Sole proprietors pay taxes on business income on their personal tax returns.

As a sole proprietor you must report all business income or losses on your personal income tax return; the business itself is not taxed separately. (The IRS calls this "pass-through" taxation, because business profits pass through the business to be taxed on your personal tax return.)

Here's a brief overview of how to file and pay taxes as a sole proprietor -- and an explanation of when incorporating your business can save you tax dollars.

Filing a Tax Return

The main difference between reporting income from your sole proprietorship and reporting wages from a job is that you must list your business's profit or loss information on Schedule C (Profit or Loss from a Business), which you will submit to the IRS along with Form 1040.

You'll be taxed on all profits of the business -- that's total income minus expenses -- regardless of how much money you actually withdraw from the business. In other words, even if you leave money in the company's bank account at the end of the year (for instance, to cover future expenses or expand the business), you must pay taxes on that money.

You can deduct your business expenses just like any other business. You are allowed to expense (deduct) much of the money you spend in pursuit of profit, including operating expenses, product and advertising costs, travel expenses, and some of the cost of business-related meals and entertainment. You can also write off certain start-up costs and the cost of business equipment and other assets you purchase for your business.

But you'll need to keep accurate records for your business that are clearly separate from your personal expenses. One good approach is to keep separate checkbooks for your business and personal expenses -- and pay for all of your business expenses out of the business checking account.

Estimated Taxes

Because you don't have an employer to withhold income taxes from your paycheck, it's your job to set aside enough money to pay taxes on any business income you bring in during the year. To do this, you must estimate how much tax you'll owe at the end of each year and make quarterly estimated income tax payments to the IRS and, if required, your state tax agency.