One of the advantages of a sole proprietorship is its simplicity. You do not separate taxes for your business, you simply report all of your business income and losses on your personal income tax return. But with that simplicity comes personal liability for legal judgments, taxes, and debt. You will need to make quarterly tax payments based on estimates for the year, for which you will be refunded or charged -- depending on whether you over- or underpaid -- at the regular April 15 federal tax deadline. You also will need to pay self-employment taxes (since their are no "payroll" taxes).
Below is an overview of how to file your taxes as a sole proprietorship:
Estimating Your Sole Proprietorship Taxes
Unlike a traditional employee, as a sole proprietor you don't have anyone withholding income taxes from your paycheck. This means that it is your job to estimate how much you'll owe in taxes at the end of each year. You will then make quarterly payments based on your estimations to the Internal Revenue Service (IRS) and, if required, to your state as well.
Filing Your Sole Proprietorship Taxes
Your sole proprietorship's profits are treated as simple income on your personal income tax return, but with a few caveats. First, you will be taxed for the full profits of your business, even if you have not personally withdrawn the money. Second, in addition to a traditional personal income tax statement, you will have to fill out a Schedule C (detailing your profits or losses) and a Schedule SE (see the information on self-employment taxes below) which you submit alongside your 1040 income tax return to the IRS.
In a sole proprietorship, you can take business deductions just like with other forms of business. This means that you can deduct things such as operating expenses and advertising, as well as business-related travel and entertainment (though be very careful to ensure it really is business-related). Start-up costs, such as buying business equipment, can also typically be deducted.
To take advantage of deductions, however, you will need to keep meticulous records. If you're going to take a deduction, you should be able to demonstrate to the IRS that it was a legitimate business expense.
Finally, it is smart to keep separate accounts for your personal and business expenses. This will help you maintain clear, business-only records. Just as importantly, this will also demonstrate to the IRS if they ever audit you that you tried to separate your business expenditures from your personal ones.
Paying Self-Employment Taxes
As a sole proprietor, you must pay self-employment taxes (contributions to Social Security and Medicare). Employees have this deducted from their paychecks, but as a sole proprietor, it is up to you to make these contributions while paying your income taxes. You will report your self-employment taxes on a Schedule SE which is submitted along with your Schedule C (see above) and 1040 income tax return.
A real significant difference between a sole proprietor and an employee, however, is that the sole proprietor will have to pay the full contribution, whereas employees only pay half because their contributions are matched by their employers. This can be largely offset, however, because sole proprietors can deduct up to half of the total cost of these contributions.
Consider Incorporating Your Business for Tax Reasons
Finally, it pays to compare how a sole proprietorship is taxed to how other business forms are taxed to make an intelligent decision about how to run your business. The primary difference in tax treatment is that sole proprietorship profits are treated as personal income, whereas corporations are taxed separately.
Because sole proprietorship income is taxed as personal income, the tax amount depends on your personal income tax bracket. Corporations, however, are not only taxed separately, but also typically have lower tax rates than personal income. You will often end up paying fewer taxes by incorporating your business than running it as a sole proprietorship.
Despite the fact that many businesses would owe fewer taxes as a corporation, balance that against the added time and expense of having to prepare corporate taxes. For smaller businesses, any tax savings may be outweighed by the cost and complexity of filing a corporate tax return.
Get Peace of Mind for Your Sole Proprietorship: Contact a Tax Law Attorney
Although the tax code allows sole proprietors to include profit and loss from their business in their personal income tax returns, it can be quite confusing to sort out. Even honest mistakes can trigger an audit from the IRS. That's why it's critical to speak with an experienced tax attorney before problems arise.