A sole proprietorship is a business operated by an individual owner. It is unique for several reasons. If you want to start a business by yourself, you can just get started, and you're automatically a sole proprietor for tax purposes. A sole proprietorship doesn't have to register with their state. Finally, there's no separation between the owner and the business in a sole proprietorship for both tax and legal purposes. As we'll see, that can be a good and not-so-good thing.
Key Takeaways
- Sole proprietorships are different than other business structures because they're extremely easy to set up but the owner is liable.
- Sole proprietors typically use Schedule C to file their taxes.
- A sole proprietorship is known as a "pass-through" business, in that your profits and losses pass through to your personal taxes.
- Sole proprietors are responsible for several different taxes, including self-employment and estimated taxes.
What Makes Sole Proprietors Different
Sole proprietors are one-person owners of unregistered businesses. That means they don't register their businesses with a state. For legal and tax purposes, sole proprietorships are the only business type that isn't separate from the owner. The owner is liable for all the debts of the business and can be sued in connection with its actions.
For tax purposes, a sole proprietorship is considered a "pass-through" business. The profits or losses of the business pass through to the owner's personal tax return.
Note
If you're a single-member LLC, you pay income taxes in the same way as a sole proprietor, including self-employment taxes. If you're the only owner of a limited liability company [LLC]. This information applies to you, too.
How Sole Proprietors Pay Income Tax
A sole proprietorship is taxed through the personal tax return of the owner via Form 1040. Your business profit is calculated and presented on Schedule C. To complete Schedule C, the income of the business is calculated including all income and expenses, along with cost of goods sold for products sold and costs for a home-based business. The result of this calculation [income minus expenses] is the net income [the amount of taxable business income].
This net income or loss of the business is entered on Line 31 of the owner's Schedule C, to be included along with other income or losses of the owner [and spouse] for income tax purposes. The figure is entered on Line 3 of the Form 1040 if the business has a profit. A loss may be used to reduce the total adjusted gross income of the owner [the income before exemptions and deductions] on the tax return if the business has a loss.
The owner of the sole proprietorship pays income tax on all income listed on the personal tax return, including income from business activities, at the applicable individual tax rate for that year.
Self-Employment Tax
A sole proprietor is a self-employed individual and must pay self-employment taxes based on the income of the business. Self-employment tax is included in Form 1040 for federal taxes, calculated using Schedule SE. If the business has a loss, no self-employment tax is payable, but the owner doesn't receive Social Security or Medicare benefit credits for that year.
Here's a simplified example of how simplified taxes might work. Amar is a sole proprietor, a single tax filer. He completes his Schedule C, which shows a net business income as $10,000. This is his taxable business income. He must pay self-employment tax of 15.3% on this income, or $1,530. He gets a deduction of half this amount, so he must pay $765 toward this tax. He also has an income of $12,000 for a part-time job. The Schedule C income of $10,000, the self-employment tax of $765, and their taxable work pay are all used as part of the calculation of the income tax he owes for the year.
Estimated Taxes
Because a sole proprietor is not an employee, no income taxes or self-employment taxes are withheld from their pay. The IRS requires that these taxes be paid throughout the year, not just at tax time. That means they must make estimated tax payments each quarter [April 15, June 15, September 15, and January 15 of the next year].
This article has tips for ways to calculate your estimated tax payments, using the best guess of your business income for the year. Don't forget to include an estimate of self-employment tax due on that income.
Other Employment Taxes
If a sole proprietor has employees, the business must pay employment taxes on their incomes, including withholding and reporting federal and state income taxes, and paying and reporting FICA [Social Security and Medicare] taxes. They're deductible business expenses if your sole proprietorship pays employment taxes. Amounts withheld from employees and forwarded to the government by your business are not deductible to your business.
Property Taxes
If your sole proprietorship owns a building or other real property [land and/or buildings], you have to pay property taxes on the property. The tax is based on the appraised value and tax rates for the town or city where the business is located.
State Sales, Excise, and Franchise Taxes
Sole proprietors are required to pay state sales taxes on taxable products and services sold by the business. In addition, the sole proprietor may have to pay excise [use] taxes in the same manner as other business types.
Check with your state department of revenue for more information on sales and excise taxes. Sole proprietorships are not typically liable for franchise taxes, because these are levied by states on corporations and other types of state-registered businesses.
Frequently Asked Questions [FAQs]
How does a sole proprietor pay taxes?
Ideally, sole proprietors pay taxes via estimated tax payments at the end of each quarter. At tax time, they primarily use a 1040, Schedule C, and Schedule SE.
How much should a sole proprietor set aside for taxes?
A good rule of thumb is to set aside 20%-30% of your income for taxes. If you'd like a more exact estimate, it may help to hire a tax professional.