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.Any wages you earn reduce the self-employment tax basefor retirement and disability benefits.For example, if you earned over $84,900 inwages in 2002, and had Schedule C income in addition, the Schedule C income isonly subject to SE tax at the rate of 2.9 percent.See the expanded discussion ofSE tax in Chapter 9.Who Can Be a Sole Proprietor?The word proprietor might bring to mind a shop owner, but you can operate anybusiness under this form as long as you are the only owner.You could operate alarge company with hundreds of employees as a sole proprietorship, or youcould be a one-person consulting firm.You could operate a sole proprietorshipon a full-time or part-time basis, and you can have more than one proprietor-ship if you want.A sole proprietorship must be a business not an investmentactivity or a hobby.(See Chapter 2.)If you work primarily or exclusively for one company, but are not classified asan employee for income tax purposes, you are a type of sole proprietor referred toas an independent contractor.Sometimes there is a very fuzzy line betweenbeing an independent contractor and being an employee, but the distinction has SOLE PROPRIETORSHIPS37important tax implications.As an independent contractor, your business ex-penses are deductible above-the-line on Schedule C (Form 1040).This meansthey are deductible even if you claim the standard deduction.As an employee, onthe other hand, all of your unreimbursed employment-related expenses must bededucted on Schedule A (Form 1040) as Miscellaneous Itemized Deductions, which means that you don t get the full benefit of these deductions because theyare subject to the 2 percent floor.An advantage of being an employee is that you pay only one-half of your so-cial security tax the other half is paid by your employer.You also qualify foremployee benefits offered by your employer that you don t get as an indepen-dent contractor.The determination of whether you are an employee or an inde-pendent contractor generally follows the same tests for both income tax andsocial security tax purposes, but there are differences.If you are unsure ofwhether you should be classified as an independent contractor or an employee,see Chapter 9 under Who Must Pay Self-Employment Taxes? Tax Accounting Methods and PeriodsACCOUNTING METHODSA sole proprietorship is not an entity separate from the individual proprietor, soany income or loss from the proprietorship is combined with income and de-ductions from other sources on Form 1040.However, you can choose a methodof accounting for your business that is different than the method used for yourother income and deductions.1 In fact, you can run several businesses as soleproprietorships and use a different accounting method for each one.For exam-ple, you are a cash method taxpayer when you report wage income and non-business deductions; but you can adopt an accrual method for your soleproprietorship.If you have two separate businesses, you can use the cashmethod for one and an accrual method for the other.You should report eachbusiness on a separate Schedule C.The general rules for the cash and accrualmethods are discussed in Chapter 4.TAXABLE YEARWouldn t it be neat if you could adopt January 31 as the year-end for yourSchedule C, so eleven months of your income from this year would not be re-ported until you file next year s return? Forget it you can t do that.Unlikethe rule for accounting methods, as an individual you can use only one ac-counting period for all your income and deductions.2 Individuals are requiredto use a calendar year unless, when they file their first return, they have abookkeeping system in place and adopt a fiscal year.As a practical matter, in-dividuals rarely meet this requirement.As a result, they are required to use CHOICES FOR BUSINESS ORGANIZATION38the calendar year.Once adopted, a taxable year cannot be changed withoutthe approval of the IRS.Retirement PlansAs a sole proprietor, you can set up a Simplified Employee Pension (SEP) plan,a Keogh plan, or both, and make deductible retirement contributions for your-self and your employees.Alternatively, you may be able to set up a Savings In-centive Match Plan, known as the SIMPLE retirement plan, for yourself andyour employees (if you have any).Enacted as part of the Small Business JobProtection Act of 1996, this type of plan does not have to meet many of the re-quirements of qualified plans.Deductible contributions to these plans and theearnings on them remain tax free until you or your employees receive distribu-tions from the plans in later years.These plans are available for your own re-tirement even if you do not have employees.See Chapter 10 under RetirementPlans for the Self-Employed for details on these plans.Contributions for em-ployees are claimed on Schedule C (Form 1040) or Schedule F (Form 1040),but your own contributions are deductible on page one of Form 1040.Thatmeans contributions for your account do not reduce self-employment income incomputing self-employment tax.Health InsuranceYou can also deduct from your gross income a percentage of the amount you payduring the year for health insurance for yourself, your spouse, and your depen-dents.This above-the-line deduction cannot exceed your earned income fromthe business for which the plan was established.Also, you cannot deducthealth insurance premiums above-the-line if you are eligible to participate in ahealth insurance program sponsored by your own or your spouse s employer.The portion of health insurance costs that are not deductible above-the-lineare deductible on Schedule A as medical expenses, subject to the 7.5 percent ofAdjusted Gross Income (AGI) reduction.The above-the-line portion is de-ductible on page one of Form 1040 rather than on Schedule C, so it does not re-duce your self-employment income in computing self-employment tax.Under Section 162(l) of the Code, as amended by the Trade and Tax ReliefExtension Act of 1998, the above-the-line percentage for 1999 through 2001 was60 percent.It increased to 70 percent for 2002, and becomes 100 percent for2003 and thereafter.Liability for Sole Proprietorship Debts and ClaimsBecause a sole proprietorship is not a separate legal entity, the owner has unlim-ited liability for debts and other claims against the business, so it would be wiseto review your insurance policies.If you are doing business from your home, you PARTNERSHIPS39might want a business liability policy separate from your homeowner s policy.Ifyou are dealing with customers, at least be sure to have the office, school, orstudio option in effect with your homeowner s policy.The quest for limited liability is the most common reason some small busi-ness owners believe it is prudent to incorporate, or to form a limited liabilitycompany (LLC).C corporations, S corporations, and LLCs are entities indepen-dent from their owners and are legally responsible for their own debts and lia-bility claims.However, creditors of home-based businesses typically require theowners to cosign for any significant debt
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