Being a sole proprietor or independent contractor can simplify your finances. However, it’s important to understand how your business structure affects your taxes. There are tax laws that sole proprietors need to know. This guide explains how to prepare, file, and pay taxes when you run a business alone.
A financial advisor can help you optimize a tax strategy for your business needs and goals.
What Is a Sole Proprietorship?
A sole proprietorship is the most common business structure and the easiest to establish. In short, a sole proprietor draws no distinction between yourself and your business for tax purposes. As a result, the IRS treats you as both. This type of business structure is unincorporated and you can receive all income from your business activities. Similarly, you’re solely responsible for any debts and tax obligations the business accumulates.
The advantages of a sole proprietorship include easy setup and complete control over business decisions. Depending on the state you live and do business in, you may form a sole proprietorship without a special license. It also runs more simply if you’re the only employee and don’t manage payroll for others.
Sole Proprietorship Taxes Defined
For tax purposes, a sole proprietorship is a pass-through entity. Business income “passes through” to the business owner, who reports it on their personal income tax return. This can reduce the paperwork required for annual tax filing. But it’s important to understand which sole proprietorship taxes you’ll pay.
Sole proprietors are responsible for paying:
- Federal income tax.
- State income tax, if this applies in your home state.
- Self-employment tax.
- Federal and state estimated taxes.
- Sales tax, if applicable.
Each type of tax has its own requirements for reporting and payment.
Federal and state income taxes: Sole proprietors file need to file two forms to pay federal income tax for the year. Firstly, there’s Form 1040, which is the individual tax return. Secondly, there’s Schedule C, which reports business profit and loss. Form 1040 reports your personal income, while Schedule C is where you’ll record business income.
Your tax bracket and the amount of income tax owed are based on your combined income from both Form 1040 and Schedule C. If your state assesses income tax, you’d carry your income numbers from your federal forms over to your state forms to determine how much income tax is due. Again, your income tax liability would be based on the tax bracket you land in, based on your combined business and personal income.
Self-employment taxes: When you work for an employer, they’re responsible for taking Social Security and Medicare tax out of your pay. If you’re a sole proprietor who’s completely self-employed, you’re responsible for paying this sole proprietor tax yourself.
Here’s how the self-employment tax breaks down 2023:
- 12.4% goes toward Social Security tax, on up to the first $132,900 of your income.
- 2.9% goes toward Medicare tax.
Altogether, the self-employment tax rate is 15.3%. If your total income is more than $200,000 as a single filer, $250,000 if you’re married and file jointly and $125,000 if married filing separately, you’ll pay the additional Medicare tax of 0.9%. These amounts are reported on Schedule SE each year when you file your federal tax return.
Federal and state estimated taxes: Estimated taxes aren’t a separate class of tax by themselves. When you pay estimated tax, you’re actually paying money ahead toward what you think you’ll owe for income and self-employment tax at the end of the year. Normally, an employer would withhold money from your paychecks to be applied to your tax liability. But if you’re a self-employed sole proprietor, you’ll have to do this yourself.
Federal and state estimated taxes are due in January, April, June and September. The first tax payment of the current tax year is in April. As a result, the last is due in January of the following year. Filing deadlines are typically the 15th day of their respective month, unless the 15th falls on a holiday or weekend. In that case, the filing deadline would be the next regular business day. You can file these taxes with Form 1040 ES. However, you also have to file your income taxes for the previous year in April.
It’s important to make sure you’re paying enough in estimated taxes each quarter. Shorting your estimated taxes could trigger an underpayment penalty if you end up owing more in taxes at the end of the year.
Sales taxes: If you sell products or services in your business, you may have to collect and pay sales tax. How you pay and collect this tax depends on your home state. Your state’s department of revenue can tell you if and when you pay and file taxes.
Tax Deductions for Sole Proprietorships
One good thing about being a sole proprietor and running a business is that you can claim certain deductions to offset your income for the year. Deductions reduce your taxable income, which could mean owing less in taxes. Meanwhile, you could get a refund when you file if you overpay your estimated taxes.
Some of the most common deductions available to sole proprietors include:
- Home office deduction.
- Contributions to self-employed retirement plans, such as a SEP IRA or solo 401(k).
- Traditional individual retirement account contributions.
- Contributions to a Health Savings Account associated with a high deductible health plan.
- Advertising and marketing expenses.
- Interest on business loans.
- Bank fees.
- Education expenses related to the business.
- Legal and professional fees.
- Telephone and internet service.
- Business meals.
- Business use of your car.
- Taxes and licenses.
You can also claim personal deductions. Personal deductions for sole proprietor taxes may include health insurance premiums paid out of pocket, child and dependent care expenses, mortgage interest if you own a home, and charitable contributions.
This allows sole proprietors and pass-through entities to deduct up to 20% of net business income from their taxes. Eligibility requires qualified business income and taxable income for the year.
This deduction has income limits. For 2023, the maximum total income threshold is $364,200 for married couples filing jointly and $182,100 for single filers. You can take a pass-through deduction of up to 20% of your qualified business income if your income is within these limits, based on your filing status.
If your income exceeds those limits, you may claim a partial deduction. But that amount depends on your total income and the nature of your business. If your business offers certain personal services, such as investment advice or health care, then the deduction isn’t as favorable in reducing taxable income.
You can’t avoid filing sole proprietor taxes, but understanding them can make the process easier. While you might be comfortable filing taxes on your own if you have a fairly straightforward return, you may want to meet with a professional accountant if your income or expenses are more complex. The most important thing to remember is to always file your taxes on time to avoid any federal or state tax penalties.
Tax Filing Tips
- Consider where retirement planning fits into your tax picture. Contributing to a tax-advantaged retirement plan can reduce your taxable income each year, while also growing your future nest egg. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Take care to maintain good records for any deductions you plan to claim. For example, hang on to copies of your credit card or bank statements to show when and what you paid for deductible business expenses. Create a mileage log for your vehicle if you use it for business purposes. Get receipts for charitable donations you make and if you’re taking the home office deduction, consider whether it makes more sense to use the regular or simplified method.
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