Looking to Benchmark Pay?
PROPRIETORSHIPS AND PARTNERSHIPS
Let's look at the difference between a sole proprietorship and a partnership.
| Sole Proprietorship | Partnership |
|---|---|
| An unincorporated business with only one owner. This is the most common form of new company. The owner is responsible for the business liabilities and entitled to all its profits. | An unincorporated business with two or more owners, who agree to provide a part of the labor and capital and share a fixed proportion of profits or losses. |
Income Taxes
For federal income tax purposes, there's no stock in a sole proprietorship or partnership. You can't hire yourself; therefore the owners are not considered employees. The business income is the owner's income, and is taxed as such. The business CANNOT deduct the money that an owner takes as salary.
Deductions
A sole proprietorship is a form of business structure and therefore can claim many of the deductions intended for business entities. Premiums for health insurance for the business owner, spouse, and dependents are deductible. In addition, many of the start-up costs incurred are tax-deductible. In a partnership, a partner CAN receive a guaranteed payment for specific services. This income isn’t considered salary for the individual, and the partnership CAN deduct the payments as an expense. Partners can also receive certain benefits. The cost of these benefits, such as health insurance premiums, is considered a guaranteed payment, is taxable to the partner, and deductible by the partnership.
Self-employment tax
Self-employed individuals (for example, sole proprietors and partners) are subject to a self-employment tax. The net operating income earned by a sole proprietorship or a partner is considered self-employment income and is a guaranteed payment. A self-employed person is considered to be an employee AND an employer so they must pay both portions of the FICA tax, which is 15.3% (7.65% x 2). However, in determining self-employment income, the net earnings from self-employment are reduced by 1/2 of the self-employment tax paid. The effect of this provision is that only 92.35% (100% - [0.5 x 15.3%]) of the net earnings from self-employment are subject to self-employment taxes. Thus, a self-employed individual is subject to both employee and employer taxes, but the net impact of these taxes is reduced by half of the self-employment tax. This effectively reduces the taxes to a level similar to that of standard employees.
Example 1: Black Mesa Products as Partnership
Black Mesa Products was started by Andy Redhouse and his sister, Loren, in Albuquerque, New Mexico. The company produces dolls and other tourist items (all made by plastic processing), that are sold in shops throughout the Southwest.
Black Mesa Products has been successful — revenue for each of the past 3 years has been close to $2.2 million.
In the beginning, Andy was the manager of the operation and owned 60% (he's now CEO). Loren did all of the bookkeeping and owned 40% (she's now CFO). Last year, Loren decided to cut down on her work schedule and now works 5 hours a day (62.5% of full time). As a result, the percentage of ownership was changed (Andy owns 70% and Loren owns 30%). Net operating income this year was $275,000.
Income tax
(Note: 2025 tax rates are used throughout this course.)
The $275,000 net operating income is ordinary income to Andy and Loren in proportion to their interest in the company.
- Andy's income is $192,500 ($275,000 x 0.70).
- Loren's income is $82,500 ($275,000 x 0.30).
Assuming Andy and Loren are both married filing jointly AND ignoring other deductions:
- Andy's tax is $39,047 = $17,651 + (24% x [$192,500 - $103,350])
- Loren's tax is $13,064 = $5,578.50 + (22% x [$82,500 - $48,475])
Self-employment tax
Each partner pays tax on his or her share of the pro-rata income. In 2025, Old Age, Survivors and Disability Insurance (OASDI) taxes that pay for Social Security were 12.4% on the first $176,100, and the Medicare tax on all wages was 2.9% (together these self-employment taxes are known as FICA).
| Andy |
Tax on $176,100 at 12.4% = $21,836 Tax on $192,500 at 2.9% = $5,583 |
|---|---|
| Loren |
Tax on $82,500 at 12.4% = $10,230.00 Tax on $82,500 at 2.9% = $2,393 |
In addition, each partner may deduct 50% of his/her self-employment taxes from their adjusted gross income when they file their taxes.
Memory Jogger
In a sole proprietorship, the owner's: