A quick tax guide for sole proprietors just starting out
Starting a small business is exciting, however, if you’re used to working as a full-time employee, the transition to self-employment can be overwhelming when it comes to keeping track of your taxes. Understanding what the IRS expects from small business owners is a key piece in the success of keeping your business running.
In today’s blog, we’ll focus on taxation for sole proprietorships, as this business structure is the simplest and the most common choice for many business owners who are transitioning from employee to self-employed to launch their first small business. A sole proprietorship is an unincorporated business that has just one owner. It is known as a “pass-through entity” for tax purposes because the business income passes through to the business owner, who then reports it on their personal income tax return. We will focus on sole proprietorships reported on Federal Schedule C. Sole proprietors that do farming activities are similar but are reported on Federal Schedule F. Sole proprietors with rental business activities reported on Schedule E will not be covered in today’s blog.
As a sole proprietor, you are responsible for paying the following:
- State and federal income tax
- Self-employment tax
- Sales tax, if applicable
We’ll dive into each of these items below.
State and Federal Income Tax
For Wisconsin sole proprietors, business income and expenses are generally reported on Federal Schedule C – Profit or Loss from Business. The revenues and expenses of the business are reported on this schedule with the net profit/loss carried to the first page of Form 1040, your personal income tax return. Depending on the type of expenses incurred, other Federal supporting schedules may also need to be completed. You are required to file a Form 1040 for a tax year if your net income from a business for the year, often called self-employment income, is $400 or greater.
As an employee, you would use the information given on a W2 to fill out your 1040 and you would report it on the appropriate line on the form.
Wisconsin personal income taxes start with information from your Federal personal income tax return, so a separate Wisconsin schedule is not required to report income from a Wisconsin sole proprietorship, however, there may be separate Wisconsin supporting schedules, for example, depreciation expenses. Other states may have different requirements, so consult a tax professional if you are unsure about your state’s requirements.
The Self-employment (SE) tax is a tax paid by sole proprietors to pay their Social Security and Medicare taxes. As a sole proprietor, you must also pay this tax which is calculated separately on Schedule SE, and the amount is carried to the other tax line on Form 1040. Generally, the current SE tax rate is 15.3% for sole proprietors earning $142,800 or less.
When you are an employee, your employer withholds the employee portion of Social Security and Medicare taxes from your paycheck, matches the amount as an employer tax, and remits both amounts to the IRS. The SE tax calculation accounts for both the employee portion and employer portion of these taxes.
Instead of making weekly payments toward this tax, sole proprietors are required to estimate their income and pay the SE tax four times per year – more on that next. A tax expert can help you find your estimated quarterly taxes and keep your filings up to date.
Quarterly Tax Payments
Quarterly income tax estimated payments are payments made to the IRS to pay both SE and income taxes and to the State of Wisconsin (or other states, if applicable) to pay income taxes. For Federal tax purposes, estimated payments are owed when a sole proprietor has a tax liability of $1,000 when their personal income tax return is filed. To calculate and pay your estimated tax, download Form 1040-ES and its related instructions from the IRS website. Once calculated, you can either mail a payment to the IRS or make a payment online.
The first three estimated payments are due on the 15th of April, June, and September of the tax year. The fourth payment is due on January 15th of the following tax year. Most self-employed taxpayers like to divide their annual estimated tax due by four and make equal payments. However, if your estimated income changes throughout the year, you can calculate the tax due and send it to the IRS every quarter. Failing to pay your quarterly taxes can result in penalty and interest charges from the IRS and/or your state taxing department. If you are unsure about your estimated income or the 1040-ES requirements, consult a tax professional.
If you’re contracted to work for one or more companies as a sole proprietor, your customer(s) will send you a 1099-NEC on or before January 31 of the following year if they paid you $600 or more for services performed. The customer should have or will ask for you to complete a Form W-9 as they will need your EIN to prepare the form.
A 1099-K is sent from a credit card company or third-party processor to report transactions made on behalf of other businesses. You may receive this form because you received a certain dollar value or a number of payments by credit or debit card. If you run an eBay or similar business, you may receive this form if you meet the transaction or dollar amount requirements.
Note that Forms 1099-NEC and 1099-K are issued to you and the IRS. The IRS will compare amounts reported on these forms to the revenue that you report for your business and may send you a notice if the revenue reported on your business does not make sense in relation to the amounts reported on the 1099 forms.
Deductions to Consider
Earlier this year, we published a blog about the most common deductions for sole proprietors to consider claiming when working from home. When filing, some businesses may also qualify for these common business expense deductions on Schedule C:
- Your home office
- Business use of your phone, internet, and vehicle
- Business insurance premiums
- Ordinary and necessary business expenses. These can include:
- Office supplies such as pens and paper
- If you rent an office space, you may deduct the amount you pay for rent
- Subscriptions to professional, technical, and trade journals that are related to your business
- On-going credentials or classes (e.g., a beautician could deduct the cost of maintaining their license.)
In addition, sole proprietors may be eligible to claim the following deductions on Form 1040, Schedule 1:
- Self-employment Tax Deduction (you can deduct the employer-equivalent portion of your self-employment tax in figuring your adjusted gross income as calculated on Sch. SE).
- Health insurance premiums that are paid out of pocket by the sole proprietor where the sole proprietor is the primary insured on the policy – the policy can be in the name of the sole proprietor or in the name of the business.
These deductions are not direct business deductions reported on Schedule C, however, they are deductions from total income reported on Form 1040 which reduces your adjusted gross income.
Other Business Tax Considerations
Depending on your business, sole proprietors may also be required to keep track of inventory, owe sales tax in the jurisdiction where you sell, file local income taxes, or be responsible for following other regulations depending on your industry. Be sure to consult with your tax professional for additional clarification and assistance in these areas.
Many sole proprietors ask whether they should obtain an Employer ID number, or EIN, sometimes called FEIN or TIN. Though it is not required, your EIN allows your business to more easily open a business bank account and/or complete various forms, such as Form W-9, and you’re able to use your EIN instead of your social security number. You can obtain an EIN at the IRS website at irs.gov.
Transitioning from employee to self-employed, whether full-time or part-time, can be overwhelming, especially when establishing and maintaining a sole proprietorship. With the assistance of a tax professional, understanding your deadlines, estimating your income, and filing properly can become a simple item on your to-do list instead of something that causes anxiety. If you’re ready to take the next step in your entrepreneurial journey, reach out to us here to see if we can help smooth the transition.