This article will discuss how sole proprietorships are taxed, what tax returns you must file, and when you must file them. We will focus on federal income and payroll taxes since they are the most common.
What Is A Sole Proprietorship?
Sole proprietorships are probably the most common form of small business ownership. A single person owns a sole proprietorship and assumes all the risks and rewards of the operations. The owner is not an employee of the company.
The Internal Revenue Service (IRS) recognizes five entities for tax purposes. Each type has many advantages and disadvantages, which you can find in this <table>.
How Are Sole Proprietorships Taxed
The business itself does not pay taxes.
However, because the owner and the business are one and the same, the owner pays income tax if there is a profit. The profit is included with other income sources on the owner’s personal tax return. The total level of income (also known as taxable income) determines individual tax rates after taking all deductions. Tax tables that show what an individual would pay based on their taxable income can be found on the IRS website.
| Tax rate | on taxable income from . . . | up to . . . |
|---|---|---|
| 10% | $0 | $11,000 |
| 12% | $11,001 | $44,725 |
| 22% | $44,726 | $95,375 |
| 24% | $95,376 | $182,100 |
| 32% | $182,101 | $231,250 |
| 35% | $231,251 | $578,125 |
| 37% | $578,126 | And up |
If the sole proprietorship has a loss, it deducts the loss against any other income on the individual tax return and then applies the rates.
Furthermore, the owner is also subject to self-employment tax on their personal tax return if the business has a profit (but not if there is a loss). Self-employment taxes are how sole proprietorships pay payroll taxes for the owner since they are not an employee of the company. (See below for more on payroll taxes).
The sole proprietor must pay 15.3% of the self-employment income (the business’s net profit). The sole proprietor can deduct one-half of these taxes (technically the business’s share) on their personal tax return.
What Tax Form Does a Sole Proprietorship File?
The business itself does not file a tax return. Instead, the owner attaches a Schedule C, Profit or Loss From Business, to their individual Form 1040 (which is filed by April 15th). A six-month extension to file is available. Please note that any extension is an extension of time to file the return and not an extension to pay.
Estimated Taxes for a Sole Proprietor
The sole proprietor must pay careful attention to their estimated taxes, due each quarter on April 15th, June 15th, September 15th, and January 15th (of the following year). These estimates must reflect both the income and self-employment taxes (described above). Taxable income, again, includes the profits from the business throughout the year and any other income (and withholdings) incurred outside the business reported on their individual tax return.
Many sole proprietors fail to plan for both taxes and are surprised by large tax bills and penalties when they file their tax returns. A competent professional, such as a Certified Public Accountant or Enrolled Agent, can help the sole proprietor proactively plan for these payments.
Payroll Taxes for a Sole Proprietor
Since the owner is not an employee, they take a draw against capital and profits instead of a salary and are not subject to payroll taxes themselves. However, they will be responsible for self-employment taxes on their individual tax return (described above).
The Sole Proprietorship is responsible for the payroll taxes of all its employees who receive salaries, wages, or other compensation. The owner’s responsible for withholding these taxes, matching any required by law, and remitting these amounts to the appropriate taxing agency on time. Payroll taxes can be a significant cost of doing business with potential ramifications on cash flow and should not be ignored.
Every business operator should know their tax obligations. Taxes are one of the most significant costs a business will incur. If you don’t plan for them or your business does not follow the rules, the results can be devastating.
You should consult a qualified tax expert, like a Certified Public Accountant, to discuss your situation.