(a fictitious business name, or FBN). This is sometimes referred to as a DBA, which stands for “doing business as.”
From a legal standpoint, as a sole proprietor, you are personally liable for any debts your business incurs. For example, if you borrow money and default on a loan, the lender can look not only to your business equipment and other business property but also to your personal stocks, bonds, and other property. Some states may give your house homestead protection; state or federal law may protect your pensions and even Individual Retirement Accounts (IRAs). Your only protection for your personal assets is adequate insurance against accidents for your business and other liabilities and paying your debts in full.
Simplicity is the advantage to this form of business. This form of business is commonly used for sideline ventures, as evidenced by the fact that half of all sole proprietors earn salaries and wages along with their business income. For 2015 (the most recent year for statistics), more than 24.7 million taxpayers filed returns as sole proprietors.
One type of sole proprietor is the independent contractor. To illustrate, suppose you used to work for Corporation X. You have retired, but X gives you a consulting contract under which you provide occasional services to X. In your retirement, you decide to provide consulting services not only to X, but to other customers as well. You are now a consultant. You are an independent contractor to each of the companies for which you provide services. Similarly, you have a full-time job but earn extra money by performing chores for customers through TaskRabbit. Here too you are an independent contractor.
More precisely, an independent contractor or freelancer is an individual who provides services to others outside an employment context. The provision of services becomes a business, an independent calling. In terms of claiming business deductions, classification as an independent contractor is generally more favorable than classification as an employee. (See “Tax Treatment of Income and Deductions in General,” later in this chapter.) Therefore, many individuals whose employment status is not clear may wish to claim independent contractor status. Also, from the employer's perspective, hiring independent contractors is more favorable because the employer is not liable for employment taxes and need not provide employee benefits. (It costs about 30 % more for an employee than an independent contractor after factoring in employment taxes, insurance, and benefits.) Federal employment taxes include Social Security and Medicare taxes under the Federal Insurance Contribution Act (FICA) as well as unemployment taxes under the Federal Unemployment Tax Act (FUTA).
You should be aware that the Internal Revenue Service (IRS) aggressively tries to reclassify workers as employees in order to collect employment taxes from employers. A discussion about worker classification can be found in Chapter 7.
There is a distinction that needs to be made between the classification of a worker for income tax purposes and the classification of a worker for employment tax purposes. By statute, certain employees are treated as independent contractors for employment taxes even though they continue to be treated as employees for income taxes. Other employees are treated as employees for employment taxes even though they are independent contractors for income taxes.
There are 2 categories of employees that are, by statute, treated as non-employees for purposes of federal employment taxes. These 2 categories are real estate salespersons and direct sellers of consumer goods. These employees are considered independent contractors (the ramifications of which are discussed later in this chapter). Such workers are deemed independent contractors if at least 90 % of the employees’ compensation is determined by their output. In other words, they are independent contractors if they are paid by commission and not a fixed salary. They must also perform their services under a written contract that specifies they will not be treated as employees for federal employment tax purposes.
Some individuals who consider themselves to be in business for themselves – reporting their income and expenses as sole proprietors – may still be treated as employees for purposes of employment taxes. As such, Social Security and Medicare taxes are withheld from their compensation. These individuals include:
● Corporate officers
● Agent-drivers or commission-drivers engaged in the distribution of meat products, bakery products, produce, beverages other than milk, laundry, or dry-cleaning services
● Full-time life insurance salespersons
● Homeworkers who personally perform services according to specifications provided by the service recipient
● Traveling or city salespersons engaged on a full-time basis in the solicitation of orders from wholesalers, retailers, contractors, or operators of hotels, restaurants, or other similar businesses
Full-time life insurance salespersons, homeworkers, and traveling or city salespersons are exempt from FICA if they have made a substantial investment in the facilities used in connection with the performance of services.
Traders in securities may be viewed as being engaged in a trade or business in securities if they seek profit from daily market movements in the prices of securities (rather than from dividends, interest, and long-term appreciation) and these activities are substantial, continuous, and regular. Calling yourself a day trader does not make it so; your activities must speak for themselves.
Being a trader means you report your trading expenses on Schedule C, such as subscriptions to publications and online services used in this securities business. Investment interest can be reported on Schedule C (it is not subject to the net investment income limitation that otherwise applies to individuals).
Being a trader means income is reported in a unique way – income from trading is not reported on Schedule C. Gains and losses are reported on Schedule D unless you make a mark-to-market election. If so, then income and losses are reported on Form 4797. The mark-to-market election is explained in Chapter 2.
Gains and losses from trading activities are not subject to self-employment tax (with or without the mark-to-market election).
Usually when 2 or more people co-own a business, they are in partnership. However, spouses who co-own a business and file jointly and conduct a joint venture can opt not to be treated as a partnership, which requires filing a partnership return (Form 1065) and reporting 2 Schedule K-1s (as explained later in this chapter). Instead, these “couplepreneurs” each report their share of income on Schedule C of Form 1040. To qualify for this election, each must materially participate in the business (neither can be a silent partner), and there can be no other co-owners. Making this election simplifies reporting while ensuring that each spouse receives credit for paying Social Security and Medicare taxes.
Every state allows a single owner to form a limited liability company (LLC) under state law. From a legal standpoint, an LLC gives the owner protection from personal liability (only business assets are at risk from the claims of creditors) as explained later in this chapter. But from a tax standpoint, a single-member LLC is treated as a “disregarded entity.” (The owner can elect to have the LLC taxed as a corporation, but this is not typical. An election may be made to be taxed as a corporation, followed by an S election, so that the owner can easily make tax payments through wage withholding rather than making estimated tax payments, as well as minimize Social Security and Medicare taxes.) If the owner is an individual (and not a corporation), all of the income and expenses of the LLC are reported on Schedule C of the owner's Form 1040. In other words, for federal income tax purposes, the LLC is treated just like a sole proprietorship.
Sole proprietors, including independent contractors and statutory employees, report their income and deductions on Schedule C, see Profit or Loss From Business (Figure
