Guide to Sole Proprietorship Taxes

All the Taxes a Sole Proprietor Pays

A business proprietor looks up tax information on a laptop
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A proprietor is a business owner, and a sole proprietor is a solo business owner. Sole proprietorships are the most popular business type in the U.S. As of 2014, there were 23 million sole proprietorships in the U.S., compared to 1.7 million C corporations, and 7.4 million partnerships and S corporations.

If you’re thinking about running this type of small business, it’s important to understand how a sole proprietorship operates—including how these businesses pay taxes.

Key Takeaways

  • Sole proprietorships are single-owner businesses not registered with a state as a specific business legal type.
  • Sole proprietorships are not separate from their owners for tax, liability, and debt purposes.
  • This type of business pays income tax by filing a Schedule C form as part of their proprietor’s personal tax return.
  • Sole proprietors must pay Social Security and Medicare taxes, and may need to pay quarterly estimated income taxes.
  • Sole proprietorships may take expense deductions and tax credits to cut their business tax bills.

What Is a Sole Proprietorship?

Sole proprietorships are one-owner businesses, and sole proprietors are considered to be self-employed (as opposed to being employees). A sole proprietorship is the default business type, unless the owner registers with their state as another business legal type. This business type is easy to form; all someone needs to do is publicly announce that their business is open and they’ve started a sole proprietorship.

Sole proprietorships are unique because the owner has complete control over their business without a board of directors looking over their shoulder.

But the downside of a sole proprietorship is that complete control means complete accountability and liability. If the business is prospering, the owner receives all the profits, but if it isn’t doing well, the owner takes all the losses.

Sole proprietorships are not legally separate from their owners for the purpose of personal assets and liabilities. The owner can be held personally liable for the debts and obligations of the business. For example, a lawsuit against the business for negligence is a lawsuit against the owner.

Most businesses need an Employer ID Number (EIN), a unique business tax identifier. Sole proprietors can use their Social Security number as the identifier for their business taxes unless they have employees or pay certain types of taxes.

How Sole Proprietorship Taxes Work

Sole proprietorships pay many kinds of taxes. Some taxes are paid by all sole proprietors, and other taxes depend on a business’s specific situation and what kinds of products or services it sells.

Federal Income Taxes

Sole-proprietorship businesses don’t pay income tax as separate entities; they are considered pass-through entities because the company’s income taxes are paid through the owner’s personal return.

The federal income tax filing process begins with the owner completing a Schedule C - Profit or Loss from Business, including income and deductions, to determine the business’s net income. This income is combined with the business owner’s other income, credits, and deductions using Form 1040 to determine their overall taxable income and tax liability.

State Income Taxes

Sole proprietorships are also considered pass-through entities for state income tax purposes. The information from the federal return is carried over to the state forms.

Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming don’t have an income tax. New Hampshire doesn't tax earned income (including sole proprietorship income), but it does tax interest and dividends at 5%.

Self-Employment Tax

Sole proprietors are considered to be self-employed for the purposes of paying Social Security and Medicare taxes. Almost everyone who works in the U.S. must pay these taxes to gain credits toward benefits.

The self-employment tax rate is 15.3%, including 12.4% for Social Security and 2.9% for Medicare. The Social Security part is capped each year at a specific amount. The Medicare part is not capped, and there is an Additional Medicare Tax of 0.9% for yearly income above a specific amount.

Self-employment tax is based on the net income of your business as calculated on Schedule C. You must file Schedule C and pay self-employment taxes if your net income is $400 or more for the year. If you have a net loss for the year, you don’t have to pay self-employment tax for that year.

To calculate the amount of your self-employment tax liability for the year, you must complete Schedule SE and include the total tax owed in your personal tax return. As part of this calculation, you can deduct half of your self-employment tax (the part an employer would pay) on your tax return.

Estimated Taxes

As a self-employed sole proprietor, you aren’t an employee, and you don’t receive a paycheck from which to withhold income taxes and self-employment taxes. In this case, you must make quarterly estimated tax payments if you expect to owe tax of $1,000 or more for the year from all sources.

Estimated tax payments must be made on April 15, June 15, September 15, and January 15 of the following year. You can pay by mail or through one of the IRS online payment options. You can run a quick calculation of the estimated taxes you might owe by using the worksheet in Form 1040-ES.

Employee Taxes

If your sole proprietorship has employees, you must pay several employment taxes. Some of these taxes are collected in part from employees, while others are not.

Income taxes are paid by employees, but you must withhold these taxes from your employees and pay them to the IRS.

Employee Social Security and Medicare taxes, called FICA taxes, are paid by both the employee and the employer. The total tax is 15.3% of the employee’s gross pay. You must withhold 7.65% from the employee and pay the other 7.65% as the employer. The employee withholding is capped each year, but the employer portion is not.

You must withhold an Additional Medicare Tax when an employee’s earnings reach $200,000 for the year. The employer must continue paying Medicare taxes, but not the additional tax. 

Employers must also report and pay unemployment taxes, called FUTA taxes, to fund unemployment benefits for terminated employees. Most employers pay both federal and state unemployment taxes, but they get a credit for the state tax. The standard FUTA tax rate is 6% on the first $7,000 of an employee’s wages subject to FUTA tax, reduced by up to 5.4% for the state credit.

Workers’ compensation is a state insurance program funded by employers to give benefits to employees for on-the-job illnesses and injuries. Employers pay into these state insurance programs through commercial insurance or by self-funding (if allowed by the state). You can find out more about your state’s workers’ compensation regulations by searching this list of state workers’ compensation agencies.

All of the federal taxes discussed here must be reported to the IRS. Here’s a list of the forms needed to file periodic tax reports.

Employment taxes are complicated, and there are many requirements and restrictions. See IRS Publication 15 (Circular E), Employer’s Tax Guide for details on collecting, paying, and reporting these taxes.

Property Taxes

If your sole proprietorship owns real estate (land and buildings), you must pay property taxes to your county tax collector, based on the appraised value of the property. To find out more about how to pay this tax, go to the website of your state’s department of revenue or find your county’s website.

Sales Taxes

If your sole proprietorship sells products or services, you may have to collect sales taxes from your customers and pay these taxes to one or more taxing entities. Sales taxes are imposed on end users (consumers), and sellers are required to pay these taxes even if they aren’t collected from consumers.

Five states don’t have sales taxes: Alaska, Delaware, Montana, New Hampshire, and Oregon. Alaska allows local sales taxes, and Delaware has a rental and sales tax.

The sales tax landscape is complex and constantly changing. Each state has its own regulations that include a specific tax rate and a list of taxable products and services. In addition, some local taxing agencies also impose sales taxes. Finally, many states impose sales taxes on online or out-of-state sales.

Use Taxes 

Every state that has a sales tax also has a use tax on the storage, use, or consumption of taxable items or service, but not on those on which sales tax has been paid.

The best way to get information about sales taxes and use taxes is to search the website of your state’s taxing agency.

Excise Taxes

Excise taxes are imposed on certain types of business goods, services, and activities. For example, there are excise taxes on indoor tanning services, sports wagering, and many types of fuels. The IRS has a list of common excise tax forms and publications.

Sole Proprietorship Tax Deductions and Credits

Yes, sole proprietors qualify for self-employment tax deductions and other incentives.

Business-Expense Deductions

Like other businesses, sole proprietorships can deduct business expenses that are ordinary and necessary. Ordinary expenses are those common and accepted in your industry, and necessary expenses are helpful and appropriate for your business.

In addition to common expenses—everything from advertising, insurance, and payments to employees to legal and professional fees, office expenses, and utilities—there are some special deductions you may be able to include on Schedule C.

  • Businesses that sell products and keep an inventory can deduct their cost of goods sold.
  • If you have a home office for your business, you can deduct your expenses for the use of this office if it is your principal place of business and you use it both regularly and exclusively for business purposes. You can calculate this deduction using actual expenses or use a simplified method.
  • Businesses can deduct the cost of capital expenses (major purchases of long-term assets like equipment, machinery, and vehicles) using a process called depreciation, which spreads the expenses over the item’s useful life.

A Special Tax Deduction for Pass-Through Businesses

Sole proprietors, along with other types of pass-through businesses, can get an additional tax deduction of 20% from their business income through a Qualified Business Income (QBI) tax deduction. The deduction is in addition to ordinary business deductions. There are requirements and limitations on this deduction, so check with your tax professional for more details.

See IRS Publication 535 Business Expenses for details on how to deduct business expenses, including limitations and restrictions on these deductions.

Tax Credits

Tax credits are a way sole proprietorships can save money on business taxes by engaging in certain activities. Tax credits are taken out of your tax return before your taxable income is calculated to directly reduce the amount of tax you owe. Each tax credit has a specific form you must use after your business has spent money on the activity. Some common business tax credits include:

  • A disabled-access tax credit for updates to your business location to accommodate people with disabilities.
  • A small employer health care tax credit to help pay health care premiums for employee health insurance.
  • A work-opportunity tax credit to employers who hire individuals who have faced significant barriers to employment.

There are many other tax credits available to sole proprietors; they’re listed in the instructions for IRS Form 3800 General Business Credit.

Frequently Asked Questions (FAQs)

Do sole proprietors pay more in income taxes than partnerships or limited liability companies (LLCs)?

Sole proprietorships, partnerships, and LLCs pay income taxes in the same way as pass-through entities, so paying more or less tax depends on the individual owner’s tax situation. The total tax paid by all these business owners is based on their total income from all sources, not their business incomes alone.

A partnership doesn’t pay taxes, but it files an information return with the IRS. The partners receive a Schedule K-1 showing their share of the partnership income.

Single-member LLCs generally pay income taxes as sole proprietorships, and multiple-member LLCs generally pay taxes as partnerships.

What happens if a sole proprietor doesn’t pay estimated taxes?

The U.S. tax system is “pay as you earn,” and the IRS expects taxpayers to pay taxes on their income during the year they earn it, rather than waiting until they file their taxes early the following year. If you didn’t pay enough tax on your business income during the year, you may have to pay a penalty for underpayment. You may also be charged a penalty if your estimated tax payments are late, even if you receive a refund.

You may be able to decrease the penalty if:

  • You increase your withholding from employment income.
  • You have uneven income during the year, so you annualize your income and make unequal payments during the year.
  • You qualify for later payment due to a casualty or declared disaster.
  • You retire after age 62 or become disabled during the year and didn’t make the payments due to reasonable cause.

Can being a corporation instead of a sole proprietorship help you save money on taxes?

That’s a difficult question to answer because it depends on the individual’s tax situation. Corporations file a corporate tax return and pay the corporate tax rate, but corporate owners pay tax on dividends they receive. For sole proprietors, income from all sources is combined to get a net taxable income. The federal tax rates vary depending on the person’s tax filing status. 

Other factors, like whether the business has a loss or profit, and available tax credits and dividends in each business type also come into play when figuring a business owner’s personal tax liability. This question is best answered by having a licensed tax professional review your sole proprietorship income on a regular basis.