To Be or Not To Be A Sole Proprietor
This Week's Quote:
“Spread love everywhere you go”
-Mother Teresa
Consulting, freelancing, starting a side business, there’s a lot of talk about flashy terms like these nowadays. This week’s article from Forbes Advisor gets a little more into the weeds, offering a detailed look into the sole proprietorship, one of the simplest business entities you can form. It goes over the definition, tax benefits, and risks of a Sole Proprietor. No matter what type of business you are involved in, always know the taxes involved.
-Zak Kitzmiller
A Guide To Sole Proprietorship Taxes
Sole proprietorships—run by freelancers, consultants or other independent contractors—typically have simple taxes compared to other business structures. However, there are specific tax guidelines sole proprietors must follow come tax season.
Let’s walk you through sole proprietorship taxes to ensure you make no mistakes when paying Uncle Sam.
What Is a Sole Proprietorship?
A sole proprietorship is owned by one person, and the owner doesn’t have a separate legal existence from the business. As a sole proprietor, you’re entitled to all income; however, you’re also personally liable for any debts and losses incurred.
Similar to partnerships and S-corporations, a sole proprietorship is considered a pass-through entity, which means profits and losses are reported on the owner’s personal income tax return instead of being subject to corporate income taxes.
There are several advantages and disadvantages of a sole proprietorship, including the following:
Advantages of a Sole Proprietorship
Easy to form. A sole proprietor is simple and easy to form. It’s the least expensive of all business structures and doesn’t require complicated paperwork.
Full ownership. Unlike with other business entities, you have complete control of your business, decisions and any profits earned by your sole proprietorship.
Simplified tax reporting. Sole proprietors can report their business income and deductions on their personal income tax returns.
Disadvantages of a Sole Proprietorship
Unincorporated and unlimited liability. Sole proprietorships are typically unincorporated entities, which means they are personally liable for any business debts and other obligations.
Limited funding. It can be difficult for a sole proprietor to obtain funding. Unlike corporations, sole proprietorships can’t raise funds through stock sales, and some banks may provide only limited funding.
Responsible for 100% of losses and debts. While full ownership of a sole proprietorship is an advantage, it also comes with the downside of being fully responsible for losses and debts incurred by your business.
How to Pay Sole Proprietorship Taxes
Sole proprietorship taxes depend on your net profit (income minus expenses), whether you have employees and if you’re subject to local and state taxes.
Self-employment Taxes
You’re required to pay self-employment taxes on your net profits, which occurs when your business income exceeds your expenses. The self-employment tax rate is 15.3% for 2022, which consists of two parts:
Social Security tax: 12.4%
Medicare tax: 2.9%
For 2022, the first $147,000 of your combined wages, tips and net profits are subject to Social Security taxes, and all of your combined earnings are subject to Medicare taxes. Also, if your combined income exceeds $200,000 for 2022, you’ll pay an additional Medicare tax rate of 0.09%.
Generally, the amount of your net profit subject to the self-employment tax is 92.35%. For example, if you had a net profit of $50,000 from your sole proprietorship, you’ll pay $7,065, which is 15.3% of $46,175 ($50,000 x 92.35%).
There are also some cases where you’re not required to pay self-employment taxes—for example, if your net profits were less than $400 for the taxable year.
Federal and State Income Taxes
In addition to self-employment taxes, you must pay income taxes on your net profits. In some cases, this includes both federal and state taxes, depending on where you live.
The amount of federal income tax you owe depends on the federal income tax bracket you fall in. There are seven federal tax brackets: 10%, 12%, 22%, 24%, 32%, 35% and 37%.
The state in which you reside or earn your income also determines if you have to pay state income taxes. However, some states, including Washington, Florida and Texas, don’t impose state income taxes.
Employment Taxes
Along with self-employment, federal and state income taxes, if you hire employees for your business, you will pay employment taxes.
Generally, employers must withhold and deposit the following for their employees:
Federal and state income taxes
Federal Insurance Contributions Act (FICA) taxes
Federal Unemployment Tax Act (FUTA) taxes for their employees
You should also note that as a sole proprietor, you can’t treat yourself as an employee of your business.
Tax Deductions for Sole Proprietors
Understanding your deductions is key when you’re a sole proprietor. Since you are only taxed on your net profits, taking advantage of available tax deductions is beneficial.
Common tax deductions for sole proprietors include:
Self-employment taxes
Health care insurance
Business mileage
Business meals at restaurants
Advertising costs
Rent and leasing costs
Home office deduction
Cell phone
It’s always a good idea to speak with a tax professional concerning your sole proprietorship and which deductions are available to you.
Credit goes to Kemberly Washington. Published July 1, 2022 on Forbes Advisor
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
This Week’s Author, Zak Kitzmiller
