How Sole Proprietors Are Taxed | Guide to Which Taxes You Need to Pay, Forms to Fill Out & Potential Deductions

It’s that time of year again: tax time. Many things have changed in the past year, perhaps one of them being your employment status. If you’ve recently become a sole proprietor, you may be totally confused and overwhelmed by the prospect of filling out your taxes. However, dealing with taxes as a sole proprietor doesn’t have to be an anxiety-inducing process. Read on to learn everything you need to know about business accounting for sole proprietors and how you can get through this process without paying an arm and a leg. 

What Is a Sole Proprietorship?

According to the U.S. Small Business Administration, a sole proprietorship is a type of business that is relatively easy to form and maintain. A sole proprietorship is an unincorporated business owned and operated by a single individual with no distinction between the business and the individual. Essentially, you are your business. As a result, you alone are entitled to all profits and are responsible for all debts, losses, and liabilities from the business. 

This is the most common structure when it comes to starting a business because it doesn’t require any formal action to form. Instead, this status is automatically granted to you as long as you are the only owner. Although this business status is automatic, you still need to obtain all required licenses and permits to legally operate your business according to federal, state, and local regulations. Along the way, you may need legal assistance, so checking out our top formation service / registered agent service reviews should prove useful - Swyft Filings, BizFilings, SunDoc Filings, Inc Authority, or MyCorporation are some the best.

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Benefits of Sole Proprietorships

Sole proprietorships are the most common business structure for new businesses for a reason -- they come with tons of benefits. For instance, sole proprietorships come with minimal costs and allow you to maximize your profit. Sole proprietorships also give you complete control over your business without involving other parties that may have conflicting opinions. Finally, sole proprietors enjoy lower tax rates when compared to other business structures and don’t require you to file separate business taxes. Instead, you only have to file individually and include any and all relevant information from your sole proprietorship.

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Different Required Taxes for Sole Proprietorships

Sole proprietors are required to pay federal income tax, state income tax (if applicable), self-employment tax, and sales tax (if applicable).

  • Within the federal income tax area, sole proprietors will need to file both a Form 1040 (personal income) and a Schedule C (business income). The two numbers on both your Form 1040 and Schedule C forms are used to calculate your tax bracket. That being said, it’s important to note that taxes in the United States are based on a progressive system. This means that different portions of your income are taxed at different rates. For example, say you made $45,000 as a sole proprietor in 2020. That would put you in the 22% tax bracket. However, you would only pay 22% on $4,126 as the previous bracket of 12% covers amounts from $9,876 to $40,125.
  • State taxes largely follow the same process as federal taxes. However, not all states assess income taxes. As of 2021, nine states don’t have an income tax: Alaska, Tennessee, Wyoming, Florida, New Hampshire, South Dakota, Texas, Washington, and Nevada.
  • Self-employment taxes cover the costs of entitlements that are usually taken out by your employer. For example, in 2020, you should expect to pay 15.3% as a self-employment tax with 12.4% going toward Social Security and 2.9% going toward Medicare.
  • Sales taxes are required if you’re actively selling products or services as a part of your business. These rates will vary depending on where you live and you can get more information for your taxes from the state’s department of revenue. 

Potential Tax Deductions for Sole Proprietorships

After hearing about all the different taxes you have to pay as a sole proprietor, it’s understandable that you’re feeling pretty overwhelmed. Thankfully, there are tax deductions you can potentially use to lower the amount of taxes you have to pay. While there are countless deduction options out there that can depend on your type of business, there are some common ones to look out for as a sole proprietor. 

Here are some potential tax deductions available for sole proprietorships:

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  • Home office deduction: Allows you to deduct expenses for the business use of your home. Requires that you regularly use part of your home exclusively for conducting business and that your home is your principal place of business. 
  • Advertising and marketing expenses: Allows you to deduct the expenses for the business use of advertising and marketing materials. This may include things like print ads, social media ads, website development, search engine optimization services, business cards, and more.
  • Certain savings account contributions: Allows you to deduct amounts that you have contributed to certain savings accounts such as Health Savings Accounts or retirement plans.
  • Telephone and internet service: Allows you to deduct the costs of telephone and internet services that you used to run your business. Obviously, these things are essential for a successful business in 2021 and can actually save you money on taxes. That being said, it’s important to prorate the amounts you claim based on how much time you use the services for business versus personal use.
  • Education expenses related to the business: Allows you to deduct the cost of education expenses directly related to your business. The education or classes you claim must be a necessity for your business or improve your work abilities.
  • Legal and professional fees: Allows you to deduct the costs of legal and professional fees used to run and maintain your business. This includes fees paid to lawyers, accountants, bookkeepers, tax preparers, and online bookkeeping services.
  • Bank fees: Allows you to deduct the cost of bank fees from business accounts. It’s always a good idea to keep your business and personal finances separate, but in this case, it’s a necessity.
  • Taxes and licenses: Allows you to deduct the costs of taxes and licenses that you use to run your business. For example, you can deduct the cost of state income taxes, payroll taxes, personal property taxes, real estate taxes, sales taxes, excise taxes, fuel taxes, and business licenses.
  • Interest on business loans: Allows you to deduct the cost of interest on business loans or credit cards. Business loans from trusted lenders are a great way to grow your business and could actually result in a nice tax deduction. In order to qualify for this deduction, you must be legally liable for the debt, intend for the debt to be repaid, and have a true debtor/creditor relationship.
  • Business use of your car: Allows you to deduct the cost of operating your car for business purposes. This deduction comes with two options: the standard mileage rate of the actual expenses method. The standard mileage method allows you to deduct a standard amount based on the number of miles you drove for business. In 2021, this amount is $0.56 per mile. The actual expenses method allows you to include the costs of things like gas, oil, repairs, tires, insurance, and registration fees.
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How to File Taxes as a Sole Proprietor

Filing taxes as a sole proprietor is a simple and easy process since it’s included with your individual tax return. You will need to file a Schedule C form which covers profits and losses from a business. From there, you can consider your potential deductions and try to decrease the amount that you owe. However, it’s important to remember that you will be on the hook for this amount with the federal and state governments.

This can be a surprise to new sole proprietors who are used to their employers withholding estimated tax amounts throughout the year. As a sole proprietorship, nothing is withheld, so if you’re not careful, you could receive a huge unexpected tax bill come April. In order to avoid this from happening, you should estimate your taxes ahead of time and put money aside throughout the year to eventually pay your taxes. 

Do Sole Proprietors Need Accountants to File Taxes?

If all of this information has left you totally confused and overwhelmed, you may want to consider hiring an accountant to handle your taxes for you. While hiring an accountant isn’t completely necessary, they may be able to help you maximize your deductions. Additionally, you should also remember that the cost of an accountant can be used as a deduction! In any case, be sure to maintain careful records to make the process easy -- whether you do it on your own or use an accountant. 

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Wrap Up

Dealing with taxes as a sole proprietor can seem like a real headache, but it doesn’t have to be with proper research and planning. If you find that you need help along the way, you can always consult with an accountant for professional assistance. 

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