This article has been reviewed by tax expert Erica Gellerman, CPA.
How Are Sole Proprietorships Taxed?
Sole proprietorships are subject to pass-through taxation, meaning the business owner reports income or loss from their business on their personal tax return, but the business itself is not taxed separately. A sole proprietor will submit a Schedule C with their personal 1040 tax return on an annual basis. They will also be responsible for filing Schedule SE with these returns and paying self-employment taxes on a quarterly basis.
As a small business owner, you have a number of complicated responsibilities on your plate—perhaps none as complex and as significant as filing your business taxes. As far as business accounting goes, filing taxes is certainly one of the most time-consuming and involved processes you’ll need to complete. The extent of your tax responsibilities, however, will largely depend on the specifics of your business—including, first and foremost, your business entity type.
This being said, if you’re a sole proprietor, you may be wondering: How are sole proprietorships taxed? What tax forms do I need to complete? Fortunately, this guide is here to help. We’ll break down everything you need to know about sole proprietorship taxes—including the types of taxes you may be responsible for, what returns you need to file, what the sole proprietorship tax rate looks like, and more—so that when tax season comes around you’ll know exactly how to file taxes as a sole proprietor.
Overview of Sole Proprietorship Taxation
Before we dive into the details involved with sole proprietorship taxes, let’s start with the basic information you need to know. How are sole proprietorships taxed? In essence, sole proprietorship taxation is different from other business entities, like corporations, because the business itself is not taxed separately from the business owner. Instead, you report and pay your sole proprietorship taxes as part of your personal tax return.
To explain, the IRS calls this type of taxation “pass-through taxation” because the tax liability belongs to the owner of the business, “passing through” to the business owner’s personal tax return. As we’ll discuss in greater detail shortly, this means that you’ll complete a separate form for your sole proprietorship taxes, Schedule C, which you file with your personal income tax form, Form 1040.
This being said, sole proprietorship taxation has a few implications that are important to note. First, “pass-through taxation” means that the net income from your business will increase your personal taxable income—meaning your business income could push you into a higher tax bracket. Second, with sole proprietorship taxation, the income taxes that you pay are not business expenses. Some business owners post income tax payments on their profit and loss statement as expenses; however, this is incorrect if you’re a sole proprietor—these payments are actually distributions of equity and should not be posted as expenses.
Although you should not post these tax payments as expenses, this does not mean your business cannot fund your tax payments. In fact, you should set aside a percentage of your business’s income to cover the sole proprietorship taxes due on the profit in your business. You should remember, however, that when you take money out of your business to pay your taxes, it will come out as an owner’s draw and not an expense.
Sole Proprietorship Taxes for LLCs
Moreover, it’s important to note that even if your business is an LLC, you may still be filing taxes as a sole proprietor. Since an LLC is a legal status granted at the state level, and not a federal tax status, single-member LLCs are subject to sole proprietorship taxation. If your LLC has two members, you’ll be classified as a partnership for tax purposes; however, either single- or multi-member LLCs can elect to file their taxes as a corporation by completing IRS Form 8832.
With this in mind, if your business is an LLC and you’re unsure of what your tax status is, you’ll want to consult with your business accountant or attorney, especially if this individual helped you form your LLC.
Determining Your Income Tax Liability
As we mentioned, as a pass-through entity, you’ll pay income taxes on your sole proprietorship as part of your personal tax returns, using Form 1040 Schedule C. In order to file this return, you’ll need to determine your sole proprietorship’s taxable income.
Fortunately, you do not pay taxes on the full amount of your sole proprietorship’s income. Instead, you’ll only pay sole proprietorship taxes on the profit of your business. Essentially, this means you’ll be taxed on all profits—total income minus expenses—regardless of how much money you withdraw from the business. Therefore, your sole proprietorship’s taxable income will be close to the “net income” or “net profit” number at the bottom of your profit and loss statement, but with a few adjustments.
Like any business, you’ll be able to deduct business expenses on your return; however, you’ll want to ensure that you’re managing your bookkeeping correctly to report your taxable income and any deductions accurately. A common mistake that sole proprietors make, for example, is recording cash activity—owner’s draws, cash infusions from loans or investments, payments on long-term debt—as expenses or income on their profit and loss statement when these activities do not impact taxable income. These incorrectly recorded transactions will skew your profit calculation and can result in you paying too much or too little on your sole proprietorship taxes.
Additionally, it’s important to note that although you can deduct your business expenses, not all of them correctly reported on your profit and loss statement are 100% deductible. For example, business meals are only 50% deductible—and starting with the 2018 tax year, entertainment expenses are not deductible at all. Therefore, even though these expenses may appear on your profit and loss statement, you’ll want to remember that they may not have a 100% impact on your taxable business income.
Sole Proprietorship Taxes: Special Deductions
On the other hand, although there is some cash activity in your business that does not impact the taxable income for your sole proprietorship, there is also some non-cash activity that can reduce your taxable income—but these activities might not appear on your profit and loss statement.
When it comes to your sole proprietorship taxes, therefore, you’ll want to keep these special and sometimes overlooked business tax deductions in mind, as they can make a huge impact on your tax liability. Let’s explore further.
Health Insurance Deduction
Many sole proprietors don’t realize they can deduct health insurance premiums for themselves and their families without itemizing their tax returns. If you are a sole proprietor, your health insurance premiums are an “above the line” deduction, meaning you can deduct it before you arrive at your adjusted gross income. You’ll want to note, however, that this only applies to the premium for months when you (or your spouse or other family members) are not covered by a group insurance plan.
Although the business mileage deduction isn’t limited to sole proprietorships, sole proprietors often tend to overlook this deduction, thinking it’s insignificant. However, if you use your car for business purposes, at 57.5 cents per mile (in 2020), this deduction can make a sizable impact on your tax liability. In order to receive this deduction, though, you’ll need to keep thorough mileage records, but luckily, there are a number of available business apps that can help facilitate this process.
Home Office Deduction
Many sole proprietors hesitate to claim the home office deduction because they’ve heard this deduction is a red flag and makes their return more susceptible to audit. If you run a home-based business, however, you are entitled to this deduction, and it can have a significant effect on your tax liability. With this deduction, though, you should keep in mind that you can only deduct expenses for the percentage of your home you use for your business. Additionally, your home office space must be used exclusively for business, so if your “office” is a corner of your kitchen table, you can’t take this deduction.
When you’re an employee, your employer pays 50% of your social security and Medicare taxes and the other 50% is withheld from your paycheck. As a sole proprietor, on the other hand, you’re responsible for 100% of these taxes. These taxes are referred to as self-employment taxes and currently, the self-employment tax rate is 15.3% of your net self-employment income. This being said, 50% of your self-employment taxes are deductible. These specific sole proprietorship taxes are reported on a special form, Schedule SE, which we’ll discuss in greater detail below.
If you want to make sure you maximize your sole proprietorship tax deductions, we recommend working with an accounting pro. Users of the accounting software Bench can be paired with a professional bookkeeper who can handle all their tax filing needs.
How to File Your Sole Proprietorship Tax Returns
Keeping in mind everything we’ve explored thus far, let’s dive into the details regarding the different forms you’ll need to file to fulfill your obligations for sole proprietorship taxes. At this point, it’s important to note that although we’ve been first and foremost discussing your business’s income tax liability, you may be responsible for additional taxes—such as payroll, property, sales, and excise taxes. In this regard, the IRS provides a reference list of taxes that sole proprietorships may be liable for, as well as the respective forms you would need to complete for each tax.
Sole Proprietorship Taxation: Income and Self-Employed Taxes
As we explained, as a sole proprietor you’ll report and pay income tax on your business’s profit—and you’ll do so by filing additional forms with your personal return, Form 1040. This being said, most sole proprietors only need to file two forms with their individual return. Let’s take an in-depth look at each of these forms.
First, Schedule C is used to report the profit and loss of your business. You’ll also use this form to report your business mileage.
Overall, Schedule C is a relatively easy form to follow—broken up into five sections asking about your income, expenses, cost of goods sold, information on your vehicle, and other expenses. When completing this form, you’ll be able to refer to the IRS instructions for guidance and pull most of the information you’ll need from your financial statements and, if applicable, your mileage tracking app.
This being said, however, there are a few questions that warrant upfront explanation:
- Accounting method: In the first section of Schedule C, you’ll be asked about your business’s accounting method. Most sole proprietors file their taxes on a cash basis, even if they keep their books on an accrual basis. Unless your accountant tells you differently, you’ll want to choose cash basis for your tax return—by doing so, you’re ensuring that you’re only paying taxes on the income you’ve actually received.
- Material participation: If you’re actively involved in your business’s operations, then you will answer “yes” to this question. If you are an investor, or if the income from your business is passive in nature, consult with your accountant about how to proceed with your tax return.
- 1099 requirements: If you paid one or more independent contractors at least $600 by check, cash, electronic funds transfer, or wire transfer during the course of the year, you must file 1099s for them. If you paid your contractors by credit card or a service such as PayPal, the merchant processor is responsible for filing the 1099s.
Ultimately, you’ll use the information from your Schedule C to complete your personal 1040 tax form and the sole proprietorship tax rate you’ll pay on your business’s income will be equal to your personal income tax rate.
As we mentioned earlier, as a sole proprietor, you’re responsible for self-employment taxes—the social security and Medicare taxes that an employer normally takes out of an employee’s pay. In order to calculate the self-employment taxes you owe, you’ll complete Schedule C first, and then fill out Schedule SE. Currently, the self-employment tax rate is 15.3%, but once again, you’ll be able to deduct half of this amount on your 1040 form.
It’s important to note, however, that although you’ll file Form 1040, Schedule C, and Schedule SE on an annual basis, you’re responsible for paying self-employment taxes on a quarterly basis. Therefore, in order to calculate these payments, known as estimated taxes, you’ll complete Form 1040-ES and pay the respective amounts quarterly, based on the IRS due dates.
Sole Proprietorship Taxation: Additional Taxes
On top of your sole proprietorship taxation requirements for income and self-employment, you may also be liable for other types of taxes depending on the specific nature of your business:
- Employment taxes: If your sole proprietorship has employees, you’ll be responsible for employment taxes, also commonly referred to as payroll taxes. This requirement involves withholding tax from your employees’ paychecks for income taxes, FICA (social security and Medicare) taxes, and unemployment taxes, as well as reporting these taxes and paying your respective responsibility as an employer. To report and pay these taxes, you’ll complete Forms 940 and 941. Additionally, you’ll also be required to report an employee’s wages and tax withholdings annually by filing Form W-2 (you’ll file 1099s instead if you’re reporting payments to independent contractors).
- Property taxes: If your sole proprietorship owns real estate, land, or any business property, you may be required to pay property taxes. The business property tax that you’re required to pay will depend specifically on your location and the rules as defined by your local tax authority.
- Sales and excise taxes: At the state level, your sole proprietorship will need to pay sales taxes on the products and taxable services that you sell. Like business property taxes, sales taxes will vary based on your location and product or service, so you’ll want to consult your state tax agency for the relevant requirements. Similarly, with excise taxes, you’ll only be required to pay these taxes if you sell certain products, like alcohol or tobacco. If you need to pay excise taxes, however, you’ll need to do so at the federal, state, and local levels—meaning the cost and schedule will once again depend on your business’s location.
When to File Sole Proprietorship Taxes
Ultimately, the returns for your sole proprietorship taxes will depend on the specific tax. Along these lines, it’s important to remember that some tax returns, like Form 1040 and the accompanying Schedule C, must be filed annually, whereas others, like Form 941 for payroll taxes, must be filed quarterly.
This being said, in order to file your general income taxes for your sole proprietorship, you must complete the required forms on the same schedule as your personal tax returns. Therefore, you must file by April 15 unless you file an extension, which will give you until October 15 to file.
However, you’ll also want to keep in mind that, as we discussed earlier, the IRS requires you to pay this tax liability throughout the year—meaning you must complete Schedule SE to determine your estimated tax payments and pay the respective amounts on a quarterly basis.
Although there are different deadlines to adhere to, you’ll want to be sure to keep track of your tax responsibilities, pay your estimated taxes, and file on time. If you don’t pay your estimated taxes and wait until you file your annual return, the IRS may charge you a penalty for failure to pay on time. Similarly, you may face a penalty for any IRS business form that you don’t file completely by the deadline.
The Bottom Line
With the significance of taxes—and the consequences if you neglect them—it’s important to know not only how sole proprietorships are taxed, but also the various forms, deadlines, and deductions that are involved in fulfilling your tax responsibilities.
Considering all of the forms and payments that may be required for your sole proprietorship taxes, you’ll want to ensure that your bookkeeping is accurate and up to date at all times—not just when tax season comes around.
This being said, since every tax situation is different—depending on your business and location—it’s always helpful to consult a CPA, enrolled agent, or other business tax advisor for assistance with your business taxes. These professionals can answer any questions you have, ensure that you receive the maximum deductions, and even complete the returns on behalf of your business.
Nevertheless, even if you decide to outsource your tax processes, it’s worth knowing the ins and outs of sole proprietorship taxation so that you have a handle on your responsibilities and can work effectively with any professional you hire.
- IRS.gov. “Expenses for Business Meals Under Section 274 of the Internal Revenue Code“
- IRS.gov. “Topic No. 502 Medical and Dental Expenses“
- IRS.gov. “Standard Mileage Rates“