepreneurs — the most important driving force behind our economy — would be forced to pay an additional tax. In reality, however, sole proprietors are simply paying this particular tax instead of another one.

If you’ve had a job where you were paid a salary or an hourly wage, you’re probably familiar with the fact that part of your income was withheld for taxes. A portion of the amount withheld from an employee’s wages goes to pay the Social Security and Medicare taxes.

The way these taxes are structured, the burden is shared equally between the employee and the employer. The employee’s share is calculated as 6.2% of the employee’s wages for Social Security tax and 1.45% for the Medicare tax. At the same time, the employer also pays both taxes, calculated at the same rate. As a result, an amount equal to 12.4% (or 6.2% + 6.2%) is paid in total for Social Security tax, and an amount equal to 2.9% (or 1.45% + 1.45%) is paid in total for the Medicare tax.

Given that you are self-employed, there is no employer with whom you can split the burden. You are therefore responsible for paying both halves of the Social Security and Medicare taxes, or 15.3% in total. We simply call the tax something different; we call it the self-employment tax.

How to Calculate Your Self-Employment Tax

As long as your “net earnings from self-employment” are $400 or more, you will be responsible for paying the self-employment tax — calculated as 15.3% of your net earnings from self-employment.

To calculate your net earnings from self-employment, subtract your business expenses from your business revenues, then multiply the difference by 92.35%. (This odd multiplication figure is the result of the fact that you’re allowed to deduct 50% of your self-employment tax when calculating the income upon which the tax will be charged.)

It’s important to note that the 12.4% Social Security tax only applies to the first $118,500 of earned income per year. (This number is updated annually, so be sure to check what the most recent limit is.) The 2.9% Medicare tax, however, does not have a limit.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

The Importance of Business Expenses (Schedule C Deductions)

Now that you’re self-employed, you have an additional, extra-valuable level of deductions: business deductions. The reason business deductions are so valuable is that they reduce not only your taxable income (and thus your regular income tax), but also your earnings from self-employment, thus reducing your self-employment tax as well.

From now on, whenever you learn that a particular expenditure can be deducted, it will be important for you to determine whether that expenditure counts as a personal expense, or if it can be classified as a business expense, thereby saving you even more money.

In order for an expense to be deductible for your business, it must be both “ordinary” and “necessary.” The IRS considers an ordinary expense to be one that is both common and accepted in your field. A necessary expense is one that is helpful and appropriate for your business. (Note that this means that an expense does not have to be absolutely indispensable for it to be considered necessary.)

Deduction for One-Half of SE Tax

One small piece of good news relating to the self-employment tax is that you get a little bit of it back in the form of an above the line deduction. After using Schedule SE to calculate your self-employment tax, you’ll enter an amount equal to one-half of your self-employment tax on line 27 of your Form 1040 as a deduction to arrive at adjusted gross income.

Simple Summary

  • The self-employment tax exists simply to take the place of the Social Security and Medicare taxes that you and your employer would be paying if you had a job as an employee.
  • The tax is calculated as 15.3% of your net earnings from self-employment (or 2.9% for amounts beyond the annual maximum amount subject to Social Security tax).
  • Business deductions (sometimes called Schedule C deductions) are more valuable than either above the line or below the line deductions. This is because business deductions reduce your earnings from self-employment, thereby reducing your regular income tax and your self-employment tax.
  • You will get a little bit of the money you pay for self-employment tax back when you file your taxes for the year. This is because you are allowed an above the line deduction equal to 50% of the amount you pay for self-employment tax.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

Solo 401(k) Contributions: Employee or Employer?

A reader writes in, asking:

“I have a solo 401k at Vanguard. There’s no way I will hit the total contribution limit for the year, so should I be making employer or employee contributions to the account?”

As background information, if you are a business owner with a solo 401(k) — sometimes referred to as an individual 401(k) or self-employed 401(k) — you can make two types of contributions to the account:

  • An “employee” contribution, limited to $18,000 ($24,000 if age 50 or over) for 2016, and
  • An “employer” contribution, limited to 25% of your net earnings from self-employment (if you are a sole proprietor or LLC taxed as a sole proprietorship) or 25% of your compensation (if you are an owner-employee of an S-corp or LLC taxed as an S-corp).

Solo 401(k) for Sole Proprietors

For a sole proprietor, pre-tax (i.e., “traditional”) contributions (whether they’re employee or employer contributions) will be deducted on line 28 of Form 1040 under “Self-employed SEP, SIMPLE, and qualified plans.”

Because pre-tax employer and employee contributions are deducted in the same way, neither one is more tax-efficient than the other.

That said, because employee contributions can be Roth or pre-tax, whereas employer contributions can only be pre-tax, if you want to make pre-tax contributions, it often makes sense to make them as employer contributions (to the extent possible), thereby saving your (more flexible) employee contribution space, in case you decide that your further contributions should be Roth rather than pre-tax.

Solo 401(k) for S-Corporation Owner/Employees

If your business is taxed as an S-corporation, contributions that you make as an employee would reduce the amount of wages that would appear in box 1 on your W-2 — and therefore the amount of wages that show up on your Form 1040. Note that they do not reduce the amounts that show up in boxes 3 and 5 (“Social Security Wages” and “Medicare Wages”). In other words, these contributions reduce your income tax, but they do not reduce your payroll taxes.

Employer contributions to the solo 401(k) would show up on line 17 of Form 1120S as “Pension, profit-sharing, etc., plans.” This would reduce the amount of income from the S-corporation that would be passed through to you as the owner, thereby reducing your income tax. But, because this income is not subject to payroll taxes in the first place, these contributions will not reduce your payroll taxes.

In other words, for an S-corp owner-employee, employer and employee pre-tax solo 401(k) contributions are equally advantageous (just as they are for a sole proprietor). Though again, by prioritizing employer contributions, you preserve your more flexible employee contribution space, in case you decide you want to make Roth contributions later in the year.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

SEP vs. SIMPLE vs. Solo 401(k)

(The following is an excerpt from my book Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

One of the biggest benefits of being self-employed is that there are more (and better) retirement plan options available to you than are available to most taxpayers. In addition to the standard traditional IRA/Roth IRA options that everybody has, you have three more noteworthy options:

  1. Simplified Employee Pension (SEP IRA),
  2. Savings Incentive Match Plan for Employees (SIMPLE IRA), and
  3. Individual 401(k) — sometimes called a solo 401(k) or a self-employed 401(k).

Much of the IRS literature comparing these three options is rather complicated. Fortunately, most of that literature is irrelevant if you have no employees. If you have no employees, the primary difference between the plan options is the contribution limit for each. (Note: These limits are not cumulative, so there’s usually no benefit to opening more than one retirement plan for your business.)

If you do have employees and you want to set up a retirement plan for your business, I strongly recommended that you consult with a tax professional, not only because there are additional factors in the decision of which plan to open, but because there are ongoing reporting and nondiscrimination requirements as well.

I should also note here that there are several other types of retirement plans aside from the three listed above. But for self-employed taxpayers without employees, it’s unlikely that any of the other plan types will be a better choice.

Retirement Plans in General

Most of the retirement plan options for self-employed taxpayers function similarly to a traditional IRA. That is, contributions made to the plan reduce your taxable income, and your investments are allowed to grow tax-deferred until you start making withdrawals from the plan. Unfortunately, contributions are above the line deductions rather than Schedule C deductions, meaning they save you money on income tax but not self-employment tax.

SEP IRA

SEP IRAs work in almost the exact same way as a traditional IRA. That is, you are allowed an above the line deduction for any contributions you make, and distributions from the account are taxable as income. The only really important difference is the contribution limit. For 2016, if you have a SEP, you are allowed to contribute the lesser of:

  1. 25% of your net earnings from self-employment, or
  2. $53,000.

Once the money is in the plan, you can invest it in all of the same things you would be allowed to invest in with a regular IRA (stocks, bonds, mutual funds, CDs, etc.). Also, the same withdrawal rules apply. With a few exceptions, you cannot make withdrawals from the plan prior to age 59.5 without being penalized.

One important thing to know is that, for purposes of calculating your maximum contribution, “net earnings from self-employment” is perhaps not quite what you’d expect. Basically, it’s all your revenues, minus your expenses (makes sense so far), minus two other items:

  1. The deduction for one-half of your self-employment tax, and
  2. The deduction for contributions to your SEP IRA.

The idea of deducting your contribution amount when attempting to figure out how much you can contribute in the first place might sound a little confusing. It turns out it’s not so tricky: 25% of your net earnings from self-employment is just 20% of your net earnings from self-employment before considering your deduction for SEP contributions.

EXAMPLE: Prior to considering any deduction for SEP contributions, your net earnings from self-employment for this year are $80,000. Assuming you do not contribute to another retirement plan for your business, your annual SEP contribution will be limited to $16,000 (20% of $80,000).

SIMPLE IRA

SIMPLE IRAs also function much like traditional IRAs. Again, the primary difference is the contribution limit. If you have a SIMPLE IRA, you can make:

  1. An employee contribution equal to 100% of your net earnings from self-employment, up to $12,500 for 2016 ($15,500 if you are 50 or over), plus
  2. An employer contribution equal to 3% of your net earnings from self-employment.

For SIMPLE IRA purposes, “net earnings from self-employment” is your revenues, minus your expenses, times 92.35% (to account for your deduction for one-half of your self-employment tax).

EXAMPLE: You’re under 50 years old, and, after subtracting your deduction for one half of your self-employment tax, your business’s net profit is $50,000. Assuming you don’t contribute to any other retirement plans, the most you’ll be able to contribute to a SIMPLE IRA is $14,000 ($12,500, plus 3% of $50,000).

One other difference between a SEP IRA and a SIMPLE IRA is that, should you have to make an early withdrawal from a SIMPLE IRA within two years of the plan’s inception date, you will be penalized more than you would be if it were a SEP IRA (25% penalty as compared to 10% penalty).

Individual 401(k) Plans

An individual 401(k) plan functions very much like a 401(k) plan with a person’s employer. The difference is that you are allowed to make a contribution in the role of employee and a contribution in the role of employer. You are allowed to make:

  1. An employee contribution of $18,000 for 2016 ($24,000 if you are 50 or over), plus
  2. An employer contribution of 20% x (your business’s profit, minus the deduction for one-half of your self-employment tax).

However, the total contribution is limited to the lesser of, for 2016, $53,000 ($59,000 if you are 50 or over) or your net earnings from self-employment, which in this case is calculated as:

  • Your business’s profit, minus
  • The deduction for one-half of your self-employment tax, minus
  • Any employer contributions made to the plan.

EXAMPLE: You’re under 50 years old, and you have a business with no employees. Prior to considering any contributions you make, your net earnings from self-employment are $100,000 for 2016. If you have an individual 401(k) plan (and no other retirement plans to which you’re contributing), your contribution limit will be $38,000 calculated as follows:

  • Employee contribution of $18,000, plus
  • Employer contribution of $20,000 (20% of $100,000).

If you had a SEP IRA instead, your contribution would be limited to $20,000 (20% of $100,000). Alternatively, if you have a SIMPLE IRA, your contribution limit would be even lower ($12,500 plus 3% of net earnings from self-employment).

The conclusion here? In most circumstances you can contribute more — sometimes much more — to an individual 401(k) than you could contribute to a SEP IRA or SIMPLE IRA.

(For more information, see the book on Amazon: Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less.)

Individual 401(k): Roth Option

In addition to usually allowing for greater contributions, individual 401(k) plans have another benefit: If you would prefer to do so, you can make Roth contributions to an individual 401(k) rather than pre-tax (“traditional”) contributions.

Note, however, that many brokerage firms do not allow for this option, so be sure to check with the brokerage firm you’re considering if it’s important to you to be able to make Roth contributions.

If you decide to open an individual 401(k) with a Roth option, it’s important to know that only the employee contributions (those limited to $18,000 per year or $24,000 if 50 or older) can be Roth contributions. The employer contributions must be made as traditional, tax-deferred contributions.

Is an Individual 401(k) Always Best?

Given the dual advantages of Roth contribution capability and (usually) higher contribution limits, one might wonder why anybody would choose a SEP or SIMPLE IRA over an individual 401(k).

Previously, a significant disadvantage to individual 401(k) plans was that they came with higher administrative costs. In the last few years though, price competition has brought costs down considerably at some brokerage firms. For example, Fidelity’s individual 401(k) has no set-up or administrative costs at all. Similarly, Vanguard’s individual 401(k) has no set-up fees and only a modest administrative fee: $20 per year for each mutual fund in the plan — and this fee is waived if you have at least $50,000 of assets with Vanguard.

Given the decline in costs, the only real remaining drawback is paperwork. Setting up an individual 401(k) will likely require you to fill out more forms than opening a SEP or SIMPLE IRA. In addition, individual 401(k) plans require  you to file Form 5500-EZ with the IRS every year once the plan reaches $250,000 in assets.

Deadlines for Retirement Plans

A SEP IRA can be set up as late as the due date (including extensions) for the business’s tax return for the year. The deadline for contributions is the same date. For a sole proprietor, this means that you can set up the plan and make contributions for a given year as late as April 15 of the following year (or October 15 of the following year if you filed for an extension).

Assuming you’ve never had one before, a SIMPLE IRA can be set up as late as October 1 of the first year for which you wish to make contributions. (If you have had a SIMPLE IRA before and are setting up another one, you must set it up by January 1 of the first year for which you wish to make contributions.)

For a sole proprietor, the deadline for SIMPLE IRA employee contributions is January 30 of the following year. The deadline for the employer contribution is the due date (including extensions) for the business’s tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

The deadline for opening an individual 401(k) is December 31 of the first year for which you wish to make contributions. For a sole proprietor, contributions can be made up until the due date (including extensions) of your tax return for the year (i.e., April 15 of the following year, or October 15 if you filed for an extension).

What if You Have Other Retirement Accounts?

Given that you now have so many different options available to you, it’s important to know how each of these plans interacts with other retirement accounts. None of the above-mentioned plans will affect your ability to contribute to a traditional or Roth IRA. They could, however, affect your ability to claim a deduction for a contribution to a traditional IRA, because if you have one of the business retirement plans described above, you are considered to be covered by a retirement plan at work, which means that if your adjusted gross income is over a certain amount, you will not be able to claim a deduction for a traditional IRA contribution.

In addition, if you have another job as an employee and you are allowed to contribute to a 401(k) at that job, contributions you make to your plan at work — to take advantage of an employer matching contribution for instance — will count against the limit for employee contributions to an individual 401(k) or SIMPLE IRA. Conversely, employee contributions you make to an individual 401(k) or SIMPLE IRA will count against the contribution limit for your plan at work.

EXAMPLE: Jan is 40 years old and has a full-time job that offers a dollar-for-dollar match for contributions she makes to her 401(k), up to $4,000. She also has a part-time business for which she has an individual 401(k). Prior to considering any contributions, her net earnings from self-employment are $40,000.

To get the maximum match from her employer, she contributes $4,000 to her 401(k) at work. The maximum employee contribution she can make to her individual 401(k) for the year is $14,000 ($18,000 — $4,000). In addition, she can make an employer contribution of up to $8,000 (20% of her net earnings from self-employment, before considering contributions).

Simple Summary

  • As a business owner, you have several options for retirement plans.  In most cases, contributions to these plans reduce your taxable income.
  • Generally speaking, you want to choose the plan that has the highest contribution limit for your situation.
  • In most cases, an individual 401(k) plan will allow for the largest contribution. In addition, individual 401(k) plans allow for Roth contributions (though this is not available at all brokerage firms).
  • SEP IRAs and SIMPLE IRAs, however, can sometimes be good choices because of their simplicity.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

How Are Sole Proprietorships Taxed? | Sole Proprietor Taxes

Much like forming a sole proprietorship, handling the taxes for a sole proprietorship is fairly simple. It really comes down to filling out just a few forms.

“Pass-Through” Taxation

Sole proprietorships are known as “pass-through” entities. What this means is simply that the profit (or loss) from the business is “passed through” to the owner of the business. Therefore, if you run a sole proprietorship, the profit from the business will show up on your regular individual tax return (i.e., Form 1040).

Schedule C

Schedule C is the form that you’ll use to compute the profit or loss from your business. As tax forms go, this one isn’t terribly complicated. For the most part, it’s just a list of all your revenues followed by a list of all your expenses.

Generally, the only time something isn’t straight-forward occurs when you have an expense that doesn’t seem to fit nicely into any of the expense categories listed. And even then, all you have to do is list it on the line for “Other Expenses” and (on Page 2 of Schedule C) give an explanation of what the expense was.

The end-result of Schedule C will be a figure known as your “Net Profit or Loss,” which you then carry over to your Form 1040 to be entered on Line 12 (Business Income or Loss). This income will be added to any salaries or wages that you or your spouse earn and will be taxed at the regular individual income tax rates.

The Self-Employment Tax

In addition to being subject to regular income tax, earnings from a sole proprietorship are subject to the self-employment tax (SE tax). The SE tax is calculated (on Schedule SE) by multiplying your net earnings from self-employment by 15.3%.

At first glance, it may seem unfair to subject somebody to an extra tax simply because they are self-employed. However, the SE tax is really just a substitute for the Social Security and Medicare taxes that are paid on salaries and wages for employees.

For employees, a Social Security tax of 6.2% and Medicare tax of 1.45% are withheld from each paycheck. Then the employer is required to pay a matching amount. As such, the employee is paying 7.65%, and the employer is paying 7.65% for a grand total of 15.3%. When you run a sole proprietorship, you are, in essence, both the employee and the employer, so you get stuck with both halves of the bill.

Deduction for One-Half of SE Tax

Because you’re paying a little bit of extra tax (the 7.65% that your employer would be picking up if you were an employee), Congress decided it would be fair to allow you to claim a deduction for the extra tax paid. As such, after using Schedule SE to calculate your self-employment tax, you get to enter — on line 27 of your Form 1040 — an amount equal to one-half of your SE tax as an “above the line deduction.”

Simple Summary

  • Sole proprietorships are known as “pass-through” entities because the income from the business is passed through to the owner, showing up eventually on his or her Form 1040.
  • The profit or loss from a sole proprietorship is calculated on Schedule C.
  • Earnings from a sole proprietorship are subject to the self-employment tax (in addition to being subject to the regular federal income tax). The SE tax is calculated as 15.3% of your net earnings from self-employment.
  • Schedule SE is the form used to calculate the self-employment tax.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."
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