Tax Rules For Sole Proprietorships With Employees

You may be operating a sole proprietorship and not even know it.

The sole proprietorship is the most basic business structure in the United States. They are also the default entity. With a few exceptions, once you start your business, you function as Sole proprietor.

But is the business structure right for you? And how can you be sure you're doing it right?

Consider this a unique crash course in Sole proprietorship. We'll cover everything you need to know: how a Sole proprietorship works, what types of businesses typically operate with a Sole proprietorship, how it is taxed, and tax rules for sole proprietors with employees.

What is a sole proprietorship?

A Sole proprietorship is a type of unregistered business owned (and operated) by one person. When you run a single business, you are responsible for everything the business has to pay for. So if your business owes someone money, you owe them personally. And if someone sues your business, you, as the business owner, are being sued.

Sole proprietorship taxes

When you run a Sole proprietorship, you and your business are taxed the same (even if you have a registered business name). Which means your "business" doesn't pay taxes. Instead, your business income is considered "personal income," so you pay your taxes yourself. This means that the tax table you usually refer to find your personal tax rate is the same as the individual tax table.

All business income and expenses are filed on IRS Form 1040 Schedule C with your personal tax return. If you plan to pay income taxes or more than $1,000, you will need to file estimated taxes.

Since Sole proprietors are self-employed, they have to pay taxes (social security and health insurance) themselves, which are normally partially covered by the employer. The self-employment tax represents 15.3% of net income.

Tax rules for sole proprietorships with employees

Hiring employees is a big sign that a business is growing and becoming a constant success. The only difficulty is meeting the various reporting requirements.

Employers are generally required to withhold and report Federal Income Tax (FIT), State Income Tax, Social Security and Medicare taxes, and Federal unemployment tax. In addition, depending on where the employee works, you may need to withhold and deposit local income tax.

Even when a sole proprietor hires an employee, the Sole proprietor's income is still subject to self-employment tax and cannot be treated as an employee. The exclusion to this rule is in the case of businesses, where business owners are considered as employees of the business.

Federal and state income tax

When hiring new employees, one of the first documents to be received is the W-4 form. This form helps determine the amount of federal and state income tax withheld from the employee's pay. Failure to comply with an employee's Form W-4 means that income tax must generally be withheld at the maximum rate set for the number of wages.

• How to report it: Most employers must submit IRS Form 941 quarterly to report income tax withheld from employee wages, while agricultural employers file IRS Form 943 annually. The presentation of state tax deductions varies.

• Annual Reporting: In addition to Form 941 or 943, the employer must complete IRS Form W-3 along with Employee Form W-2 attached annually to the Social Security Administration.

Medicare Taxes and Social security 

Employers are generally required to deduct a portion of social security and Medicare taxes (known as "FICA" taxes, as created under the Federal Insurance Contributions Act) from their employee's wages and pay an equivalent amount themselves.

Currently, the withholding rate is generally 6.2% for Social Security and 1.45% for Medicare. The employer is required to pay an equal amount for each employee. However, as soon as the employee's salary for that year exceeds a certain amount, his salary is no longer subject to the social security rate.

Since 2013, employers are also responsible for withholding 0.9% of additional Medicare tax on wages and claims that exceed a threshold value based on an employee's marital status. However, employers are not required to pay equivalent amounts for the additional Medicare taxes.

How it is reported: Most employers must submit IRS Form 941 quarterly to report employee payroll deductions to FICA, while agricultural employers file IRS Form 943 by February 28 of each year.

Unemployment tax

The Federal Unemployment Tax (FUTA) and state unemployment plans provide unemployment insurance payments to workers who have lost their jobs. Most employers pay federal and state unemployment taxes. Currently, FUTA is only paid for the first $7,000 of salary, while for States, that salary base varies. In addition, only the employer pays the FUTA tax, which means that nothing is deducted from the employee's income to pay the tax.

It is important to note that the FUTA rules differ for commercial, farm, and home employers.

How it is reported: The employer must complete IRS Form 940 each year to report the amount of FUTA payroll tax paid to employees. Different forms apply for each state.

FOR MORE INFORMATION ON HOW DANIEL P VIGILANTE, CPA & PROFIT CONSULTANTS CAN BEST HELP YOU WITH YOUR TAX FILING NEEDS, PLEASE CLICK THE BLUE TAB ON THIS PAGE.

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