If you’re a sole proprietor and you’re wondering precisely how Uncle Sam takes his cut of your earnings, the answer is simple. You, as the operator of your business, report your income on your personal income tax return. The business itself is not taxed independently of your earnings.
The IRS refers to this as “pass-through” taxation because your profits are passed through the business onto your personal income tax return.
The question then becomes: how do I file and pay taxes on the income I earned through self-employment?
Sole proprietors need to report their earnings on Schedule C which is submitted to the IRS alongside Form 1040.
Just like any business, expenses can be deducted. This can include either full or partial expenditures on items you use every day in your business. For instance, if you bought a new computer, but you also use that computer for recreation, part of the cost of that computer can be written off as an expenditure. In other words, you are only expected to pay taxes on your net earnings after expenses, not on your total income.
The 2018 Tax Cuts and Jobs Act also entitles sole proprietors to a pass-through tax deduction of up to 20%, given that certain conditions are met.
The trick for sole proprietors will be to keep their business expenditures separate from their general income. Establishing a separate business checking account can go a long way toward keeping your monies organized. One caveat to that is that if you do want to set up a separate checking account for your business, you may need to apply for EIN as opposed to using your social security number for business-related transactions. Many financial institutions require an EIN, but setting one up is an easy process.
One pitfall to self-employment is when proprietors don’t set aside money to pay their taxes. Then they file and find out that they owe thousands of dollars.
You’ll want to estimate what your quarterly taxes will be based on the previous year. You’ll be expected to pay quarterly as opposed to yearly, and can be penalized for not getting the payment in on time. If this is your first year as a sole proprietor, you won’t have to worry about quarterly payments.
In addition, there is a “self-employment tax”. It’s not really a special tax for those that are self-employed, but it ends up working out that way. When you work a job as an employee, your employer pays half your Medicare and social security. As a sole proprietor, you must pay the full amount. Hence why it’s called a self-employment tax.
This comes to 15.3% of your earned income. However, you’ll also want to bear in mind that there will be taxes you will have to pay to the state you live in as well.
Sole proprietors are poised for excellent earnings with the pass-through deduction, yet there might still be good reason to incorporate for tax purposes. In the end, what makes the most sense for one individual will depend heavily on their amount of earned income.
Scott Royal Smith is an asset protection attorney and long-time real estate investor. He's on a mission to help fellow investors free their time, protect their assets, and create lasting wealth.
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