How a Sole Proprietor Pays Income Tax & Other Taxes

How a Sole Proprietor Pays Income Tax & Other Taxes

A sole proprietorship is a business run by one owner. It is unique for several reasons:

  • A sole proprietorship does not require to be registered in your state.

  • There is no separation between owner and company in a sole proprietorship for tax and legal purposes. 

  • This is the default business type. If you plan to be your own boss and start your own business, you can just start it, and it will automatically be a sole proprietorship business for tax reasons.

As we will see, this can be both good and bad.

What makes a sole proprietorship business different?

Sole proprietors are the owners of unregistered businesses. This means that the owner does not register his/her business with the state. For legal and tax purposes, a sole proprietorship is the only type of business that is not separate from the owner. The owner is responsible for all the debts of the company and can be sued for the business's actions.

From a tax aspect, a sole proprietorship is considered a "pass-through" company. The profit or loss of your business is transferred to the owner's income tax return.

It is a one-person LLC and pays income tax the same way as a sole proprietorship, including self-employment taxes. Assuming you are the sole owner of a Limited Liability Company (LLC). This information is also valid for you.

How Sole Proprietors Pay Income Tax

A sole proprietorship is taxed through the owner's income tax return on Form 1040. Business gains are calculated and reported on Schedule C, Small Business Gains or Losses. To complete Schedule C, business income is calculated by including all income and expenses and the cost of goods sold for the products sold, and the costs of a home business. The result of this calculation is net income (the value of the business's taxable income).

This net income or business loss is included on line 31 of the owner's Schedule C, to be included with the owner's (and his or her spouse's) other income or loss for income tax purposes. The amount is entered on line 3 of Form 1040 if the business is making a profit. A loss can be used to reduce the owner's total adjusted gross income (income before exemptions and deductions) from the tax return if the business has a loss.

The sole proprietor pays income tax on all income shown in the personal income tax return, including income from business activities, at the individual tax rate applicable in that year.

Self Employment Taxes

A sole proprietorship is a self-employed individual and must pay self-employment taxes (social security/health insurance tax) based on the business's income. Self-employment tax is included on Federal Tax Form 1040, which is calculated using Schedule SE. If the business incurs a loss, no self-employment tax will be paid, but the owner will not receive credit for Social Security/Medicare benefits for that year.

Let's say John has a business, and he is the sole owner of his business (sole proprietor), the sole taxpayer.

  • John completes his Schedule C, which shows a net business income of $10,000. This is the taxable income of John's business.

  • He must pay a self-employed worker tax of 15.3% of this income, or $1,530. As a sole proprietor, he gets a deduction for half of that amount, so he ends up paying $765 for this tax.

  • John also has an income of $12,000 from part-time employment.

  • Schedule C income of $10,000, self-employment tax of $765, and taxable labor wages are used in calculating his income tax payable for the year.

Estimated Taxes

As the sole proprietorship is not an employee, income and self-employment taxes are not deducted from wages. The Internal Revenue Service requires that these taxes be paid throughout the year, not just at the time of taxation. This means that they must make the estimated tax payments each quarter (April 15, June 15, September 15, and January 15 of the following year).

Other Employment Taxes

If a sole proprietorship has employees, the business must pay payroll taxes on their income, including withholding and filing federal and state income tax, social insurance payment and reporting and health insurance), taxes on workers and taxes on unemployment. There are deductible business expenses if your sole proprietorship pays payroll taxes. Obviously, the amounts withheld by employees and sent to the government by your business are not deductible for your business.

Property Taxes for Sole Proprietorship

If a sole proprietor owns a building or other property (land and/or buildings), the property tax must be paid. The tax is based on the estimated value and tax rates of the town or city in which the business is located.

State taxes on sales, excise duties, and franchises

Individual owners must pay state taxes on the sales of taxable goods and services sold by the business. Also, the sole proprietor may have to pay excise (usage) duties in the same way as for other types of businesses.

Check with your state's revenue department for more information on sales and excise duties, or consult a tax expert for guidance. Sole proprietorships are not normally subject to franchise taxes, as states charge corporations and other types of state-registered businesses.

Deduction of business tax payments

Taxes paid by your business may be deductible as business expenses, but you cannot deduct federal income tax.



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