Posted by Debi G Hill, CPA

Tax rules for Sole-proprietors with Employees

Tax rules for Sole-proprietors with Employees

A business operated by an individual owner is what we will call a sole proprietorship. And, for several reasons, the sole proprietor is unique:

  • You can just get started if you want to start a business and for tax purposes, you are automatically a sole proprietor that is why it is the default business type. 
  • Registering with a state is not necessary to a sole proprietorship.
  • For both tax and legal purposes between the owner and the business in a sole proprietorship, there is no separation. That can be a not-so-good and a good thing as we’ll see. 

Pass-through tax businesses for sole proprietors

You may be wondering how your personal taxes work with your business taxes as a sole proprietor. By completing a business tax calculation form (called a Schedule C), you compute your business income tax then you add this information to your personal tax return. 

Since the profits or losses of the business pass through to the owner’s personal tax return, this form of business as described above is called a “pass-through”. Since the sole proprietor business is not separate from the owner for both tax and legal purposes, then the business doesn’t pay its own tax. 

You will pay income taxes including self-employment taxes in the same way as a sole proprietor is you are the sole owner of a limited liability company (LLC) and you are a single-member LLC. 

For income tax purposes, here’s how this works:

How Income Tax is paid by Sole Proprietors

On Form 1040 through the personal tax return of the owner, a sole proprietorship is taxed. On Schedule C- Profit or Loss from Small Business, the business profit is calculated and presented. Along with the cost of goods sold for products sold and costs for a home-based business, the income of the business will be calculated including all income and expenses to complete Schedule C. The amount of the taxable business income AKA the net income is the result of this calculation (income minus expenses). 

All the income listed on the personal tax return must be paid by the owner of the sole proprietorship, which includes income from business activities at the applicable individual tax year. 

Self-Employment Tax

Based on the income of the business, self-employment taxes (Medicare/ Social Security tax) must be paid by a sole proprietor since being one means you are a self-employed individual. In federal taxes, self-employment tax is included in Form 1040 and it can be calculated using Schedule SE. And, on line 57 of Form 1040, the total self-employment tax liability is included. There will be no self-employment payable for that year if the business has a loss but, Social Security credits are not available for the owner too. 

Estimated Taxes

No self-employment taxes or income taxes are withheld from the owner’s pay since a sole proprietor is not an employee. The IRS requires that not only at tax time, but these taxes must also be paid throughout the year. That means that on April 5, June 15, September 15, and October 15 (quarterly schedule) you must make estimated tax payments. 

Other Employment Taxes

The business must pay employment taxes on the income of the employees if a sole proprietor has employees. This includes paying and reporting FICA (Social Security and Medicare), withholding and reporting federal and state income tax, unemployment taxes, and worker’s compensation. These are deductible business expenses if your sole proprietor business pays employment taxes. Of course, it will not be deductible to your business if there are amounts withheld from employees and paid by your business. 

Property Taxes

Property taxes are required to be paid on the property if the sole proprietor owns a building or other real property (buildings and land). The appraised value and tax rates for the city or town where the business is located are where the tax will be based from. 

State Sales, Excise, and Franchise Taxes

State sales taxes are required for products and taxable services sold by the business to be paid by sole proprietors. In addition, as other business types’ manner of paying excise (use) taxes must be done by sole proprietors.

For more information about sales and excise taxes, you can check your state department of revenue. Since franchise taxes are levied by states on corporations and other state-registered businesses, sole proprietors are typically not liable for it. 

Business tax payments deductions 

As business expenses, the taxes that your business pay may be deductible. But, the self-employment taxes and federal income taxes can’t be deducted. 

Debi G Hill, CPA
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