Selecting the right business structure for your new enterprise can have far-reaching tax implications, so it's important to understand how sole proprietorships are taxed. The most common business entity is a sole proprietorship business, which is owned and run by one person.
If you're thinking of starting a sole proprietorship, here are a few things to keep in mind about sole proprietorship taxes when April 15 rolls around.
Sole proprietor taxes
How are sole proprietorships taxed? Sole proprietorships are not taxable entities under Internal Revenue Service (IRS) guidelines. Rather, revenue passes through the business and the sole proprietor reports all income and expenses on Schedule C “Profit or Loss From Business" or Schedule C-EZ “Net Profit From Business" and submits this along with their federal Form 1040 when they file their personal tax returns, also called “pass-through" taxation.
One of the most common mistakes that sole proprietors make is not reporting all earned income. For example, if a freelance writer makes $600 or more from a single client in a given year, that client is required to send the writer a Form 1099-MISC. However, even if you don't receive a Form 1099-MISC from a client, you're still required to report to the IRS any income you receive from that client.
Estimated quarterly taxes
Sole proprietors must estimate how much they'll owe in taxes at the end of the year. If you're not sure what you'll owe, use your last year's federal tax return as a guide. A major mistake that sole proprietors can make is failing to make estimated quarterly tax payments.
Businesses that expect to owe $1,000 or more in taxes by the end of the year can make one estimated lump sum tax payment or take this amount and divide it into four equal payments that are due the 15th of every quarter in April, June, September, and January. This does not apply if you didn't owe any taxes the previous year.
You want to be as accurate as possible when calculating your estimated tax payments in order to avoid an estimated tax underpayment penalty. If you underpay by 10 percent or more, the tax penalty will be between eight and 12 percent of the difference between what you paid and what you owed. If you overpay, you'll receive a refund when you file your current year's federal tax return.
You can deduct ordinary and necessary business expenses that are associated with starting and running your business, including expenses for books or classes and webinars that you take to add to your skill set and help you run your business.
Ordinary expenses include everyday expenses that businesses similar to yours might incur, while necessary expenses include expenses that are essential for running your business.
Common business expenses include:
- Advertising costs
- Capital expenses
- Health insurance premiums
- Home office deduction
- Meals and entertainment expenses
- Office rent or mortgage payments
- Operating expenses
- Travel expenses
Sole proprietors are often hesitant to claim the home office deduction because it can raise a red flag with the IRS. But if you're entitled to it, go ahead and take it. You'll be able to deduct certain expenses like rent and utilities, which can further reduce your tax liability. To qualify for the deduction, you must use one section of your home exclusively for your business.
Good recordkeeping is important. Save your receipts and document every purchase for when tax time rolls around, just in case the IRS decides to audit you.
Self-employment taxes are calculated based on your business's net profit, which is the amount that is left over after you subtract your business expenses from your business revenue. You can use Schedule SE “Self-Employment Tax" to help figure what you owe.
The 2016 self-employment tax rate is 15.3 percent: 12.4 percent for Social Security taxes up to the first $118,500 and 2.9 percent for Medicare taxes. Sole proprietors report self-employment taxes on Schedule SE, which they submit along with their federal Form 1040 tax return and Schedule C. Unlike wage earners who only pay half because their employer picks up the other half, sole proprietors must pay the full amount. Fortunately, they can claim half the cost as an income tax deduction.
Sole proprietors can choose to incorporate their business and file taxes as a corporation. Unlike sole proprietorships that pay taxes on both their personal and business income combined, corporations are taxed as a separate legal entity and often have lower tax rates. So it's important to do your research because, in the long run, you might be able to save money if you incorporate your business. However, setting up your business and running it as a corporation is more complicated than setting up and running a simple sole proprietorship.
Ultimately, make the decision that's best for you. Just remember the decision can have long-term tax consequences. While taxes for sole proprietorships may seem complicated, with a bit of research, they become one more skill you'll master as you run and grow your business. If you're not sure which form of business organization is right for you, talk with a business attorney who understands tax law to help you sort things out.
When you sign up for the business legal plan, you'll be able to talk to a tax professional who can answer your questions about sole proprietorship taxes. In addition to tax advice, the business legal plan includes unlimited 30-minute attorney phone consultations on new legal matters, legal document review, and more for one low monthly fee.
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