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How is a Sole Proprietor Taxed?

I recently received the following question from a reader:

I’ve earned a significant amount this year so far in self-employed income. Is there anything special I need to be doing taxwise before actually doing my taxes next April?

I know many of you earn self-employment income, so I thought it’d be worth addressing as a blog post. In brief, yes, there are a few things you should be doing. Specifically:

  1. Keeping records,
  2. Making estimated tax payments (maybe), and
  3. Saving money (maybe).

Keeping Records for Your Sole Proprietorship

It’s important to track your business transactions if you want to be able to claim every possible deduction come tax season. An easy way to do this is to set up a spreadsheet with columns for the date, description, and amount of each transaction. This way, when tax time rolls around, you’ll have all the necessary information in one place.

If you have more than a handful of business-related transactions each year, your best bet is to open a separate checking account for your business. That way, you won’t need to bother with recording every transaction, because the bank statements from your business checking account will have all the necessary information already.

Note: For the purposes of protecting yourself against an audit, you’ll actually need to do a little more recordkeeping — in addition to keeping bank statements (and/or credit card statements), you’ll have to keep receipts for your business expenses.

Making Estimated Tax Payments

Unlike salary or wages from a normal job, payments made to your business will not have anything withheld for taxes. As a result, you may end up needing to make estimated tax payments throughout the year.

In order to avoid interest or penalty, over the course of the year, the sum of your withholding (if any) plus your estimated tax payments must equal the smaller of:

  1. 90% of your tax for this year, or
  2. 100% of your tax from last year (Line 60 from Form 1040).

For many people who start a business in addition to their normal job, no estimated tax payments will be required in the first year, because the withholdings from their normal job are sufficient to meet requirement #2.

Saving Money to Pay Taxes

Even if you don’t have to make estimated tax payments (because the withholding from your or your spouse’s “real job” will be equal to your total tax from last year), you’ll still probably want to start saving now for next tax season. It’s likely that instead of getting a refund this year, you’ll be writing a check to the US Treasury.

When attempting to estimate how much you need to save, be sure to remember that income from a sole proprietorship is also subject to self-employment tax (calculated as roughly 15% of the net profit from your business) in addition to being subject to income tax at your current tax rate.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

Comments

  1. You make an excellent point about record keeping! Another thing to consider is that a LLC can have benefits over a sole proprietorship. I’m not a tax professional, of course, my my accountant switched me to a LLC, and I pay most of my distributions to my partner, who is the limited partner. This reduces the amount of money that I have to pay self-employment tax on, and has saved me a bundle. At least, I think that’s how it works…I do know that my tax bill has been lower since I switched from a sole proprietorship to a LLC.

  2. Actually, just forming an LLC doesn’t change anything regarding (federal) taxation. After forming an LLC, however, you can then elect S-corp taxation or C-corp taxation should either of those be beneficial.

    I’ve written a bit about it here before.

  3. Mike – found your blog a few months ago and really enjoy it. This is a great post, so many people who have side jobs or are just starting out don’t understand how much they need to make in estimated payments.

    Just wanted to point out that for taxpayers who earned $150,000 joint or $75,000 single in the previous year they have to have estimates equal to 90% of current year or 110% of previous year to meet the safe harbor.

    Keep up the good work – John

  4. Indeed. Thank you for mentioning that.

If you want to discuss this article, I recommend starting a conversation over at the Bogleheads investing forum.
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