A Guide to Sole Proprietorship Taxes

Written by True Tamplin, BSc, CEPF®

Reviewed by Subject Matter Experts

Updated on March 29, 2023

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When a sole proprietorship is first established, it's not considered to be doing any business until there is some activity.

Business activity includes providing services or selling goods, but can also include accepting payments for future services or goods.

Sole Proprietorship Defined

A sole proprietorship is an unincorporated business with only one owner.

That person has total control of the business and personal liability for all of its debts and obligations.

Sole proprietorship businesses are simpler compared to corporations and partnerships because reporting business income for tax purposes does not take as much effort.

The owner simply reports all the earnings from their business on a Schedule C and then includes that amount with their personal 1040 income form.

Pass-Through Entity Taxation

When business profits are passed through to their owners they are considered "passed-through" entities. This means that no separate tax return is filed at the corporate level; instead, these items are listed on an individual's personal income tax returns where may be taxed as ordinary income or as a capital gain.

Pass-through taxation can be beneficial for sole proprietorships because it allows business owners to avoid the double taxation that would otherwise be imposed on corporations.

Sole proprietorships receive pass-through treatment automatically, whereas other types of businesses have to elect how they are taxed when filing tax returns.

What Taxes Do Sole Proprietors Have to Pay?

A sole proprietorship has more or less the same tax reporting requirements as any other individual taxpayer.

The forms needed in filing for taxes relative to sole proprietorship businesses can be accessed here.

Sole proprietors are required to pay the following:

Federal Income Tax

This refers to all income earned throughout the year, including capital gains and losses, and business income and expenses.

Sole proprietors have to file their individual tax returns or personal income through Form 1040 and their business' profit and loss or business income through Schedule C.

The sum of income from both Form 1040 and Schedule C will determine which tax bracket will be used, along with the amount of income tax to be paid.

In most cases, a sole proprietorship is not required to pay federal income taxes on all of its earnings because there are deductions available for everything from equipment to travel expenses.

State Income Tax

Depending on the state, sole proprietors may be required to pay state income tax on all of their business earnings.

The taxable amount would simply be the same amount as with the federal income tax and computation of taxes will be based on the specific tax bracket applicable.

Self-Employment Tax

Self-employment tax is similar to the social security and Medicare taxes withheld from employees' pay.

It's required of any sole proprietor who pays himself or herself wages.

The self-employment tax rate is set at 15 percent, half of which will be automatically deducted from income via the Schedule SE form along with the individual's 1040 form.

Federal and State Estimated Taxes

Sole proprietors who expect to owe more than $1,000 in federal income tax after credits and deductions are applied must pay quarterly estimated taxes.

Estimated payments could be made through Form 1040-ES for individuals or Form 1120-W for corporations which would require full payment by January, April, June, and September of the following year.

Sales Tax

Sales tax is collected when the proprietor receives payment for taxable goods or services.

A sole proprietorship is required to report all sales through a Sales Tax Return form and either pay monthly or yearly tax on their earnings. Take note that not all states impose a sales tax.

How to Report Business Expenses for Tax Purposes

Tax deductions are expenses that are subtracted from business earnings before income taxes are calculated.

It is important to keep expense records so they can be shown on the Schedule C form, along with other documents such as invoices or receipts.

Sole proprietors may deduct the following:

Business Operating Costs

This includes any money spent for supplies, equipment maintenance, advertising and marketing initiatives, rent or lease payments for non-home office space, and insurance premiums related to business operations.

Additionally, internet service charges related to business use, legal fees involving company matters, vehicle expenses incurred during business activities, transportation costs if transporting goods around town or to vendors, and depreciation deductions can also be deducted.

Depreciation Deductions

Depreciation is the process of allocating the cost of an asset over its useful life.

It can apply to assets such as office furniture, equipment used in processing or manufacturing, land improvements like fences or sidewalks, and long-term machinery and building improvements.

Start-Up Costs

Business start-up costs are those incurred before opening day or within the first twelve months of business operations.

This includes expenses related to consultants, accounting fees, promotional events, leasing equipment for inventory purposes, and signage.

The full amount of these deductions must also be added back into income if it is later discovered that they were not deductible after all (e.g., due to overestimating their value).

Contributions to Retirement Plans

Sole proprietors may contribute to any qualifying retirement plans and such can be deducted from earnings.

This deduction can include money going to a traditional IRA, a simplified employee pension plan (SEP), a self-employed 401(k) account, and a SIMPLE IRA.

Education Expenses

The cost of courses related to business operations may also be deducted from income as long as they are required by the business or meet the express requirements set by law.

Interest in Business Loans

Business loans such as mortgages, lines of credit, and other short-term loans can be deducted from business income.

If interest is incurred on a long-term loan intended to acquire an asset that will last more than one year, this may also qualify for the deduction.

Taxes and licenses

For sole proprietors, the costs of complying with state and local government regulations may be deducted.

This includes business licenses, permit fees, registration fees for official designations like a seller's permit or health care provider license, and any other allowable license or tax deduction.

Final Thoughts

Sole proprietor taxation is less complex compared to that of corporations and other forms of business organization.

As such, sole proprietorships only require the filing of a Schedule C form on an annual basis to report taxable income and deductions along with copies of receipts or invoices for deduction purposes (not required by all states).

If this is done correctly and within the rules set forth by the Internal Revenue Service (IRS), these filings are straightforward and do not take long to complete.

Taxation for Sole Proprietorship FAQs

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide, a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website or view his author profiles on Amazon, Nasdaq and Forbes.

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