How to File Taxes as a Sole Proprietor: Everything You Need to Know

If this is your first tax filing season as a sole proprietor, you are probably wondering what to expect. Filing taxes as a sole proprietor is different than filing taxes as an employee with a W-2. With a little bit of education and planning, though, filing taxes as a sole proprietor is almost as easy as filing your individual return.

If you’re wondering how to file taxes as a sole proprietor, this article will tell you (almost) everything you need to know. As always, we recommend checking with a tax professional for guidance regarding your particular tax situation.

LLCs Are (Often) Sole Proprietorships, Too

We frequently have business owners tell us their business is taxed as an LLC. It’s important to remember than an LLC is a legal status granted at the state level, not a federal tax status. Unless you have elected partnership or corporation status for your LLC, you will file taxes for your business as a sole proprietor.

How do you know if you have elected partnership or corporate status for your LLC? Consult with the business attorney or accountant who helped you form your LLC if you are unsure of your business’s tax status.

Who Is Responsible for the Taxes in a Sole Proprietorship?

A sole proprietorship is a pass-through entity for tax purposes. This means the tax liability belongs to the owner of the business, “passing through” to the business owner’s personal tax return by means of a special form called a Schedule C.

This has a couple of implications. For one, it means the net income from your business will increase your personal taxable income. This means the income from your business could push you into a higher tax bracket.

Another implication of owning a pass-through entity is that the income taxes you pay are not business expenses. We often see income tax payments posted on a business’s profit and loss statement, but these are actually distributions of equity and should not be posted 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 taxes due on the profit in your business. Just know that when you take the money out of your business to pay your taxes, it will come out as an owner’s draw and not an expense.

Determining Your Sole Proprietorship’s Taxable Income

Fortunately, you do not pay taxes on the full amount of your sole proprietorship’s income. Instead, a sole proprietor pays taxes only on the profit in their business. This is pretty close to the net income or net profit number at the bottom of your profit and loss statement, but with some adjustments.

Your first line of defense in making sure you are reporting the correct taxable income in your business is good, solid bookkeeping. Engage with a professional bookkeeper or an accountant to review your books prior to filing your tax return to ensure your bookkeeping is accurate.

Sole proprietors often mistakenly record cash activity that does not impact taxable income as expenses or income on their profit and loss statement. This includes owner’s draws, cash infusions from loans or investments, and payments on long-term debt, to name just a few. These incorrectly recorded transactions will skew your profit and result in you paying too much or too little tax.

Another item to note is that not all business expenses correctly reported on your profit and loss statement are 100% deductible. Business meals are only 50% deductible, and—starting for the 2018 tax year—entertainment expenses are not deductible at all. This does not mean these expenses should not appear on your profit and loss statement, just that they may not have a 100% impact on your taxable business income.

Special Tax Deductions for Sole Proprietors

Just as 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 does not appear on your profit and loss statement and that can reduce your taxable income.

These special deductions can make a huge impact on your tax liability. Unfortunately, many sole proprietors disregard these deductions:

Health Insurance Deduction

Many sole proprietors don’t realize they can deduct the health insurance premiums for themselves and their families without itemizing their tax returns. If you own a sole proprietorship, your health insurance premiums are an “above the line” deduction, meaning you deduct it before you arrive at your adjusted gross income. Note 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.

Business Mileage

The business mileage deduction isn’t limited to sole proprietorships, but sole proprietors often tend to overlook this deduction, thinking it is insignificant. At 54.5 cents per mile (in 2018), the business mileage deduction can make a sizable impact on your tax liability. You have to keep records of your business mileage in order to take this deduction, but there are a number of apps available that make this easy.

Home Office Deduction

Many sole proprietors hesitate to take the home office deduction, because they have heard this deduction is a red flag and makes their return more susceptible to audit. If you run your business out of your home, though, you are entitled to this deduction, and it can have a significant impact on your tax liability. Keep in mind that you can only deduct expenses for the percentage of your home you use for your business. Also, 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.

Self-Employment Tax

When you are an employee, your employer pays 50% of your Social Security and Medicare tax. The other 50% is withheld from your paycheck. As a sole proprietor, though, you are responsible for 100% of your Social Security and Medicare tax. Fortunately, 50% of this tax is deductible on your taxes. This is done by means of a special form, which we will discuss later.

When Are Tax Returns for Sole Proprietorships Due?

Tax returns for sole proprietorships are due on the same schedule as personal tax returns. This means you must file your return by April 15 unless you file an extension, which will give you until October 15 to file.

Tax payments are a different matter, though. The IRS requires tax liability to be paid throughout the course of the year. When you are a W-2 employee, this happens automatically through payroll deductions. As a sole proprietor, you must make estimated quarterly tax payments. Typically, the IRS expects you to make equal tax payments each quarter, but if your business income is seasonal, you can vary your payments in relation to the income fluctuations in your business.

Waiting until you file your tax return to pay your taxes is a costly mistake. If you owe $1,000 or more in taxes with your return, the IRS will assess a penalty for failure to pay your taxes on time. Don’t overpay your estimated taxes, but do try to pay most of your tax liability prior to filing your return. Use Form 1040-ES to help you calculate your estimated tax payments.

Forms You Need to File Taxes as a Sole Proprietor

Most sole proprietors only need to file two additional forms with their 1040 individual tax return. Let’s take an in depth look at each of these forms.

Schedule C or Schedule C-EZ

Schedule C or Schedule C-EZ is used to report the profit and loss in your business. This is also where you will report your business mileage.

The first section of the Schedule C asks questions about your business. Most of these questions are self-explanatory, but a few of the questions warrant more exploration:

• 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 want to choose cash basis for your tax return. This ensures you are only paying taxes on income you have actually received.
• Material participation: If you are 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.

The rest of Schedule C is relatively self explanatory, and the information can be pulled from your business’s financial statements and your mileage tracking app.

Schedule SE

Schedule SE is used to calculate your self-employment tax. Complete Schedule C or C-EZ first, and then use Schedule SE to calculate the amount you owe for social security and Medicare tax. You will report both the full amount of your self-employment tax due as well as the 50% deduction on your individual Form 1040.

(Almost) Everything You Need to Know to File Taxes as a Sole Proprietor

If your tax situation is relatively uncomplicated, this primer is a good overview of everything you need to know about how to file taxes as a sole proprietor. As long as your bookkeeping is accurate and you have kept good records throughout the course of the year, you can complete your tax return in just a few hours.

Every tax situation is different, though, and each state has its own set of rules regarding business tax filings, which are outside the scope of this article. Your bookkeeper or accountant can help you form a tax preparation checklist which will make tax season easier.

Regardless of the complexity or simplicity of your tax situation, you might want to consider investing in the services of a tax professional. Investing in the services of a qualified tax professional might yield greater savings in taxes than the fee you pay the professional. Just remember that even if you hire a professional, it is still your responsibility as a business owner and taxpayer to know the rules when it comes to taxes.

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