Beginner's Guide to Sole Proprietorship Taxes
For new entrepreneurs going out on their own for the first time, sole proprietorship taxes can be daunting. But for federal income tax purposes, there’s no extra tax return to file – you simply include business income and expenses as part of your personal income tax return. On the other hand, you must pay self-employment taxes, and you might have to make estimated tax payments and handle payroll taxes if you have employees. Other tax obligations might be required, too.
Key Takeaways
- Sole proprietors report their business income and losses on their personal tax returns by attaching Schedule C to Form 1040, which keeps the tax process straightforward but also ties personal and business finances together.
- A sole proprietor is also responsible for paying self-employment taxes, which fund Social Security and Medicare. This tax is calculated using Schedule SE and represents both the employer and employee portions of these taxes.
- A wide range of business expenses may be deductible by sole proprietors, including office supplies, advertising costs, and a portion of home and vehicle expenses if they’re used for business purposes. Half of a sole proprietor’s self-employment tax is also deductible.
- Sole proprietors may also be responsible for estimated tax payments, withholding and paying employment taxes for their workers, excise taxes, sales taxes, and more.
Whether you’re ready to begin a side gig or go completely out on your own, operating a business as a sole proprietor is often the best way to go for self-employed entrepreneurs.
Sole proprietorships are easy to set up. Unlike other types of businesses – such as partnerships, limited liability companies (LLCs), and S corporations – you don’t have to register or formally do anything special to form a sole proprietorship.
And being a sole proprietor is fairly straightforward from a tax perspective, too. Since your business income and expenses are ultimately treated as personal income and expenses, you don’t even need to file a separate federal income tax return for your business.
But before conducting business as a sole proprietor, there are a few unique tax twists and turns you need to know about. The checklist below will guide you through the critical federal tax requirements for sole proprietorships. So, if you’re venturing out on your own as a new sole proprietor, you’ll have a basic understanding of the federal tax code provisions and IRS rules that apply to you.
What is a sole proprietorship?
Before diving into the tax aspects of being a self-employed sole proprietor, let’s talk a bit about sole proprietorships in general.
A sole proprietorship is the simplest and most common structure for new businesses. It’s an unincorporated business owned and operated by one person with no legal distinction between the business and the owner. The IRS calls a sole proprietorship a “disregarded entity” because, as the tax agency puts it, it’s “disregarded as separate from its owner.”
Establishing a sole proprietorship is typically straightforward and less costly than setting up other business entities. There is usually less paperwork and fewer regulatory hurdles. A sole proprietor can cease business operations without much formal procedure, too.
The owner has complete control over all business decisions. He or she is also entitled to all profits from the business.
But the owner is responsible for all the business's debts, losses, and liabilities as well. As a result, the owner can be held personally liable for the debts and legal actions taken against the business. For this reason, sole proprietors often purchase business insurance to help protect their personal assets.
How are sole proprietorships taxed?
As already noted, a sole proprietorship and its owner are one and the same in the eyes of the law. As a result, when it comes to federal income taxes, the business itself is not taxed separately as an entity.
Instead, a sole proprietorship’s profits and losses are "passed through" directly to the owner. So, if you’re a sole proprietor, your business's financial activities are included on your personal income tax return and taxed at your personal income tax rate. But this also means your taxable income will be higher if your business is profitable, which can knock you into a higher tax bracket.
Sole proprietors are also subject to a special self-employment tax, which helps fund Social Security and Medicare (although you can deduct 50% of the tax you pay). They generally must make estimated tax payments, too. Plus, if you have employees, you’ll have to withhold, pay, and report payroll taxes for them as well.
On the bright side, sole proprietors can reduce their taxable income by deducting business expenses – such as costs for goods sold, rent, utilities, and other necessary costs – directly on their personal tax return. They may also be eligible for certain tax deductions specifically designed for self-employed people, such as a deduction for health insurance premiums.
I’ll flesh out all of these tax breaks and requirements in a moment.
How to file a sole proprietorship tax return
When filing your federal income tax return as a sole proprietor, any profit or loss from your business is reported on your 1040 form as ordinary income or loss. However, you’ll need to file another tax form first to calculate your business’s profit or loss.
You’ll also have to file a separate form to calculate your self-employment tax and the 50% deduction. Both the tax and the deduction ultimately find their way to your Form 1040, too.
Schedule C for sole proprietors
If you’re a sole proprietor, your business income and expenses are first reported on Schedule C. Your business expenses are subtracted from your business income to determine if you have a profit or loss. If your income is greater than your expenses, you have a profit for the tax year. If your expenses exceed your income, you have a loss.
Any profit or loss calculated on Schedule C is then carried over to Schedule 1 of your 1040 form. From there, it’s added to the rest of your taxable income (or subtracted from it if you have a loss).
You must report all income from your business, no matter the source. This includes payments to you shown on any of the various 1099 forms that may have been sent to you in relation to your business. Common 1099 forms you might receive as a sole proprietor include:
- Form 1099-MISC – For royalty payments of $10 or more, or for rent, prizes, awards, and other miscellaneous payments of $600 or more.
- Form 1099-NEC – For payment of at least $600 for services performed as a nonemployee.
- Form 1099-K – For payments from credit, debit, gift, or other payment card transactions, or from transactions through payment apps such as Venmo and PayPal or online marketplaces like StubHub and eBay. There is no reporting threshold for card transactions but for third party payment transactions, the 2024 limit is $5,000 but will eventually be lowered to $600.
Also use Schedule C to report income received as a “statutory employee” (an independent contractor treated by statute as an employee).
Your business expenses must be both ordinary and necessary in order to deduct them from your business income. An expense is “ordinary” if it’s common and accepted in your field of business. It’s “necessary” if it’s helpful and appropriate for your business. An expense doesn’t have to be indispensable to be considered necessary.
Examples of common business expenses claimed on Schedule C include costs for:
- advertising
- cars and trucks
- commissions and fees
- depreciation
- employee benefit programs
- cost of goods sold
- insurance
- interest
- mortgages
- legal and professional services
- office space (including home offices)
- rent
- repairs and maintenance
- supplies
- taxes and licenses
- travel
- utilities
- wages
Some of these are discussed in more detail later.
Schedule SE for sole proprietors
You generally must pay self-employment taxes if you have a profit of $400 or more as a sole proprietor or other self-employed person. But as mentioned earlier, you can also deduct 50% of the self-employment tax you must pay.
Both the self-employment tax and the 50% deduction are calculated on Schedule SE. They’re then reported on Schedule 1 (deduction) and Schedule 2 (tax). But both the tax and the deduction eventually are reflected on your 1040 form itself.
The self-employment tax rate is 15.3%, which includes 12.4% for Social Security and 2.9% for Medicare. However, only 92.35% of your net earnings from self-employment is subject to the tax.
Also note that there are limits to how much of your income is subject to the Social Security part of the self-employment tax. For 2024, the first $168,600 of your combined wages, tips, and net earnings from self-employment is subject to the Social Security portion (up from $160,200 for 2023). Amounts above this threshold aren’t subject to the tax for Social Security, but they continue to be subject to the tax for Medicare.
TurboTax Tip:
You must also pay an additional 0.9% Medicare tax if your total wages, compensation, and self-employment income exceed $250,000 for joint filers, $125,000 for married people filing separate returns, or $200,000 for all other people. File Form 8959 if you owe this extra payroll tax.
Business tax deductions for sole proprietorships
I already touched upon the business expenses deductible on Schedule C, but there are a handful of other federal tax deductions specifically designed for sole proprietors and other self-employed people that aren’t reported on Schedule C (including the 50% deduction for self-employment taxes).
Let’s take a closer look at a couple of the Schedule C deductions that have unique ways of calculating the deductible amount, and introduce you to the non-Schedule C deductions for self-employed people that haven’t already been discussed.
Car expenses: Standard mileage rate vs. actual expenses
Sole proprietors who use their own car for business purposes can deduct their business-related vehicle expenses on Schedule C using either the standard mileage rate or their actual expenses. For purposes of this deduction, a “car” includes a van, pickup, or panel truck.
For the 2024 tax year, the standard mileage rate is 67¢ per mile driven for business use (it was 65.5¢ per mile for 2023). This is a good option if you don’t want to keep track of all your gas, oil, repair, and other costs of using your car for business.
If you go with the actual expense method of calculating your deduction, you can deduct the cost of gas, oil, tires, insurance, repairs, lease payments, parking, tolls, garage rental, and more. However, you must divide your expenses between business and personal use, and then only deduct expenses related to the business use of your vehicle.
Health insurance costs for self-employed people
Sole proprietors and other self-employed people might be able to deduct the cost of health insurance. The insurance plan can cover you, your spouse, and your dependents.
The insurance must be established for your business. However, if you’re filing Schedule C, the policy can be in either your name or the business’s name.
You can’t claim the deduction for health insurance premiums paid for any month that you were eligible for health insurance through your or a family member's employer.
The deduction is claimed on Schedule 1, not Schedule C.
Home office deduction: Actual expenses vs. simplified method
If you’re a sole proprietor who works out of your home, you can deduct the costs of rent, mortgage interest, property taxes, insurance, utilities, repairs, maintenance, and other expenses for the part of your home used for business. The home office deduction is claimed on Schedule C.
You can only deduct expenses for a portion of your home that’s "regularly and exclusively" used as your principal place of business. So, for example, you can’t deduct expenses for a room in your home if you use the space both for business and personal activities.
The deduction for the business use of your home is calculated in one of two ways. You can either deduct:
- The actual expenses related to your home office calculated as your total home expenses multiplied by a percentage representing the portion of your home used for business.
- $5 for every square foot of your home office (up to 300 sq. ft.).
If you select the actual expense method, you must also file Form 8829.
SEP, SIMPLE, and qualified plan contributions
Sole proprietors and other self-employed people can save for retirement with special retirement plans designed specifically for small business owners. These include:
- Simplified Employee Pension (SEP) IRAs
- Savings Incentive Match Plan for Employees (SIMPLE) IRAs
- Solo 401(k) plans
There’s a non-Schedule C deduction available to sole proprietors for contributions to these accounts for themselves. The deduction is claimed on Schedule 1 of Form 1040.
Sole proprietors who put money in these plans for their employees can deduct those contributions as a business expense on Schedule C.
In either case, the deduction can’t exceed the contribution limit set up by the IRS for the year (the limits are adjusted each year to account for inflation).
Qualified business income deduction
The qualified business income (QBI) deduction is available to small business owners, including sole proprietors. However, at this time, the deduction is set to expire after the 2025 tax year.
This tax break allows qualified sole proprietors to deduct up to 20% of their QBI, which is generally the net total of income, gain, deduction, and loss from any qualified trade or business.
However, if your business income exceeds a certain amount, the QBI deduction is reduced (possibly to $0) for doctors, lawyers, accountants, and certain other service-oriented business owners. The point at which the reduction begins for the 2024 tax year is:
- $383,900 of business income for joint filers ($364,200 for 2023)
- $191,950 of business income for all other people ($182,100 for 2023)
This deduction isn’t reported on Schedule C or Schedule 1. Instead, it’s claimed on the first page of your 1040 form.
Estimated tax payments by sole proprietors
Even though we only have to file a federal income tax return once per year, we have to pay taxes throughout the year as we earn income. If you work for someone else, those tax payments are withheld from each paycheck and sent to the IRS by your employer. But if you’re self-employed, you have to make those payments yourself.
This is done by making estimated tax payments for each quarter. For the 2024 tax year, the estimated tax due dates for sole proprietors are:
- April 15, 2024, for income earned from January to March 2024
- June 17, 2024, for income earned from April to June 2024
- September 16, 2024, for income earned from July to September 2024
- January 15, 2025, for income earned from October to December 2024
Use Form 1040-ES to calculate the amount of each estimated tax payment. But you don’t need to make estimated tax payments if you don’t expect to owe at least $1,000 in taxes when you file your tax return for the year.
Employment taxes for sole proprietorships
If you have employees during the year, you’ll have some additional tax-related responsibilities. For instance, you’ll have to send each employee a W-2 form by January 31. A copy of each W-2 form must also be sent to the Social Security Administration.
You’ll also have to withhold income, Social Security, and Medicare taxes from their paychecks and send it to the IRS. Employers are also responsible for paying half of the Social Security and Medicare taxes (FICA taxes) out of their own pocket, too. And you’ll have to file Form 941, 943, 944, and/or 945 to report withheld taxes to the IRS.
Employers must also pay unemployment taxes (FUTA taxes) for each employee. Only the employer is responsible for FUTA taxes, so there’s no paycheck withholding for it. You must also file Form 940 annually to report the FUTA taxes you paid for the previous year.
1099 forms for payments made by sole proprietors
As a sole proprietor, you might also have to send 1099 forms to people and other businesses that you made payments to during the tax year (the IRS gets a copy, too). A 1099 form is a type of information return, which are tax forms used to report income and other relevant financial information about individuals, businesses, and organizations.
Two common 1099 forms that many sole proprietors must file are Form 1099-NEC and Form 1099-MISC. If you paid a freelancer or other non-employee at least $600 during the year, you must send him or her Form 1099-NEC. Form 1099-MISC is required for a number of miscellaneous business payments of $600 or more, such as for office space or equipment rental, prizes and awards, backup withholding, legal fees, and more. Form 1099-MISC is also required if you paid at least $10 in royalties during the tax year.
There are many other types of 1099 forms and information returns. Generally speaking, you must send the person or business that received your payment a 1099 form by January 31 of the following year, and the IRS must receive a copy of the form by February 28. However, there are exceptions to those general deadlines. Check the IRS’s general instructions for information returns for details.
Other taxes paid by sole proprietorships
Up to this point, I’ve focused on federal income and payroll taxes. However, there are several other types of taxes you might have to pay as a sole proprietor.
For instance, depending on the type of business you’re running, you might have to collect and/or pay excise taxes. These are basically taxes imposed on selected goods, services, and activities. As an example, if you run a tanning salon, you’ll have to collect the 10% federal indoor tanning services tax from your customers.
States and local governments impose their own taxes, too. You’re probably familiar with state and local sales taxes, which you might have to collect and pay as a sole proprietor if you sell goods or services. If you’re responsible for collecting sales tax, you probably have to register with your state, too. State excise taxes may be due as well.
If your business owns real estate or other taxable property such office furniture, machinery and computers, you might owe state or local property taxes as well.
Plus, unless you live and operate your business in a state without an income tax, you’ll likely have to pay state income taxes, too. Some local governments may also hit you with an income tax bill of their own.
The point is that federal, state, and local governments can tax you in many different ways. So, make sure you do your homework to understand all the tax obligations you will face as a business owner.
LLCs taxed as a sole proprietorship
Finally, if you set up a business as a limited liability company (LLC) according to your state’s law, you might be treated as a sole proprietorship for federal income tax purposes.
The IRS automatically treats an LLC with only one owner as a sole proprietorship (as a “disregarded entity”), unless the business files Form 8832 and elects to be treated as a corporation.
However, even if an LLC elects to be treated as a corporation for income tax purposes, an LLC with only one owner will still be considered a sole proprietorship for employment and certain excise taxes.
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