A sole proprietorship is a popular form of business that refers to a single person who owns and operates a business. Since it is not a distinct legal entity, a sole proprietor does not need to file documentation with the state to form the business. Outside of taxes and filing for any licenses specific to its industry, a sole proprietorship does not need to file any paperwork with a state or federal organization. This ease of formation and maintenance are what make sole proprietorships so popular. This ease of formation does not relieve a sole proprietor for accounting for business expenses, such as rent.
Liability for Business Expenses
When it comes to rent and other business expenses, it is important to note that the sole proprietor is personally responsible for all expenses. That means if the business does not have enough money to cover the obligation, the sole proprietor must pay the expenses from his personal resources. With some other types of business organizations, such as a corporation, the business owners are not personally liable for the debts of the business. If the business lacks the funds to pay off its expenses, the creditors generally have no further recourse.
For federal and state tax purposes, a sole proprietor must report all of the business’s income and expenses on her personal returns. For a federal return, the business income and expenses are reported on Schedule C of the 1040. The expenses tied to the rent of personal property, such as vehicles, are recorded on line 20a of Section II. All other rental expenses, including rental office space, is listed on line 20b of Section II.
Read More: The Advantages of Sole Proprietorship Taxation
Deductions for Expenses
The business’s expenses are subtracted from the sole proprietorship’s income, which decreases the amount of tax he will have to pay due to his business activities. If a sole proprietor’s total expenses exceed his business income, he may be able to use the loss to offset his other income for the year, depending on how the owner finances his business. A sole proprietor should maintain separate financial records regarding the financial activity of the business and his personal finances.
Tax Accounting for Rent
Generally rent is treated as an expense. This means that so long as the business pays reasonable rent, the entire amount it pays can be subtracted from the income it earns during the year. In some rare instances, rent must be capitalized. This means that a sole proprietorship's rent payments cannot all be used to offset the business’s income in the current year. Instead smaller, equal portions of the rents you paid are used to offset income over a period of time. Sole proprietorships are required to capitalize rent only when they produce real property or tangible personal property or acquire property for resale.
Renting Home Offices
Many sole proprietors run their business out of their rented home in a home office or workshop. A portion of this rent may be deducted as a business expense. To qualify for a deduction, an area of the sole proprietor’s home must be exclusively and regularly used as either the principal place of her business or as a place where she meets with her clients. If a portion of the rented home qualifies, the sole proprietor should divide the total square footage of the space dedicated to the business by the total square footage of the home. She would then multiply that percentage by the total rent paid during the tax year to determine her home office rental deduction.
- Entrepreneur: Sole Proprietorship
- Legal Information Institute: Corporations: An Overview
- Internal Revenue Service: Schedule C: Profit or Loss From Business
- Internal Revenue Service: Specific Instructions
- Internal Revenue Service: Rent Expense
- Internal Revenue Service: Publication 587: Business Use of Your Home
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.