Chapter 6: Schedule C

Overview

Chapter Description

Upon completion of this chapter, students will understand the federal tax responsibilities of the sole proprietor.  Students will recognize the advantages and disadvantages of operating a sole proprietorship. Students will understand each part of the Schedule C (Form 1040).  Students will have working knowledge of cost of goods sold, inventory valuation, beginning and ending inventory, and uniform capitalization rules.  Students will also be able to identify the various types of income earned by a sole proprietor.

Learning Objectives

1. Understand the advantages and disadvantages of sole proprietorship.
2. Recognize the various types of income earned by a sole proprietorship.
3. Identify deductible and nondeductible business expenses.
4. Discuss detailed business expenses, such as depreciation, section 179 expenses, entertainment expenses, and travel and transportation expenses, etc.
5. Discuss cost of goods sold and inventory. Explain inventory valuation and the methods used to value the ending inventory, etc.

Objective #1: Advantages and Disadvantages of Sole Proprietorship

A sole proprietorship is a business entity owned by one individual.  It is the most basic and least expensive business structure to establish.  The business owner decides the type of business he wants to operate (i.e. retail, service, and wholesale), chooses a name, complies with local or state license or registration requirements and opens his doors.  The owner manages the business and is responsible for all business transactions.  The owner is also personally responsible for all debts and liabilities incurred by the business.  The business does not exist separately from the owner.

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Most are usually very small and have either very few or no employees.  The sole proprietor is not considered an employee of the business.  Any money withdrawn for personal use is recorded in the “Owner’s Drawing Account” and is not a deductible expense.  Business profits (or losses) are reported on the owner’s individual tax return (Schedule C).

Owners should always maintain a separate bank account for their business.  In reality, many do not.  As tax practitioners, always advise the client to maintain a separate business checking account.  “Co-mingling” of funds is not an acceptable method of operation to an IRS auditor.

Although most sole proprietorships are very small businesses, there is no requirement for a business to choose another type of organization.  A sole proprietorship may have any number of employees, more than one location and millions of dollars in revenue.

The choice of business entity is extremely important.  In order to advise clients in this area, the tax preparer must understand the various types of structures and the advantages and disadvantages of each.  The best choice for one client is not always the best choice for another.  Each business should make this decision after carefully considering the facts and circumstances of the business and the individuals involved.  Factors influencing the decision regarding the business organization include:

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• Liabilities assumed
• Type of business operation
• Earnings distribution
• Capital needs
• Legal restrictions
• Number of employees
• Tax advantages and disadvantages
• Length of business operation

There are advantages and disadvantages to each form of business entity.  Ideally, the client will discuss this choice with their tax practitioner and fully understand the advantages and disadvantages of each type prior to making a commitment.

Advantages of Sole Proprietorships

• Sole proprietorships are easy to form and have low organizational costs.
• Sole proprietorships enjoy a tax benefit because profits are taxed only once on the proprietor’s tax return, and a separate business return is not filed.
• Sole proprietorships can work alone or hire employees.
• Sole proprietors make and control all business decisions.

Disadvantages of Sole Proprietorships

• The owner assumes all risks and has unlimited liability.  Creditors may attach his personal assets (home, car, bank accounts) to satisfy business debts.
• A sole proprietorship does not have a separate legal status (entity), so the business will cease to exist if the owner becomes incapacitated or dies.
• It is often more difficult to raise capital for a sole proprietorship than it is for other types of business entities.
• In a sole proprietorship, the owner is responsible for paying self-employment taxes.

It is not unusual for a sole proprietor to suddenly decide that he needs to “incorporate” because he has heard from a friend, relative, his barber, or even an attorney that his business should be a corporation. In fact, many of these clients sign the incorporation papers and pay the registration fees without understanding any of the implications of making such a change in their business organization. The owner may casually inform their tax preparer (after the end of the year) that they “changed their business name and incorporated”. Often, they did not make any of the required changes in accounting or operational procedures after establishing the new “entity”.

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One of the most difficult things for a small business owner or tax practitioner to understand is the concept of “entity”.  An entity, by definition, is an “actual or conceivable being”.  Partnerships and corporations are entities that are separate and distinct from their owners and as such, have their own legal status.  Sole proprietors do not have the advantage of separate legal existence.