How a Sole Proprietor Pays Income Tax - And Other Taxes
Sole Proprietor Income Taxes, Self-employment Tax, Estimated Tax and More
- It's the default business type. If you want to start a business, you can just get started and you're automatically a sole proprietor for tax purposes.
- A sole proprietorship doesn't have to register with a state.
- There is 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.
Sole Proprietors as Pass-through Tax Businesses
As a sole proprietor, you may be wondering how your business taxes work with your personal taxes. Simply stated, you compute your business income tax by completing a business tax calculation form (called a Schedule C), then you add this information to your personal tax return.
This form of business, as described above is called a "pass-through" business because the profits or losses of the business pass through to the owner's personal tax return. The business doesn't pay its own tax, because the sole proprietor business is not separate from the owner for both tax and legal purposes.
If you are the sole owner of a limited liability company (LLC), you are a single-member LLC, and you pay income taxes in the same way as a sole proprietor, including self-employment taxes (explained below). So this information applies to you too.
Here's how this works for income tax purposes:
How Sole Proprietors Pay Income Tax
A sole proprietorship is taxed through the personal tax return of the owner, on Form 1040. The business profit is calculated and presented on Schedule C—Profit or Loss from Small Business. 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, AKA, the amount of taxable business income.
This net income or loss of the business is entered on Line 12 of the owner's Form 1040, to be included along with other income/loss of the owner (and spouse) for income tax purposes. If the business has a loss, this loss may be used to reduce the total adjusted gross income of the owner (the income before exemptions and deductions) on the tax return.
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.
Here is a quick example - much simplified:
A sole proprietor is a self-employed individual and must pay self-employment taxes (Social Security/Medicare tax) based on the income of the business. Self-employment tax is included in Form 1040 for federal taxes, calculated using Schedule SE, and the total self-employment tax liability is included on line 57 of Form 1040. If the business has a loss, no self-employment tax is payable, but the owner doesn't receive Social Security credits for that year.
Here is an example (greatly simplified):
Teri is a sole proprietor, single tax filer.
- She completes her Schedule C, which shows her net business income as $10,000. This is her taxable business income.
- She must pay self-employment tax of 15.3% on this income, or $1,530. She gets a deduction of half this amount, so she must pay $765 for this tax.
- She also has an income of $12,000 for a part-time job.
- The Schedule C income, the self-employment tax, and her work pay are all used as part of the calculation of the income tax she owes for the year.
Because a sole proprietor is not an employee, no income taxes or self-employment taxes are withheld from the owner's pay. The IRS requires that these taxes be paid throughout the year, not just at tax time. That means you must make estimated tax payments each quarter (April 15, June 15, September 15, and October 15 of the next year.
Avoid IRS Fines and Penalties by Paying Estimated Taxes on Your Business Income
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 the income of those employees, including withholding and reporting federal and state income taxes, paying and reporting FICA (Social Security and Medicare) taxes, workers compensation taxes, and unemployment taxes. If your sole proprietor business pays employment taxes, these are deductible business expenses. Of course, amounts withheld from employees and paid by your business are not deductible to your business.
If the sole proprietor owns a building or other real property (land and buildings), property taxes are required to be paid on this property. The tax is based on 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 products and taxable 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, as these are levied by states on corporations and other types of state-registered businesses.
Deducting Business Tax Payments
Taxes your business pays may be deductible as business expenses. But you can't deduct federal income taxes or self-employment taxes.