Sole Proprietorship
A sole proprietorship is the default form of business for one owner who has not formed a separate legal entity. For REG, think of it as the simplest structure: the owner and the business are legally the same person for federal income tax purposes.
Core legal and tax profile
- Owners: One individual owner.
- Liability: Unlimited personal liability for business debts and lawsuits.
- Federal return: No separate business income tax return. Business activity is generally reported on Schedule C of the owner's Form 1040.
- Tax character: Income, deductions, gains, and losses flow directly to the owner.
Schedule C reporting
All income and deductible expenses of the business are reported on Schedule C (Profit or Loss from Business). Net profit flows to page 1 of Form 1040 and is also used to compute self-employment tax on Schedule SE.
Common income items
| Item | Treatment |
|---|---|
| Sales revenue (less returns/allowances) | Gross receipts |
| Service revenue | Gross receipts |
| Bartering income | Fair market value of goods/services received |
| Interest on business accounts | Business income |
| Recovery of previously deducted amounts | Income in year of recovery |
Deductible business expenses
Ordinary and necessary business expenses are deductible on Schedule C. Key categories include:
| Expense | Deductibility |
|---|---|
| Advertising | Fully deductible |
| Office rent | Fully deductible |
| Employee wages and salaries | Fully deductible (reasonable amounts) |
| Office supplies | Fully deductible |
| Business insurance | Fully deductible |
| Depreciation (MACRS) | Per IRS tables and Section 179/bonus rules |
| Home office expenses | If regular and exclusive business use |
| Business travel | Fully deductible (transportation, lodging) |
| Vehicle expenses | Actual method or standard mileage rate |
Business meals
Business meals are 50% deductible when the taxpayer (or an employee) is present and the meal has a clear business purpose.
| Scenario | Deductible % |
|---|---|
| Business meal with client or customer | 50% |
| Employee meals during business travel | 50% |
| Food and beverages for office holiday party | 100% (de minimis fringe) |
| Personal meals (not business-related) | 0% |
| Entertainment expenses | 0% (no longer deductible after TCJA) |
Example: Jamie operates Bear Co. as a sole proprietorship. She spends $2,400 on business lunches with clients during the year. On Schedule C, she deducts $1,200 (50% × $2,400). The remaining $1,200 is a nondeductible expense.
Bad debts
A sole proprietor using the accrual method may deduct business bad debts when a specific receivable becomes wholly or partially worthless. The deduction is an ordinary loss.
| Accounting Method | Bad Debt Deduction? |
|---|---|
| Accrual basis | ✅ Yes — when a specific receivable becomes uncollectible |
| Cash basis | ❌ No — because the income was never reported (no basis in the receivable) |
:::caution Cash-Basis Taxpayers
A cash-basis sole proprietor generally has no basis in accounts receivable because the revenue was never included in income. Therefore, there is nothing to write off. Bad debt deductions are available only to accrual-basis taxpayers who have previously recognized the income.
::: Example: Sarah operates Gies Co. (accrual basis). She billed a client $8,000 and included it in income. When the client goes bankrupt and the receivable becomes worthless, Sarah deducts $8,000 as a business bad debt — an ordinary deduction on Schedule C.
Business interest expense limitation
Under Section 163(j), sole proprietors with average annual gross receipts exceeding $31 million (2025 threshold) over the prior three-year period are subject to the business interest expense limitation:
- Disallowed interest carries forward indefinitely.
- Most sole proprietorships fall below the threshold and are exempt from this limitation.
- The limitation applies at the taxpayer level for sole proprietors.
Non-deductible expenses
Certain expenses are never deductible on Schedule C:
| Expense | Reason |
|---|---|
| Personal expenses | Not business related |
| Federal income taxes | Not deductible as a business expense |
| Penalties and fines | Public policy prohibition |
| Political contributions | Not deductible |
| Lobbying expenses | Generally not deductible |
| Bribes and kickbacks | Illegal payments |
| Club dues (country clubs, social clubs) | Not deductible |
| Commuting expenses (home to office) | Personal commuting |
| 50% of business meals | The nondeductible portion |
| Life insurance premiums (owner is beneficiary) | Personal expense |
Self-employment tax
Net earnings from the sole proprietorship are subject to self-employment (SE) tax in addition to regular income tax. SE tax consists of both the employer and employee portions of Social Security and Medicare taxes.
Computation
| Step | Calculation |
|---|---|
| 1. Net Schedule C income | Gross income − deductible expenses |
| 2. Multiply by 92.35% | Accounts for the "employer half" equivalent |
| 3. Apply SE tax rates | 12.4% Social Security (up to wage base) + 2.9% Medicare (no cap) |
| 4. Additional Medicare tax | 0.9% on SE income above $200,000 (single) / $250,000 (MFJ) |
The deductible portion of SE tax (50% of the total SE tax) is taken as an above-the-line deduction on Schedule 1 of Form 1040 — not on Schedule C.
Self-employment tax is one of the biggest distinctions between a sole proprietorship and an S corporation. S corporation owners who are also employees pay payroll taxes only on their wages — not on distributions. Sole proprietors pay SE tax on all net business earnings.
Example: Marcus operates Illini Entertainment as a sole proprietorship and earns net Schedule C income of $120,000.
| Calculation | Amount |
|---|---|
| SE income: $120,000 × 92.35% | $110,820 |
| Social Security: $110,820 × 12.4% | $13,742 |
| Medicare: $110,820 × 2.9% | $3,214 |
| Total SE tax | $16,956 |
| Deductible half (above the line) | $8,478 |
Hobby loss rules
If an activity is not engaged in for profit, it is classified as a hobby and subject to significant limitations. Hobby losses cannot offset other income.
The 9 factors test
The IRS uses nine factors (no single factor is decisive) to determine whether an activity is a business or a hobby:
- Manner in which the activity is carried on (business-like records, separate accounts)
- Expertise of the taxpayer or advisors
- Time and effort spent on the activity
- Expectation that assets may appreciate
- Success in similar or related activities
- History of income or losses from the activity
- Amount of occasional profits earned
- Financial status of the taxpayer (other sources of income)
- Elements of personal pleasure or recreation
The 3-of-5 year presumption
If an activity shows a profit in at least 3 of the last 5 consecutive years (2 of 7 years for horse breeding, training, showing, or racing), there is a rebuttable presumption that the activity is engaged in for profit.
The 3-of-5 rule is a presumption, not a safe harbor. The IRS can still challenge an activity as a hobby even if it meets the presumption, and a taxpayer can prove profit motive even without meeting it.
Tax consequences of hobby classification
| Item | Treatment |
|---|---|
| Hobby income | Fully taxable as "other income" on Form 1040 |
| Hobby expenses | Not deductible under TCJA (2018–2025) — miscellaneous itemized deductions subject to the 2% AGI floor are suspended |
| Net effect | The taxpayer pays tax on gross hobby income with no offsetting deductions |
Example: Jamie breeds show dogs as a side activity. Over the last five years, the activity produced losses of $8,000, $5,000, $3,000, $1,200 profit, and $6,000 loss. Because there is only 1 profit year out of 5, the IRS may classify this as a hobby. If so, Jamie must report the $1,200 of income but cannot deduct any of the $22,200 in cumulative losses against her other income.
Under current law (TCJA through 2025), hobby expenses are completely nondeductible. This means a hobby can generate tax liability on its income but provide zero tax benefit for its expenses — a worst-case scenario for taxpayers.
How the CPA exam tests sole proprietorships
Basis and asset issues
There is no separate owner stock or partner basis account. Instead, the owner generally keeps track of the basis of the business assets themselves. When the business is sold, the transaction is usually analyzed as a sale of individual assets, which may produce a mix of ordinary income and capital gain.
Losses
Business losses may offset other personal income, subject to the normal rules for basis, at-risk limitations, passive activity limitations, and the excess business loss rules.
Advantages and disadvantages
| Topic | Sole Proprietorship |
|---|---|
| Formation | Easiest and least expensive structure |
| Tax filing | Simple reporting on the owner's return |
| Liability protection | None |
| Raising capital | Limited because there is no separate ownership interest to issue |
| Continuity | Tied closely to the owner |
REG quick hits
- No separate federal income tax entity — all reported on Schedule C.
- Net earnings are subject to self-employment tax (multiply by 92.35%, then apply 15.3%).
- Deduct 50% of SE tax as an above-the-line deduction.
- Business meals: 50% deductible; entertainment: 0% deductible.
- Bad debts: deductible only for accrual-basis taxpayers.
- Business interest expense limited to 30% of ATI (for businesses above $31M gross receipts threshold).
- Penalties, fines, personal expenses, and federal income taxes are never deductible.
- Hobby loss rules: 9-factor test, 3-of-5 year presumption, hobby expenses nondeductible under TCJA.
- The owner has unlimited liability.
- Selling the business is typically treated as selling assets, not stock.
Bottom line
A sole proprietorship is easy to start and easy to report, but it offers the least liability protection and the least flexibility for adding investors. On the REG exam, it is the baseline structure against which partnerships, LLCs, and corporations are compared. Key exam areas include Schedule C deductions, SE tax computation, the hobby loss rules, the meals limitation, and the distinction between deductible and nondeductible expenses.