Ultimate Guide to Sole Proprietorship Taxes

Solo entrepreneurs benefit from not having to share their business income with partners, but they have to navigate the–often confusing–world of sole proprietorship taxes. 

This article explains what sole proprietorships are, the advantages and disadvantages of a sole proprietorship, how to pay sole proprietorship taxes, and the importance of tax deductions for sole proprietorships.

What Is a Sole Proprietorship?

A sole proprietorship is a business with a single owner, where the owners and the company are considered one entity. Freelancers and individual contractors are examples of sole proprietors. You don’t have to register as a sole proprietor; you qualify simply by being an entrepreneur and generating an income. 

A sole proprietorship is a pass-through tax entity, meaning you must report all business income and losses on your personal income tax return. In this model, taxes pass through the business owner rather than the business itself, which helps you avoid double taxation. Partnerships, LLCs, and S-corporations are other examples of business structures that can be pass-through entities. 

Conversely, C-corporations are business structures subject to corporate income tax, meaning that owners may have to pay personal income tax and corporate taxes on their businesses’ income. 

Advantages of a Sole Proprietorship

The benefits of a sole proprietorship include:

• Owners keep all business income
• No registration or maintenance requirements
• Simple to form–no registration required
• Easy to transition to an LLC or corporation as your business grows
• Tax benefits–owners may be able to deduct up to 20% of their qualified business income (QBI)

Disadvantages of a Sole Proprietorship

However, there are disadvantages to sole proprietorships. These disadvantages include:

• Owners are responsible for paying taxes on income
• Owners are personally liable for any debts incurred by or lawsuits filed against their business
• Sometimes challenging to get funding–many sole proprietors struggled to get Paycheck Protection Program (PPP) loans during the pandemic 
• No credibility–customers often choose LLCs or other registered business structures above sole proprietors

How to Pay Sole Proprietorship Taxes

Sole proprietorship taxation differs from corporate taxation in that a sole proprietorship functions as a pass-through entity, meaning the owner is responsible for paying self-employment taxes, federal and state income taxes, and employment taxes.

Self-employed individuals typically must pay taxes quarterly and file an annual tax return.  

Self-employment Taxes

Sole proprietors earning over $400 must pay self-employment (SE) taxes. SE taxes consist of Federal Insurance and Contributions Act (FICA) taxes, which fund Social Security and Medicare. Employers are responsible for paying half of FICA taxes, but self-employed individuals must pay the full amount themselves.

The current SE tax rate is 15.3% of your taxable income, which consists of:

• Social Security: 12.4%
• Medicare: 2.9%

However, there is an additional 0.9% Medicare tax for sole proprietors earning more than $200,000.

To pay your SE taxes, you will need to follow these steps:

1. Determine your net profit by subtracting your business expenses from your business income.
2. Download Form 1040-ES and follow the instructions.
3. Fill out the Internal Revenue Service’s (IRS) 2023 Estimated Tax Worksheet (you will need your 2022 tax return to use as a guide).
4. Mail your taxes to the IRS or pay them online at the IRS payment website.

You will also need to complete a Schedule C form at the end of the year. A Schedule C form is a Profit or Loss form for sole proprietorships. You may also need to fill out a Form SE, which reports your FICA taxes, and information returns if you made or received any payments as a sole proprietor. 

Federal and State Income Taxes

The amount of federal income tax you pay depends on your income level. There are currently seven federal tax brackets that correspond to different income levels. One benefit of the tax brackets system is that you don’t have to pay one tax rate on all your income. 

For example, if you earn $50,000 in 2022, you would fall in the 22% tax bracket. However, you would only pay the 22% tax rate on the amount of your income over $44,726 (the lower limit of the 22% tax bracket). The rest of your income would be taxed at the 10% (the first $11,000) and 12% (the portion of your income between $11,001 and $44,725) rates. 

Federal tax brackets are modified each year, and the tax brackets for 2023 were adjusted to reflect inflation, meaning that you may be in a different tax bracket than you were in previous years. 

2023 Tax Brackets for Sole Proprietors

It’s important to remember that being a sole proprietor can push your income level into a higher tax bracket, meaning that you might pay more taxes than you would otherwise. 

Not all states have a state income tax, but you can determine your state income tax rate by visiting your local government or state tax agency website.

You can use Form 1040 (or Form 1040-SR if you are age 65 or older) and a Schedule C form to file your income tax return. 

Employment Taxes

If you are an employer, you are responsible for paying employment (or payroll) taxes. Employment taxes include FICA taxes, federal income tax withholding, and Federal Unemployment Tax Act (FUTA) taxes. 

FICA

You are responsible for deducting FICA taxes from your employees’ paychecks and depositing payments regularly. Additionally, you must pay half of your employees’ FICA taxes.  

Federal Income Tax Withholding

Federal income tax withholding is when you withhold part of an employee’s paycheck to send to the government. The federal income tax withheld depends on how much the employee makes and the information they put on their W-4. 

You can file FICA and federal income tax withholdings quarterly using Form 941. 

FUTA/SUTA

Most employers must pay FUTA and State Unemployment Tax Act (SUTA) taxes. Only employers pay FUTA taxes, but three states–Alaska, New Jersey, and Pennsylvania–require employers and employees to pay SUTA taxes. 

The FUTA tax rate is 6% and applies to the first $7,000 (federal wage base) you pay each employee each year. If you owe more than $500 FUTA in a given year, then you must make at least one quarterly payment to the IRS. 

You can use Form 940 to calculate FUTA payments and submit FUTA payments to the IRS through the Electronic Federal Tax Payment System (EFTPS). 

SUTA wage bases vary by state, and tax rates depend on your industry, turnover rate, and unemployment claims history. You can check your state’s labor office to register for a SUTA account and start paying SUTA taxes. 

Tax Deductions for Sole Proprietors

Taking advantage of applicable tax deductions is essential to maintaining your profit margin as a sole proprietor. Taking as many tax deductions as possible reduces your taxable income, saving you money.

Sole proprietors can write off many things that employees can’t, including (depending on your business type and expenses) business meals, gas mileage, office equipment, and even utilities and mortgage payments (if you use a portion of your house as a designated office space). 

Common tax deductions for sole proprietors include:

• Business meals: 50% of qualifying business meals is generally deductible (keep your receipts!).
• Health insurance premiums: Sole proprietors who aren’t eligible for health care coverage through a spouse’s group plan can deduct their health insurance premiums. 
• Business mileage: You can deduct business mileage, but you must keep accurate records of where, when, and how far you traveled in your vehicle. You can use the standard mileage rate (65.5 cents per mile driven for business use in 2023) or calculate the actual costs of using your vehicle for work. Vehicle use costs include depreciation, gas, insurance payments, and repairs. 
• Travel: Travel expenses to places outside of your city are deductible as long as you travel for business purposes. Ensure your expenses remain reasonable and not extravagant. These expenses include transportation, dry cleaning, laundry, lodging, tips, meals, and business calls. 
• Home office: This deduction depends on the percentage of your home that is used exclusively for business purposes. The space can’t be used for other purposes: a laptop on your dining room table doesn’t count. You can write off utilities, repairs, and mortgage payments as part of your home office deduction. 
• SE taxes: Sole proprietors can deduct half of their SE tax from their net income (total revenue minus expenses) when calculating their income tax. 
• The Tax Cuts and Jobs Act (TCJA): This law allows owners of sole proprietorships and other pass-through entities to take advantage of a 20% deduction on QBI, as long as they meet income and other requirements. 

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