Sole Proprietor Taxation
According to the Internal Revenue Service (IRS), a sole proprietor is an individual who owns a business that is not incorporated by themselves. Sole proprietors have different taxation implications than incorporated businesses. Due to these differences, it can be helpful to seek legal advice to ensure the correct filing of taxes in accordance with the law.
What Is a Sole Proprietor?
A sole proprietor is an individual who owns an unincorporated business by themselves. The key characteristics of this business structure include:
- It is the most common and default type of business structure, meaning all individuals who want to start a business are already sole proprietors.
- There is no registration requirement.
- There is no distinction between the owner and the business, meaning they are the same entity for both legal and tax purposes.
Key Differences Between Sole Proprietors and Other Business Structures
Unlike other business structures, there is no distinction between the owner and a sole proprietorship. Due to this, the owner is legally responsible for any debts that the business accrues and, if someone sues the business, they also sue the owner. Alongside this, a sole proprietor company has a “pass-through” tax arrangement. This means that the business’s losses or profits are part of the business owner’s tax return, instead of there being a separation between the two.
Understanding How Sole Proprietors Pay Their Income Tax
By using IRS Tax Form 1040, sole proprietors can file their income tax, alongside the owner’s personal tax return. On this form, the business owner calculates and notes the business’s profits on Schedule C. In this section, the owner determines the business’s total income minus its expenses, the result of which is the business’s net income.
It is this value that the business pays income tax on, which can be both a positive or negative value, depending on whether the business made a profit or loss. For instance, if the business makes a profit, the owner would pay income tax on this figure, alongside their other taxable income. Conversely, if the business makes a loss, rather than paying income tax on this loss, the owner can use this loss to reduce their gross income figure.
Paying Self-Employment and Estimated Taxes
As sole proprietors are self-employed, they are legally required to submit payments for self-employment, or Social Security and Medicare, taxes, with the exact value depending on the business’s income. This type of taxation is also recorded in Form 1040 on Schedule SE. Business owners who make a loss do not pay these taxes but, in this scenario, it does mean that the owner cannot get Medicare or Social Security credits for the year.
Due to sole proprietors not being employees, self-employment and income taxes are not kept from the business owner’s paycheck. According to the IRS, sole proprietors are legally required to pay these taxes in the form of estimated tax payments at the end of each quarter, as opposed to at the end of the tax year. If you have recently started a sole proprietorship, or are considering starting one, consider speaking with Amini & Conant to check your sole proprietor taxation requirements.
What Other Taxes Do Sole Proprietors Pay?
A sole proprietorship with employees also pays employment taxes on their staff’s paychecks. Moreover, sole proprietors who own land and properties are legally required to pay tax on these, with the exact value depending on the property’s value and the local tax rates. Additionally, sole proprietors pay sales taxes on certain products and services that the business sells, depending on the state’s sales tax rates. Furthermore, the sole proprietor may pay excise taxes in the same way that other business structures do, which depends on the state’s excise tax rates. Usually, sole proprietors do not pay franchise taxes as registered businesses pay these instead.
What is Tax Deductible for Sole Proprietors?
Sole proprietors can deduct business expenses related to the establishment and running of their business. These include expenses that most other businesses typically incur, which are ordinary expenses, and necessary expenses, which include essential expenses for running the business. Some examples of common expenses include:
- Advertising and marketing costs
- Equipment and other physical company assets
- Office supplies and travel expenses
- Operating and entertainment expenses
- Office mortgage or rent payments
- Health insurance payments
Additionally, sole proprietors can claim a home office deduction, but many are reluctant to do so as they feel it makes them more likely for the IRS to audit them. Despite this, sole proprietors that qualify for this deduction can benefit significantly from claiming it. To qualify for this deduction, it is crucial for sole proprietors to demonstrate that they use a single section of their home for business purposes. By doing so, a sole proprietor can successfully deduct a proportion of their utilities and rent as a business expense.
When including deductions as part of a sole proprietor’s tax return, it is critical to keep accurate records. This includes accurately documenting all purchases and storing receipts so the business owner can easily handle an audit by the IRS if one occurs.
Incorporating a Business
In certain circumstances, it can be legally and financially beneficial for sole proprietors to incorporate the business, which allows them to file taxes as a corporation. Often, this can result in reduced tax rates for the business owner, due to the business having a separate legal identity. Despite this, setting up and running an incorporated business is generally more complex than establishing and running a sole proprietorship. Before setting up a business, it is helpful to research the most suitable business structure, including asking for advice from a legal professional, as this decision can have significant long-term tax implications.