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Understanding Sole Proprietorship Taxes: A Comprehensive Guide

Updated on :

April 11, 2024
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Understanding Sole Proprietorship Taxes: A Comprehensive Guide

Understanding the ins and outs of sole proprietorship, particularly tax-related obligations, can be quite an endeavor. For tech talents working remotely and individuals building remote or distributed teams, it's essential to navigate these business structures with confidence and acuity.

What is a Sole Proprietorship?

A sole proprietorship is a business entity managed, operated, and controlled by one person. As the name implies, it is a sole business in which the owner is entitled to all the business income. As the sole proprietor receives all the income, they also bear 100% of the losses and debt incurred in the course of running the business. As a business entity that is quite similar to the operations of corporations and partnership businesses, the sole proprietorship is regarded as a pass-through entity. This means the profits and losses are reported on the sole proprietor’s personal income tax return. 

One of the key characteristics of sole proprietorships is that there is no difference between the owner’s personal income and that of the business. Income taxes and self-employment taxes factor in here, as these must be paid from the net business income.

Sole proprietorships are one of the most common forms of business types due to their ease of operation and the lack of government regulation. As a result, it is a popular business type among small business owners, independent contractors, and consultants. In fact, most businesses launch by running their operation like a sole proprietorship before pivoting into a corporation or a limited liability company.

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Advantages of Sole Proprietorship

While being a sole proprietor comes with unique challenges, the advantages can often outweigh the drawbacks, particularly for tech talents and individuals striving to build remote or distributed teams. Let's delve into the distinct advantages that make this business structure so popular.

The Ease of Establishing

A sole proprietorship business is characterized by its lack of government regulations, and as such, it requires little to zero paperwork. Also, the sole proprietorship occasionally requires very few resources in terms of infrastructure and capital to launch the business. Also, unlike limited liability and corporation business entities, sole proprietors need not register with the states where they operate.

Affordable to Run

One of the most significant benefits of running a sole proprietorship business is that it is less expensive in comparison to other business entities. It requires no registration fee, capital, or infrastructure to launch, depending on the kind of business. However, the costs the sole proprietor may incur include registering sales and service tax, acquisition of zoning permits, licenses, and state income taxes. While other business types must pay annual fees, the sole proprietorship business has no requirement for that.

Autonomous Business Control

The sole proprietor is a single entity that reaps the entirety of the business profits. They are also responsible for making crucial business decisions and managing revenues and payroll. As a result of the sole proprietor’s full control of the business, they do not have to deal with the hassles of business positions.

Ease of Reporting Tax

While other business entities have to make complex tax documentation and reporting, sole proprietor handles tax reporting as they do with their personal tax returns. In fact, sole proprietor reports the business income and statutory deductions on their personal income tax returns. They are also subject to the self-employment tax rate and must pay federal income tax on their taxable income.

Ease of Hiring

Though many sole proprietors operate alone, there may come a time when hiring employees becomes necessary to scale operations. In such cases, a sole proprietorship allows the flexibility to hire employees as needed, making it possible to build a robust onsite or remote team.

Disadvantages of Sole Proprietorship

While the simplicity of a sole proprietorship can be attractive, there are certain drawbacks to consider before opting for this business structure. When weighing the pros and cons, one should remember that these disadvantages might pose significant hurdles in the long term, especially for tech talents working remotely and individuals building remote or distributed teams.

Difficulty in Raising Capital

While it is quite easy to launch a sole proprietorship business, and it requires less capital compared to corporations and limited liability companies, sole proprietors have less leveraging power when it comes to raising capital or scaling the business. Due to sole proprietors being personally responsible for generating funds for the business, managing overhead and labor costs, raising capital for the business can limit the business’ growth, and the cost of running the business may overwhelm the owner. 

Zero Liability Protection

Due to the sole proprietor being primarily responsible for everything related to the business, debts, litigation and other financial requirements are the owner’s responsibility. Unlike in a limited liability or corporation entity where responsibilities are shared, the sole proprietor bears the brunt of risks and other difficulties usually encountered in managing a business.

Complex Tax Responsibilities

Other forms of business have dedicated hands that ensure taxes are accurately filed, and inventory is accounted for easily. Unfortunately, the sole proprietor is responsible for carrying out all tax processes. They are responsible for managing any complications regarding tax filing, including the self-employment tax rate and income tax payments. If peradventure there is a tax error due to bad reporting, then the sole proprietor is responsible for bearing the cost of the fines or penalties due to incorrect tax filing. These tax deductions for a sole proprietorship can help alleviate some of this financial burden.

Sole Proprietorship Taxes

The taxation for a sole proprietorship is quite different from the limited liability company, partnership or corporation business entity because, unlike other business entities, a sole proprietorship business is not taxed separately from the owner’s personal income. A sole proprietorship tax is part of the owner’s personal income tax return. This type of taxation is called Pass-through taxation, according to the Internal Revenue Service (IRS). It is referred to as pass-through because the tax liability is the sole proprietor’s and is passed to their personal tax return. However, a separate tax form called Schedule C is used to document the business’ taxes, and this is filed together with Form 1040 - the business owner’s personal income tax form. 

Pass-through Taxation

According to the IRS, Pass-through taxation refers to a system where the business does not pay taxes on the entity level. Instead, the business income is passed to the sole proprietor, who then pays the personal income tax for himself and the business. Different states usually have similar pass-through taxation stipulations as the federal government. However, some states may need documentation from a beginning point that the federal government will not demand.

How to Pay Sole Proprietorship Taxes

As stated earlier, the sole proprietor is required to report all business income or tax information via their personal income tax return. The following information describes the processes of how to file and pay sole proprietorship taxes.

Filing Tax Return

Tax reporting for Sole proprietorship is documented on a Schedule C tax form. The business is taxed on all the business’ profits regardless of how much revenue was generated in the tax year. 

It is essential to keep accurate records of business expenses, and it is best practice to separate these from personal expenditures. 

After documenting the business information on Schedule C, the sole proprietor is required to submit it with Form 1040 to the IRS. Filing taxes on Schedule C is not complex. All that is required is to take note of the five sections requiring information about the income of the business under the year in review. Also, expenses and other cost information are documented. The IRS provides clear and concise information that will guide you in filling out and filing the form.

Property Taxes

Sole proprietors are required to pay property taxes if the sole proprietorship business owns or uses a business property. This tax is dependent on the location and regulations the local tax authority provides. 

Employment Taxes

If the sole proprietorship business hires employees, you will be responsible for filing employment taxes, also called Payroll taxes. Like every other employer, the sole proprietor’s accountable for withholding taxes from the employee’s paycheck for income taxes. To file and report payroll taxes, the sole proprietor must complete Forms 940 and 941. Also, it is the sole proprietor’s responsibility to report and file withheld contributions by filing the W-2 form on behalf of the employee. 

Self-employment Taxes

The sole proprietor must make tax payments on their net profits, which happens when the business income surpasses the business expense. As of 2022, the self-employment tax is fixed at 15.3%. The Social Security Tax incurs 12.4% of the self-employment tax, while Medicare tax accounts for 2.9%.

Sales Taxes

The sole proprietor must pay sales taxes at the state level for goods and services sold. This sales tax rate varies across states, just like property taxes. Therefore, it is best practice to consult the state tax agency for information.

Excise Taxes

Like sales taxes, sole proprietors must pay excise taxes only if they sell certain products like tobacco or alcohol. The excise tax is paid at the federal, state, and local levels, meaning it is location dependent, like property and sales tax.

Sole Proprietorship Tax Deductions

Like other businesses, sole proprietors can deduct certain expenses to reduce taxable income. Common deductions include:

  • Home Office Expenses
  • Vehicle Expenses
  • Supplies and Materials
  • Professional Services

For accurate deduction claims, proper record-keeping is paramount.

When to File Sole Proprietorship Taxes

Tax returns such as Schedule C and Form 1040 are required to be filed annually, while payroll taxes, Form 941, are filed quarterly. Therefore, the forms must be completed in the same period as the sole proprietor’s personal income tax returns to file the general income tax return. That being said, all taxes must be filed by the 15th of April. If an extension is granted, the deadline for filing becomes the 15th of October. 

Due to the different tax deadlines, keeping track of the tax requirements is important. Failure to pay taxes will result in fines and penalties by the IRS.

Manage Taxes For Your Global Team With Skuad

Understanding and managing sole proprietorship taxes can initially seem complex, but with the right knowledge and tools, it doesn't have to be overwhelming. Being well-informed about your tax obligations and potential deductions can empower you to run your business confidently and efficiently and meet all your tax responsibilities.

For tech talents working remotely and individuals building remote or distributed teams, managing taxes for your global team can be simpler with Skuad. As an Employer of Record platform, Skuad enables you to hire, onboard, and manage contractors and employees in over 160 countries compliantly, handling all the nuances of international tax laws and employment regulations.

Skuad takes legal risks and fines off your table by ensuring your organization fully complies with country-specific laws and regulations. This way, you can focus on growing your business, confident that your tax obligations are covered. As a result, compliance becomes part of your corporate identity without any additional hassles.

Whether you're a sole proprietor or leading a global team, navigating the tax landscape is critical to business success. You can steer your business toward sustainable and compliant growth with a clear understanding of sole proprietorship taxes and the right partnerships, such as with Skuad.

To know more about Skuad, talk to Skuad experts today.

FAQs

Do sole proprietors get tax refunds?

Yes, sole proprietors get tax refunds. However, the circumstance must warrant a tax refund for certain business expenses.

Can you write off business expenses as a sole proprietor?

Yes, as a sole proprietor, you can write off business expenses like every other business.

About the author

Sandeep Patel is a Content Marketing Manager and Strategist. Over the last five years, he has created and managed content for global brands and fintech startups. He is passionate about remote work and using tech for a better work-life balance.

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