- Taxes for sole proprietorships include federal and state income taxes and self-employment taxes.
- Your sole proprietorship tax rate is based on the tax bracket you land in as a result of your combined personal and business income.
- Sole proprietors pay estimated taxes every quarter.
- Sole proprietors can save money by converting to an LLC business structure and leveraging LLC tax deductions.
Inexperienced small business owners often get worried when tax season comes around. I hear things like, “Did I file everything correctly?” “Am I going to be audited?” and “Why is my tax bill so high?”
All of these concerns make sense when you’re running a sole proprietorship without a complete knowledge of tax strategy. Sole proprietors are often inexperienced, which unfortunately causes sole proprietorships to be three times more likely to be audited by the IRS than other business structures.
But I tell my clients that avoiding these issues is easy when you understand basic tax strategy. Sole proprietors benefit from a thing called “pass-through” taxation, which means any income the business earns “passes through” the business and to the business owner. In some cases, this means sole proprietors get to enjoy a much simpler tax season than the rest of us. To get that simplicity, though, you’ve got to know what you’re doing.
In this article, I’ll walk you through what you need to know about filing taxes as a sole proprietor, and I’ll share my thoughts on when you should upgrade to a different business structure.
What Is a Sole Proprietorship?
A sole proprietorship has no distinction between the business and the owner. So, according to the IRS, all your business income and all your personal income are considered one and the same. The same goes for liabilities. Sole proprietors are personally liable for any financial or legal trouble the business encounters.
If your business is struggling, your home, savings, and other personal assets could be threatened. When setting up a sole proprietorship, it’s important to be aware that you are taking on significant personal risks.
Which Taxes Are Sole Proprietors Responsible For?
In the tax world, we refer to sole proprietorships as pass-through entities. What that means is any income the business earns “passes through” the business, and the sole proprietor reports it on their personal tax return. This can simplify tax season for sole proprietors, but it can also bring up questions about which taxes you’re actually responsible for.
Here’s a list of sole proprietorship taxes the IRS requires of you:
- Federal and state income tax: Your tax rate as a sole proprietor is based on the tax bracket you land in after combining your personal income and profit from your business.
- 15.3% self-employment tax: The self-employment tax includes social security and Medicare tax. The social security tax is 12.4%, and the Medicare tax is 2.9%. If your income is above $200,000 for single filers or $250,000, the Medicare tax is 0.9% higher.
- Sales tax, if applicable: If your state or city government charges a tax on your product, you’ll need to collect this from your customers. You’ll then make these tax payments to the government either quarterly or monthly.
- Employment tax, if applicable: If you have employees at your sole proprietorship, you’ll need to pay payroll taxes quarterly.
How to File Taxes as a Sole Proprietor
1. Estimate Your Taxable Income Quarterly
As a sole proprietor, the best way to pay Uncle Sam is to estimate your taxable income and file your sole proprietorship taxes every quarter. At the end of the tax year, if your estimated tax is too high, you’ll get a tax refund. If you’re not sure how much you owe, it’s better to overestimate and get a refund rather than underestimate and get hit with an underpayment penalty.
These tax forms will help you report what you owe:
- Schedule C: Use this form to calculate profit and loss at your business.
- Form 1040: Report your individual income here.
- Schedule SE: Schedule SE is for reporting the amount you owe in self-employment taxes.
2. Calculate Your Tax Deductions Annually
Keep track of your deductions throughout the year so you can avoid overpaying the IRS. Tax deductions are reported annually, so you can skip this step when filing your quarterly taxes. Use Schedule C to report business-related deductions, like the following:
- Business mileage: If you use your car for business, you can deduct 58.5 cents per mile driven.
- Self-employment tax: While sole proprietors have to pay that pesky 15.3% self-employment tax, 50% of that payment is deductible from your income taxes.
- Qualified Business Income (QBI): If your income is below $182,100 for single filers and $364,200 for joint filers, you’ll be able to write off 20% of your business’s profit. For example, if your business earned a $50,000 profit, you can deduct 20% or $10,000 from your income taxes.
- Home office: If you work from home, you can deduct a portion of your home’s expenses, including mortgage interest, utilities, and depreciation. However, many people have misused this deduction in the past, causing the IRS to be more vigilant in checking that those who are reporting this deduction truly qualify for it. If you claim this deduction, make sure to only deduct costs related to the portion of your home you use for business. Additionally, that portion of your home must exclusively be used for business, meaning you cannot work at your kitchen table and take a deduction for it.
- Costs of doing business: If you spent money on your business this year, you can write it off. This includes business loan interest, insurance, business meals, advertising costs, and any other business-related expenses.
Use Form 1040 to report personal deductions. Here are some common personal deductions:
- Charitable donations: When you donate to a tax-exempt organization, that money can become a write-off. These organizations include museums, educational organizations, religious institutions, the Red Cross, and many other non-profits.
- Mortgage interest: You can deduct the interest you paid on the first $750,000 of mortgage debt.
- Medical expenses: Out-of-pocket medical expenses can be tax deductible. The IRS allows you to deduct these expenses when they exceed 7.5% of your income. So if your income is $100,000, any out-of-pocket medical expenses beyond $7,500 are tax-deductible.
3. File Your Taxes Online or by Mail
Once you’ve calculated your taxes and deductions, you’ll send the forms to the IRS either online or through the mail. Check the IRS website for the mailing address and a list of authorized online tax filing providers.
Filing Sole Proprietorship Taxes FAQ
What is the due date for filing my taxes?
April 15th is the due date for annual taxes. However, quarterly taxes for sole proprietorships must be paid by the 15th of the month during January, April, June, and September.
Are paying quarterly taxes a requirement or a recommendation?
Most self-employed individuals are required to pay estimated taxes quarterly. The reason for this is the U.S. has a pay-as-you-go tax system. Many people are unaware of the quarterly tax requirement because when you work for a W-2 employer, they withhold taxes from each paycheck automatically, so you don’t have to think about it.
However, there are a few people who are exempt from the quarterly tax requirement. If you meet these requirements, you can skip the quarterly taxes:
- You expect to owe less than $1,000 in taxes: If your business is just getting up and running, you may not yet be making a profit. Or your deductions may lower your taxable income to a point where you owe less than $1,000.
- You also have a W-2 employer: Individuals who run their own business and also work for a W-2 employer can increase withholdings from their paycheck through their W-2 employer. If you do this, you’re technically paying your taxes as you go, just like those who file their own quarterly taxes. In this case, though, you won’t have to worry about filing the paperwork because the taxes are paid automatically.
Can I apply for an extension?
Yes, you can file for an extension. Use form 7004 to request a six-month extension, allowing you until October 15th to get your taxes in.
What are some common tax mistakes that sole proprietors make that I should watch out for?
Many sole proprietors struggle to remember which expenses are deductible and whether they are 100% deductible or not. For example, 50% of the cost of a business meal can be a write-off, while 100% of office furniture is a write-off. To be sure you’re not missing any key write-offs, and you’re not over-deducting and putting yourself at risk of an audit, it’s a good idea to hire a tax professional or financial consultant to help you through the process.
Protect Your Assets by Switching Over to an LLC
While sole proprietorships are great, my favorite business structure is the LLC. I typically recommend sole proprietors convert to an LLC structure as soon as their business begins to grow, earns more profit, and takes on more legal or financial risk.
Besides the legal and financial protection you’ll get from converting to an LLC, I favor the LLC business structure because the tax advantages are huge. LLCs allow business owners to leverage tax strategies to save thousands of dollars each tax season.
If you’re interested in setting up an LLC, follow these steps:
- Choose whether you’ll be a single-member or multi-member LLC.
- Get an articles of organization form.
- Select a registered agent, file, and pay any fees.
- Create an operational agreement.
- Receive your state’s approval to operate.
- Obtain an EIN. (Even if you already have an EIN, you’ll need a new one to convert your business to an LLC.)
- Get required local, state, and federal licenses.
To learn more about the advantages of the LLC business structure, check out these articles: