By Jade Yeban, J.D. | Legally reviewed by Aviana Cooper, Esq. | Last reviewed December 06, 2023
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When you run a business as a sole proprietor, understanding your taxes is crucial. This business structure impacts how you pay taxes and what tax deductions you can claim. As a business entity, a sole proprietorship is a pass-through entity. This means that business profits pass through to your individual income tax.
Learning about tax forms and how to file taxes is vital for small business owners. Managing taxes is part of being an independent contractor or sole proprietor. It's different from how a limited liability company (LLC) or C corporation handles taxes.
One of the advantages of a sole proprietorship is its simplicity. You do not separate taxes for your business. You simply report all your business income and losses on your personal income tax return, but with that simplicity comes personal liability for legal judgments, taxes, and debt.
You will need to make quarterly tax payments based on estimates for the year and will be refunded or charged depending on whether you overpaid or underpaid at the regular April 15 federal tax deadline. You also will need to pay self-employment taxes, since there are no payroll taxes.
Below is an overview of how to file your taxes as a sole proprietorship.
For small business taxes, start by understanding your tax liability. Estimate how much you'll owe for the tax year. This involves looking at your business profits and considering state tax, federal income tax, and sales tax.
Unlike a traditional employee, as a sole proprietor you don't have anyone withholding income taxes from your paycheck. This means that it is your job to estimate how much you'll owe in taxes at the end of each year. You will then make quarterly payments based on your estimations to the Internal Revenue Service (IRS) and, if required, to your state as well.
Good bookkeeping is vital. Use your bank account statements to track business income and business expenses. Remember, as a pass-through entity, your business profits are part of your taxable income. You can write off certain expenses, like a home office deduction, to lower your tax bill at the end of the year.
Your sole proprietorship's profits are treated as simple income on your personal income tax return, but with a few caveats. First, you will be taxed for the full profits of your business, even if you have not personally withdrawn the money.
Second, in addition to a traditional personal income tax statement, you will have to fill out a Schedule C detailing your profits or losses and a Schedule SE, which you submit alongside your IRS Form 1040 income tax return to the IRS.
In a sole proprietorship, you can take business deductions just like with other forms of business. This means that you can deduct things such as operating expenses and advertising, as well as business-related travel and entertainment, though you need to be very careful to ensure it really is business-related. Start-up costs, such as buying business equipment, can also typically be deducted.
To take advantage of deductions, however, you will need to keep meticulous records. It is smart to keep separate accounts for your personal and business expenses. This will help you maintain clear, business-only records. Just as importantly, this will also demonstrate to the IRS, if they ever audit you, that you tried to separate your business expenditures from your personal ones.
As a sole proprietor, you're responsible for paying self-employment taxes. This covers Social Security and Medicare taxes (FICA). The self-employment tax rate is different from regular payroll taxes. You'll also need to make estimated tax payments throughout the year. If you're a single-member LLC, this applies to you, too. These estimated payments include your income tax and self-employment tax obligations based on your expected annual earnings.
Employees have this deducted from their paychecks, but as a sole proprietor, it is up to you to make these contributions while paying your income taxes. You will report your self-employment taxes on a Schedule SE, which is submitted along with your Schedule C and 1040 income tax return.
A significant difference between a sole proprietor and an employee is that the sole proprietor will have to pay the full contribution, whereas employees only pay half because their contributions are matched by their employers. This can be largely offset because sole proprietors can deduct up to half of the total cost of these contributions.
Sometimes, changing your business structure can offer tax advantages. For instance, forming an LLC or electing to be taxed as a C corporation might reduce your tax obligations. This is because different types of business entities are taxed differently. A CPA or tax professional can advise on whether this makes sense for your situation, considering the potential for limited liability and different tax deductions.
The primary difference in tax treatment is that sole proprietorship profits are treated as personal income, whereas corporations are taxed separately. Because sole proprietorship income is taxed as personal income, the tax amount depends on your personal income tax bracket. Corporations are not only taxed separately but also typically have lower tax rates than personal income. You will often end up paying fewer taxes by incorporating your business than running it as a sole proprietorship.
Despite the fact that many businesses would owe fewer taxes as a corporation, balance that against the added time and expense of having to prepare corporate taxes. For smaller businesses, any tax savings may be outweighed by the cost and complexity of filing a corporate tax return.
To ensure you're meeting all your tax obligations and taking advantage of available deductions, consider working with a tax attorney or tax professional. They can guide you on self-employment tax rates, tax forms, and specific deductions like health insurance premiums. Although the tax code allows sole proprietors to include profit and loss from their business in their personal income tax returns, it can be quite confusing to sort out. Even honest mistakes can trigger an audit from the IRS.
That's why it's critical to speak with an experienced tax attorney before problems arise.
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