Working as a sole proprietorship or independent contractor can simplify your finances. However, it is important to understand how the structure of your business affects your taxes. There are tax laws that self-employed people need to be aware of. This guide explains how to prepare, file and pay taxes if you run your business as a sole proprietorship.
What is Sole Proprietorship Taxation?
An unincorporated small business that is owned by one lone individual is a business entity commonly known as a sole proprietorship. Compared to other business operations, there are few regulations in place for sole proprietorships, making them very simple to set up and run and also as simple to close down.
Unlike LLCs and other small businesses, sole proprietorships don’t always have a company name, instead, they are commonly named directly after their owner. Sole proprietors do not file business tax returns: instead, they are taxed directly through their personal income tax returns as any profits generated by the business will go directly to the owner.
Sole Proprietorship Taxes Defined
Although a different form of business entity to an LLC, sole proprietorships – like LLCs – are considered pass-through entities in the eyes of the IRS. The term relates to the fact that revenue generated by the business is passed directly to the company owner, therefore necessitating the requirement for that money to be included as part of the owner’s standard personal income tax return.
Being a different form of small business entity, it is essential to know which taxes a sole proprietorship is required to pay:
- Federal income tax (and state income tax if this is applicable);
- Self-employment tax;
- Federal and state estimated taxes;
- Sales tax (if applicable to your business activities).
Federal Income Tax
Annual federal income tax filing requires two forms for the owners of sole proprietorships. First, the individual tax return, Form 1040, and then secondly, Schedule C, which records the business’s profits and its losses. The latter form is for recording business income, while the former is for the reporting of personal income.
The tax you owe and the tax bracket you will be placed in is determined by the combination of these two forms. If state income tax is applicable in your home state, then the findings of your federal forms will carry over to the state.
When employed, we are all used to seeing a chunk of our income go to the IRS. As the owner of a sole proprietorship, you are your own boss and therefore, you need to pay those taxes yourself as there is no one above you to take the IRS and Medicare cut from your wage packet. The responsibility for contributing towards these – now by way of self-employment tax – is on you and is compliance that needs to be met.
Federal and State Estimated Taxes
Paying estimated taxes is exactly what it says: it’s paying ahead, guessing what it is that you think you will owe the IRS for both self-employment and income taxes at the end of the year. When on the payroll of a company as a staff member, your employer will withhold amounts from your paychecks each pay period. As your own boss and employee, it’s on you to deal with this tax yourself.
Federal and State estimates are due four times per year: January, April, June, and September. The first estimate of a new tax year is due every April, by the 15th. The final estimate of a tax year is the one due in January.
It’s far safer to err on the side of caution and pay over what you estimate your taxes to be. If you deliberately ‘guess less’ than what you think your tax expectancy may be, then you run the serious risk of an underpayment penalty if the actual amount due turns out to be way above the estimate.
If through your sole proprietorship, your business activities include the selling of any merchandise or tangible products, or you provide services, then it is more probable than not that you will be required to pay sales tax. The rules and regulations on product tariffs and taxes vary between the states so you’ll need to enquire with your state revenue office as to if – and what – taxes are applicable.
Tax Deductions for Sole Proprietorships
Being the owner of a sole proprietorship means being your own boss, therefore you have no paycheck from an employer with taxes already docked from your wages. On account of this, sole proprietors are required to pay self-employment tax instead. You’ll be glad to know that there are some deductions sole proprietorship owners are able to claim:
Form 1040 will allow you to deduct health insurance for yourself, your spouse, and any dependents. You can also deduct other medical expenses, which are out-of-pocket, such as prescription costs and appointment co-pays.
If you use your car for both personal and business purposes, you can deduct all costs relating to the business use of the vehicle. If you have a car that is used solely for business reasons, then all costs pertaining to its operation and maintenance can be claimed.
As can be the case with members of many LLCs, it’s not uncommon for sole proprietorship owners to work from home. If this is the case, and the home ‘office’ is just that – used only as an office for the running of your company, then it may be possible to deduct some of your housing expenditure against your business revenue. However, for this to be possible, there are certain stipulations:
- You have to regularly use the room and only for business purposes. You may not be able to designate an entire room, in which case a particular area needs to be assigned and recorded: it can pay off to keep a photo of the workspace to be on the safe side, just in case the IRS decide to conduct an audit;
- It must also be your principal place of business – meaning it is the area from which you spend the majority of your time dealing with business affairs.
Qualified Business Income Deduction
Depending on the type of business you operate, some sole proprietorships are eligible for deductions of up to 20% of their earned income due to being a pass-through business entity. To qualify for this, your sole proprietorship needs to be specializing in a specific field, such as:
- Healthcare provisions;
- Performing Artists.
Note: the 20% pass-through deduction will become inapplicable if you have an income of over $207,000.
Here are some other common deductions which can be available to sole proprietorship owners:
- Contributions to self-employed retirement plans;
- Traditional individual retirement account contributions;
- Advertising and marketing expensesl
- Education expenses related to the business;
- Legal and professional fees;
- Telephone and internet service;
- Business meals.
Tax Filing Tips
Here are 5 tax filing tips for sole proprietorship owners.
If your expenses exceed your income, then you should consider non-capital losses as a way of reducing your taxes. You can use these to offset other sources of personal income.
Pay Family Wages
If any members of your family perform any services relating to your business, then you will be able to income split, which will decrease your overall tax liability. It is very important here to remember though that the wages you pay must be reasonable and fitting to the service your family members provide.
Don’t forget to claim for expenses on your business. These can range from some of the larger factors mentioned previously, to smaller things that perhaps seem less obvious – such as telephone and Internet bills.
When the time comes to file taxes, it is common for LLC owners to opt to file as S-Corps. This is an available option offered by the IRS, and it also applies to sole-proprietorship owners. Incorporating your business will open up the door to the many tax advantages available to corporations.
It may seem obvious but one of the best tips in regards to tax and sole proprietorships is record keeping. The accurate recording of all business expenses, as and when they happen, throughout the year will make your life much simpler when it comes to dealing with the IRS. Keep it up and keep it accurate – ensure you can account for every dollar spent for business purposes. You can do this with spreadsheets or accounting software, or just with old-fashioned book-keeping. Note everything – and keep ahold of those receipts.