All income and expenses generated by the business are reflected on either Schedule C (Profit or Loss from Business) or Schedule C-EZ (Net Profit from Business). Whichever one you elect to use, it must be included as part of your regular 1040.

The IRS will tax you on any profit, regardless of how much money you actually withdraw from the business. In other words, even if you leave money in the company's bank account at the end of the year (for instance, to cover future expenses or expand the business), you must pay taxes on that money. As such, you can deduct any business expenses relating to that profit -- operating expenses, travel expenses, etc.

Another important aspect you have to understand is paying self employment taxes. Self-employment taxes are equivalent to the payroll tax for employees of a business. So while an employee pays into SS and Medicare through payroll tax cuts, sole props pay them during income tax season. Issue at hand here is that employees only pay half the contribution (since the other half is matched by the employer), while sole proprietors must pay the entire amount themselves (although you can deduct half of the cost). Use Schedule SE along with your Schedule C/C-EZ and 1040.

In addition, you need to make estimated tax payments. You make these payments to the IRS and your state agency (if applicable) periodically during the course of the calendar year prior to filing your tax return. These are your general withholdings -- FICA, etc.

You can find more information here.. The first year doing so may seem daunting, but it's all rather simple once you get going on it.

As for deducting expenses, keep a well documented paper trail of your expenses -- receipts, confirmations, invoices, etc.

EDIT: I suppose it is the "honor" code. But bear in mind, that on the (off) occasion you do get audited, prepare for some heavy fees (and possibly even jail time) if you are understating your revenue or profits.