Setting up a sole proprietorship business?
There are several things to know about sole proprietorship start-ups. But most importantly, there’s a slightly complex part – sole proprietorship taxation!
Sole proprietorships have simple finances. It is easier to manage funds and resources in this business structure. However, sole proprietors face challenges in managing everything single-handedly.
When you are a sole proprietor, understanding sole proprietorship taxation is a must. There are a few laws and regulations that you must know when running a sole proprietorship.
So, we thought of helping you out with a detailed guide on sole proprietorship taxes. After reading this, you will know how to prepare, file, and pay taxes on time!
What are Sole Proprietorship Taxes?
Sole proprietorship taxes are easy to file as the business income ‘passes through the owner’s income tax return. That means you must report the taxes of a sole proprietorship business on your income tax returns.
Sole proprietorship businesses are also called pass-through entities because of their tax structure. The sole proprietors are responsible for reporting and paying the following taxes:
- Self-employment taxes
- Federal income tax
- State income tax (if applicable)
- Sales tax (if applicable)
- Federal and state estimated taxes
Sole Proprietorship Taxes For LLCs
Even if you own an LLC, sole proprietorship taxes might be applicable for you.
Why?
Because the state grants the legal status of LLC to a business.
Single-member LLCs are treated as sole proprietorships at the federal level of taxes. So, the LLC tax regulations are the same as sole proprietorship taxes.
Similarly, your LLC will categorize as a partnership business for tax purposes if there are two members. However, no if matter you are a single or multi-member LLC, your business can choose to file taxes as a corporation by filling out IRS Form 8832.
We agree that’s some serious and vital information to keep regarding sole proprietor taxes!
So, if your LLC’s tax status seems confusing, we recommend you consult a professional. Your attorney or accountant can help you out, especially if you have taken their services while forming the LLC.
Why Is It Called Self-Employment Taxes?
We have already mentioned that you must file the sole proprietorship taxes through filing taxes as a sole proprietor must be through your income tax returns. This is what pass-through taxation is about. Here, the income and losses of the business are not reported separately. You must report it using Schedule C along with the personal 1040 tax return every year.
Moreover, a sole proprietor is also responsible for paying the self-employment taxes quarterly using Schedule SE. These taxes cover Social Security and Medicare taxes.
Taken together, the owner must pay all the sole proprietorship taxes, including self-employment taxes, through their tax return. Hence, you can consider the sole proprietorship taxes as self-employment taxes.
How to Determine The Taxable Income For Sole-Proprietorship?
As we have said, you must pay sole proprietorship taxes as a part of your income tax returns. While filing the tax returns, you will need your taxable income for the business.
Thank heavens that you don’t pay taxes on the entire sole proprietorship income. It is only a part of the income that is taxable. The taxable income is what appears at the bottom of your profit and loss statement (with a few adjustments) as ‘net income’ or ‘net profit.’
All you need to do is minus the expenses from the total income. Once you arrive at the profits, you will have your taxable income. So, essentially, sole trader taxable income is the profit earned by the business.
The good news is that you will be able to deduct certain business expenses from your tax returns. However, to claim deductions, ensure that you keep the expense and income records accurately.
For instance, recording cash activities (like withdrawal by the owner, cash proceeds from investments, loans, payments, or long-term debts) can be confusing. Sole proprietors often make mistakes in the categorization of cash activities.
They fail to identify the activities as income or expenses in their profit or loss statement when these activities do not affect the taxable income. Such recording errors can show up in your profits, skewing the calculations. Hence, you might end up paying too much taxes or too little of it.
Also, note that not all your expenses are 100% deductible from the taxable income. We will get into the details of sole proprietorship tax deductions in a moment.
Sole Proprietorship Tax Deductions – Things to Keep in Mind
Fortunately, business expenses are deductible in sole proprietorship taxation. But not all correctly recorded expenses are 100% deductible.
A few cash expenses are 50% deductible, such as business meals. Further, effective from 2018, entertainment expenses are not deductible at all.
Apart from cash expenses, there are a few non-cash expenses that sole proprietorship tax deductions consider. These non-cash activities lower your sole proprietorship taxable income. However, you might not find these activities recorded in your profit and loss statement.
So, here is a list of the sole proprietorship tax deductions you might be unaware of. Keep these in mind to reduce your tax liability.
Self-employment taxes
If you are an employee, your self-employment taxes liability (social security and Medicare) is much lesser.
50% of these taxes are withheld from your remuneration, while your employer pays the remaining 50%. But, as a sole proprietor, paying the self-employment taxes in their entirety (100%) is your responsibility.
However, the good news here is that 50% of your self-employment taxes (the employer portion) are deductible. You must report these specific sole proprietorship taxes on Schedule SE.
To maximize your sole proprietorship tax deductions, make sure to consult professionals. An accounting pro with a professional bookkeeper can work wonders for your tax filing requirements.
Health Insurance and other costs
What tax deductions do you get related to health insurance?
Well, it is the health insurance premium!
Many sole proprietors are not even aware that they can deduct their health insurance premiums for themselves and their families. Besides the insurance premium, you can also deduct certain out-of-pocket medical expenses like office co-pays, prescription costs, etc.
However, note that the deduction only applies to the insurance premiums for those months when a group insurance plan does not cover you (or your family or spouse).
Home Office deduction
Are you running your sole proprietorship from home?
Then, without any hesitation, claim the home office tax deduction. However, keep in mind that you can claim deductions only on the percentage of your home that you use solely for business.
You must meet two criteria to claim the sole proprietorship tax deductions.
- First off, the space in your home must be regularly and exclusively used for business. For instance, if you use your garage for conducting your business, you can claim a tax deduction for it. But if you are using a kitchen corner as your ‘office’, that won’t work for the deduction.
- Secondly, your home space must be your primary place of business. That means you must conduct your main business activities and spend most of your time there.
When taking home deductions, you are most likely to file Form 8829 along with Schedule C.
Vehicle Used for business
Sole proprietors often miss out on the business mileage deduction as the deduction is also available to other business structures.
Under this sole proprietorship tax deduction, if you use your vehicle for business (like attending meetings, seminars, etc.), you can claim a deduction at 56 cents per mile (as of 2021). Hence, the business mileage deduction can end up making a significant impact on your tax liability.
For deducting the vehicle expenses, there are two methods. You can choose the one that results in lower taxes. Have a look at what these methods of calculation are:
- Standard mileage rate method: Using the Standard mileage rate method, you can calculate the cost by multiplying the mile traveled for business with the standard mileage rate.
- Actual expense method: Under the Actual expense method, you must consider all the costs involved in operating the vehicle. These costs might include registration fees, insurance, tires, gas, oil, repairs, and lease payments. To arrive at your deduction amount, you can multiply these costs by the vehicle’s business use percentage.
However, make sure you have your business travel records to claim this deduction. Take the help of the several business apps available to help you track the business mileage and maintain information related to vehicle usage.
Pass-Through Deductions In Sole-Proprietorship Taxes
We have already mentioned that sole proprietorships are also known as pass-through entities, as you can file the business taxes through your tax returns.
Now, pass-through deductions are for sole proprietorships and other pass-through entities. You can claim this tax deduction to reduce up to 20% of net business income from your taxes. The eligibility for pass-through deduction requires qualified business income and taxable income for the year.
However, the pass-through deduction has limits. As of 2021, the total taxable income must be within $329,800 for joint filers and $164,900 for single filers to qualify. Once you are eligible, you can take a pass-through deduction of up to 20% of your business income.
You can claim the partial deduction if your income exceeds the above limits. But the deduction amount depends on your total income and the nature of the business. The tax deduction won’t be favorable if your business offers personal services like consultations for healthcare or investment advice etc.
How To File Taxes as a Sole Proprietor
Filing taxes as a sole proprietor can be hectic. It requires you to adhere to different deadlines and keep track of your tax liabilities.
There are several forms in sole proprietorship taxes and quite a few things that must be clear to you. For instance, you must file Form 1040 with Schedule C annually. Whereas filing Form 941 (payroll taxes) takes place quarterly. Similarly, you must complete filling out Schedule SE to determine your estimated taxes and pay the respective tax quarterly to avoid penalties.
With almost everything being said about filing sole proprietorship taxes, it is important to know the forms you will need to file your taxes. So, let’s jump into the next section.
Sole Proprietorship Tax Forms – Things you Must Know
As a sole proprietor, you will report and pay your return through Form 1040. Further, you will need to fill out additional forms for reporting your business’s profit.
Mainly, there are two sole proprietorship tax forms that you need to fill out with your return. Take a sneak peek into these forms.
- Schedule C – Use this form to report the profit or loss of your business. Report your business mileage in this form too.
- Schedule SE – Fill out Schedule SE to report self-employment taxes, including social security and Medicare taxes.
To know in detail about sole proprietorship tax forms, read our blog on …
When To File Sole Proprietorship Taxes?
The sole proprietorship tax filing deadline will ultimately depend upon what specific taxes you are paying. Though the business income tax liability comes first, you might be responsible for additional taxes as well – like sales tax, payroll, property tax, etc.
However, considering income taxes, you must file Form 1040 with Schedule C annually considering income taxes. You must ensure that your required forms are on the same schedule as your tax returns. Therefore, filing them within April 15 is a must unless you want to file an extension, giving you time to file the taxes until October 15.
The deadlines or time limits on paying your taxes are significant. You must be responsible and aware of the deadlines. Failing to file the sole proprietorship taxes on time might attract hefty penalties from the IRS. Further, if you file to file tax returns at all, the penalties can be up to $25000 for each year.
Pro Tips for Sole Proprietorship Tax Filing
Sole proprietorship taxation is more straightforward than other business structures. But that does not mean you can do it in an instant. For a sole proprietor, it is often difficult to manage the taxes along with so many responsibilities.
Though we have covered pretty much every detail about sole proprietorship taxation, what we want to share here are tips – yes, two tips on filing sole proprietorship taxes!
- Tip #1 – Think about your future. Not just the near future but about your retirement plans. Consider looking at your tax picture to determine where your retirement planning fits in. If you contribute towards a tax-advantaged retirement plan, it can reduce your yearly taxable income. So, while you reduce your taxes every year at present, you can also support your plans. Hence, a win-win situation for you. To move forward with this plan, contact professional financial advisors to help you achieve your financial goals.
- Tip #2 – When planning to claim deductions take care of the records. For instance, hold on to those copies of your bank statements or credit card bills to show when claiming for deductible business expenses. To claim business mileage deduction, create a mileage log for the vehicle you use. In the case of charitable donations, keep the receipts safe and secure. For home office deductions, decide which method seems more feasible to you.
While we are nearing the end of this sole proprietorship taxes guide, we do not want to leave any stone unturned.
So, the last section of this guide discusses the additional sole proprietorship taxes on which your deadlines depend.
Additional Taxes Of A Sole Proprietorship Business
With so much information on sole proprietorship taxation, you must know by now that you are liable to pay income tax and self-employment taxes.
But on top of these two, certain additional taxes might be applicable depending on the nature of your business.
Property taxes
As a sole proprietor, if your business owns real estate, land, or any property, you might have to pay property taxes. The property tax payable will depend on your business’s location and the rules defined by the local tax authority of the specific location.
Employment taxes
If you hire employees, employment taxes (also called payroll taxes) are a must. It involves withholding a percentage from employee remuneration for income tax, FICA (social security and Medicare) taxes, and unemployment taxes. Plus, reporting and paying the taxes is also the employer’s responsibility. You will need to fill out Forms 940 and 941 to file and pay these taxes. Additionally, you will need to file W-2 annually for employee wages and tax withholdings.
Sales and excise taxes
Your sole proprietorship business will need to pay sales tax on taxable products and services at the state level. Like property taxes, sales tax will differ according to location, product type, and services. Similarly, if your business sells tobacco or alcohol, you must pay excise taxes. However, you have to pay excise taxes at the local, state, and federal levels. So, the cost and schedule will again depend on your business location.
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