How Sole Proprietorships are Taxed and Why It Matters to You

Starting and running a small business is most often a one-person operation. A lot of our clients started their company from their kitchen table or out of their garage…and many of them enjoy keeping it that way.

According to Econofact.org, “Pass-through businesses [or “sole proprietorships”] represented 83 percent of businesses and 25 percent of business income in 1980. In 2015, these values had grown to 95 percent of all businesses and 63 percent of all business income.” So, most likely, you fit into that category.

A question that new solopreneurs often ask is: “How are sole proprietorships taxed?” They’re comfortable wearing every hat in the business (sometimes all at once), but making sure they’re doing things right when it comes to their taxes makes them a little nervous.

So in this post, we’ll cover what you need to know about how sole proprietorships are taxed. That way, when April 15 rolls around next time, you can face it with confidence and peace of mind!

How Are Sole Proprietorships Taxed?

Unlike corporations, businesses that are owned by a single individual do not have to file separate tax returns. Instead, the IRS simply requires sole proprietorships to file taxes on the business along with the owner’s individual tax return.

Taxes are filed by sole proprietorships by adding Schedule C to your personal Form 1040 or 1040-SR.

Schedule C is the IRS form for reporting any profit or loss from your business. According to the IRS, “An activity qualifies as a business if your primary purpose for engaging in the activity is for income or profit and you are involved in the activity with continuity and regularity.”

The key words in that quote are “income or profit” and “continuity and regularity.” The IRS considers anything you do regularly that makes you money a business, and you are required to report that income. If your activity is sporadic, not-for-profit, or a hobby, it is not considered a business. (You would simply report any income from those kinds of things on Line 8 of Form 1040.)

A few things you should know about Schedule C:

  1. You have to file. All businesses are required to file, regardless of how much or how little money they make in a given year.
  2. There is no minimum income. Schedule C allows you to calculate all business income and expenses. Then, you record the resulting profit or loss for the year on your 1040.
  3. As of 2019, there is no longer a Schedule C-EZ. Every sole proprietor uses Schedule C now.

Since sole proprietors act as both employer and employee in their company, they are responsible for paying the entire 15.3% self-employment tax. 12.4% goes to Social Security, and 2.9% goes to Medicare. (If you earn below $400 or your business reports a loss for the year, however, you will not be required to pay any self-employment tax.)

In a traditional employee/employer relationship, the employer pays half of this tax. However, since you are paying all of it as a self-employed sole proprietor, the IRS allows you to claim half as a deduction.

Use IRS Schedule SE to calculate the taxes due on your net small business income. You can also find more information from the IRS on Self-Employment Taxes here.

How Does a Sole Proprietor Pay Their Taxes?

Sole proprietors pay their estimated taxes quarterly. These payments are due on the 15th of April, June, September, and January. If you aren’t sure how much to pay and your income is fairly steady, you can use last year’s return as a guide and divide what you paid then by 4.

You can use IRS Form 1040-ES (Estimated Tax for Individuals) to help you figure out how much to send each quarter. Details on how to submit your estimated payments to the IRS are included in the instructions for that form as well.

This article from The Balance SMB, “How Do I Calculate Estimated Taxes For My Business”, has more details and some good tips as well.

Other Taxes to Keep in Mind

Don’t forget about property taxes, state sales taxes, and possible excise taxes. You’ll want to be sure to plan for those in your budgeting throughout the year.

What Can Sole Proprietors Claim as Deductions?

The IRS allows businesses to claim “ordinary and necessary” expenses related to the running of their business as deductions at tax time. Such deductions include:

  • Vehicle mileage – The rate for 2020 is 57.5 cents per mile.
  • Vehicle repairs and maintenance
  • Advertising costs
  • Equipment and capital
  • Home office usage
  • Office rent
  • Health insurance premiums
  • Office supplies and other expenses

The important thing to remember about deductions is to keep good records. The IRS expects you to be honest and accurate, and in the event of an audit, you’ll be glad you can back up any deductions you claim. (We wrote about how to “Keep up With Receipts Like a Pro” a while back. Check that article out for more helpful tips.)

How Can I Make Sure I’m Doing My Sole Proprietor Taxes Right?

When it comes to taxes, you can’t afford to get sloppy or lazy. Keeping up with your records, staying on top of your quarterly estimated payments, and wading through all the forms the IRS requires can be a lot to handle.

Fortunately, you’re not alone!

Our tax professionals have been helping small business owners (many of whom are sole proprietors) with all kinds of tax situations for over 40 years. We get what you’re going through, and we know how to help.

Don’t risk trying to do it all yourself. The US Government’s General Accounting Office released a study showing that 77% of 71 million taxpayers reported benefiting from the help of a professional tax preparer.

Today’s tax laws are complicated, and it seems like nothing is simple. It’s very easy to overlook deductions and credits to which you are entitled. Experienced tax pros can find things that even the most popular tax preparation software can miss.

So to make sure you understand how sole proprietorships are taxed and how to stay on top of it all, schedule a call with our team today.

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