Sole Proprietors and Partnerships
As a sole proprietor, you pay income tax on your net profits. Partnerships are similar to sole proprietorships when it comes to taxes — the business itself doesn't pay: instead, the partners each pay taxes on their share of the net profits from the business.
Taxes and Sole Proprietors
In simple terms, as a sole proprietor you add up your revenue, subtract all your expenses, and pay federal and state/provincial income tax on what's left over. When it comes to your tax return, you'll still be filing your individual tax return as usual — but you'll also file additional paperwork that summarizes the income and expenses you're claiming for the business.
In the United States, you file your individual tax return via Form 1040. With it, you'll file Schedule C or Schedule C-EZ: Profit or Loss from Business. You may also need to file Schedule SE for self-employment tax and 1040-ES for estimated taxes.
In Canada, you'll file the usual T1 individual tax return for your province. It needs to be accompanied by the forms contained in the Business and Professional Income Guide (T4002) for that tax year: either the T2124 for business activities or the T2032 for self-employed professionals. You may also need to file Schedule 8 of the T1 for self-employed Canada Pension Plan contributions.
Taxes and Partnerships
In general, a partnership agreement determines how distributions (whether they're profits or losses) are to be divided among the partners. If there's no agreement in place, then the distribution is made according to how much of an interest each partner holds in the business. Just as in a sole proprietorship, each partner may have to pay estimated taxes, and (except in the case of a limited partner), self-employment tax.
In the United States, check IRS Publication 541, Partnerships, for the details. You'll need to fill out Form 1065, which reports the partnership profit or loss, and Schedule K-1, which reports each partner's share. In Canada, the partnership profit or losses noted on the forms that accompany the Business and Professional Income (T4002) guide.
Self-Employment Tax
As a self-employed person who's either a sole proprietor or in a partnership, you're not an employee — so no one's taking income taxes out of your checks, nor are they withholding deductions such as Social Security and Medicare (FICA). There's also no employer paying FICA on your behalf. It can be a shock to discover that you have to pony up not only for your share of FICA, but also for the share that the employer would normally pay.
In Canada, the self-employment tax equivalent is the payment of Canada Pension Plan contributions. Usually, you and your employer would each pay half of your contributions to CPP. When you're self-employed, you pay the whole amount — calculated on Schedule 8 of your T1 tax return.
Generally, if you make more than $400, you have to pay the tax, which you'll figure out using Schedule SE. This comes in a short and a long form, but most people can use the short form. If you have more than one business (and thus more than one Schedule C or C-EZ, you add up all of your self-employment profits and fill out one Schedule SE.
