- Sole proprietorships report their business income and expenses on Schedule C.
- As a sole proprietor, any self-employment taxes become your responsibility.
- The Tax Cuts and Jobs Act introduced new pass-through tax deductions.
- This story is for sole proprietors looking to learn about their tax responsibilities, deadlines and the IRS forms they need to file.
As a sole proprietor, it's important that your tax situation is handled with care, as any mistakes run the risk of creating tax debt, the levying of tax liens on your property or the forced closure of your company. With the right information and a basic understanding of what's required by local, state and federal government agencies, you can avoid any tax-related headaches and file before the July 15 deadline.
How sole proprietorships prepare and file their taxes
While business owners operating under different business configurations have to wade through numerous tax forms covering a litany of different governmental requirements, sole proprietors have it relatively easy.
In order to file your business taxes along with your personal tax return, you must include a Schedule C form with either your 1040 or your 1040-SR – whichever form you're required to file in that given tax year. According to the IRS, a Schedule C is used by sole proprietors to report the business's income or losses. Since the IRS automatically considers any unincorporated business operated by a single person to be a sole proprietorship, the only federal requirements to qualify as one are that, one, its primary function must be to generate income or profit, and, two, it should be conducted "with continuity and regularity."
According to the U.S. Small Business Administration, sole proprietorships are not considered a separate business entity. Even though that can simplify things for you, that means your "business assets and liabilities are not separate from your personal assets and liabilities." That means everything that happens in your business – good or bad – can reflect on your personal property. For example, a lawsuit can be particularly damaging for a sole proprietorship, since owners of LLCs and other business structures generally keep their personal and business assets separate. [Read related article: Freelance Taxes: What Every Freelancer Needs to Know]
Using the Schedule C form, you will calculate your business's profit by adding all profit and income, and subtracting the costs of goods and services, as well as any other associated business expense. Through that calculation, the business's net profit is determined and added to Line 12 of the 1040. That income is included in your personal income and taxed accordingly. If, however, your business operates at a loss, that will also be reflected in your taxes by potentially reducing your total adjusted gross income.
While the entire process can be filled out and submitted by hand, many of today's most popular online tax solutions can simplify the process for you, though the free versions often do not cover business taxes.
As for state tax liability, owners of sole proprietorships should consult their state's tax laws and requirements. Generally, things like a state sales tax and excise tax are required, though property and real estate taxes can be levied against the business if it owns a building or property.
Key takeaway: In addition to the regular 1040 form, sole proprietors must file a Schedule C form that reports business profits or losses.
Estimated tax and the self-employment tax
If you've collected any income from your business, you're going to pay taxes on it. Since you're the only person in the business, you won't have an employer to withhold your taxes and send you a W-2 for tax filing purposes. As such, you're going to have to handle this entirely on your own, making sure you save enough money to cover your business and income tax responsibilities.
Generally, you're going to want to estimate how much you will need to pay in taxes and commit to making quarterly tax payments to the IRS based on that estimation. You'll need to check on whether you must make quarterly payments to your state as well, as that requirement varies by state.
Through the use of the IRS' 1040-ES form, you can calculate how much your estimated tax liability will be. According to the IRS, you're required to pay an estimated tax if both of the following statements are true:
1. You anticipate owing at least $1,000 in taxes after subtracting your withholding and refundable credits.
2. You expect your withholding and refundable credits to be less than the smaller of:
- 90% of the taxes to be shown on your upcoming tax return, or
- 100% of the taxes shown on your tax return from the previous year, if that return covers all 12 previous months.
Along with your estimated taxes, you're going to have to pay the self-employment tax. Based on Social Security tax and Medicare tax, this tax is calculated through Schedule SE and is not unlike the payroll tax at larger companies. While employee contributions to both systems are taken out of their paychecks, a sole proprietor pays it through their taxes. If you're required to pay your estimated taxes quarterly, you may also be required to cover your self-employment taxes using that same payment schedule.
You should be aware that your contributions to Medicare and Social Security will be significantly higher. Since you are your own employer, you'll be paying both the employee and the employers' portions of those contributions. According to the IRS, the self-employment tax rate is 15.3%, with 12.4% going to Social Security and 2.9% going to Medicare.
When considering your estimated taxes and your self-employment tax responsibilities, it's important to note that failing to accurately calculate your tax burden can result in penalties. These penalties can sometimes be waived in certain circumstances, but it's best to avoid them in the first place.
Key takeaway: As a sole proprietor, you are required to pay income taxes. You must also pay self-employment taxes – which are your Social Security and Medicare contributions that you pay as both employer and employee.
Deductions to keep in mind as a sole proprietorship
Tax deductions can go a long way in reducing your overall tax burden, and sole proprietorships are no different. According to the IRS, some credits and deductions available to all types of businesses include items like the Manufacturers' Energy Efficient Appliance Credit and the Plug-in Electric Drive Vehicle Credit, among other things. [Read related article: How to Reduce Your Business's Tax Liability]
Other tax deductions that exist for sole proprietorships include health insurance deductions for yourself, your spouse and any dependents in your home. Even if you don't itemize deductions on your tax return, this deduction can still happen as an "above-the-line" item, according to Intuit. Keep in mind, however, that this deduction is limited by your taxable income.
Business operating expenses found to be "ordinary and necessary" by the IRS can also be deducted on your tax return. Things like equipment, capital improvements and other reasonable expenses can be considered for potential deduction. Furthermore, if you work out of your home, some home-office costs, including rent and utilities, can be deducted if you have a part of your house dedicated solely to your business. [Read related article: Crazy Tax Deductions Allowed by the IRS]
Following the passage of the Tax Cuts and Jobs Act of 2017, the federal government also made it so a qualifying small business owner can utilize new pass-through tax deductions of up to 20% of net business income earned. This deduction will run until 2025 and is considered an additional personal deduction if you meet certain criteria. If you have employees and make less than $315,000 (if married and filing jointly) or $157,700 (if single), then you may qualify. Furthermore, this deduction is capped at a percentage of employee wages or the property cost associated with the business.
If your sole proprietorship makes more than $415,000 (if married and filing jointly) or $207,500 (if single), then your business is not eligible for the TCJA pass-through tax deduction.
Regardless of your sole proprietorship's function and how you intend on earning profits, it's imperative that you nail down your tax burdens as soon as possible. Failing to do so can result in dire circumstances, while keeping up with your federal and state taxes will ensure you can keep operating for years to come.
Key takeaway: Save money on your taxes by taking advantage of tax deductions that reduce your tax burden.