As a sole proprietor you must report all business income or losses on your personal income tax return; the business itself is not taxed separately. (The IRS calls this "pass-through" taxation, because business profits pass through the business to be taxed on your personal tax return.)
Here's a brief overview of how to file and pay taxes as a sole proprietor -- and an explanation of when incorporating your business can save you tax dollars.
Filing a Tax Return
The main difference between reporting income from your sole proprietorship and reporting wages from a job is that you must list your business's profit or loss information on Schedule C (Profit or Loss from a Business), which you will submit to the IRS along with Form 1040.
You'll be taxed on all profits of the business -- that's total income minus expenses -- regardless of how much money you actually withdraw from the business. In other words, even if you leave money in the company's bank account at the end of the year (for instance, to cover future expenses or expand the business), you must pay taxes on that money.
You can deduct your business expenses just like any other business. You are allowed to expense (deduct) much of the money you spend in pursuit of profit, including operating expenses, product and advertising costs, travel expenses, and some of the cost of business-related meals and entertainment. You can also write off certain start-up costs and the cost of business equipment and other assets you purchase for your business.
But you'll need to keep accurate records for your business that are clearly separate from your personal expenses. One good approach is to keep separate checkbooks for your business and personal expenses -- and pay for all of your business expenses out of the business checking account. For information about allowable expenses and deductions, see Small Business Tax Deductions and Top Tax Deductions for Your Small Business.
Because you don't have an employer to withhold income taxes from your paycheck, it's your job to set aside enough money to pay taxes on any business income you bring in during the year. To do this, you must estimate how much tax you'll owe at the end of each year and make quarterly estimated income tax payments to the IRS and, if required, your state tax agency.
For more on esitmated taxes, see estimated taxes for sole proprietors.
Sole proprietors must make contributions to the Social Security and Medicare systems; taken together, these contributions are called "self-employment taxes." Self-employment taxes are equivalent to the payroll tax for employees of a business. While regular employees make contributions to these two programs through deductions from their paychecks, sole proprietors must make their contributions when paying their other income taxes.
Another important difference between employees and sole proprietors is that employees only have to pay half as much into these programs because their contributions are matched by their employers. Sole proprietors must pay the entire amount themselves (although they can deduct half of the cost).
The self-employment tax rate is 15.3%, which consists of 12.4% for Social Security up to an annual income ceiling (above which no tax applies) and 2.9% for Medicare with no income limit or ceiling. See the IRS website for current Social Security annual income thresholds. Self-employment taxes are reported on Schedule SE, which a sole proprietor submits each year along with a 1040 income tax return and Schedule C.
Incorporating Your Business May Cut Your Tax Bill
Unlike a sole proprietorship, a corporation is considered a separate entity from its owners for income tax purposes. Owners of corporations don't pay tax on the corporation's earnings unless they actually receive the money as compensation for services (salaries and bonuses) or as dividends. The corporation itself pays taxes on all profits left in the business.
Corporate owners who need or want to leave some profits in the business can benefit from lower corporate tax rates, at least for the first $75,000 of profits. The corporate tax rate is only 15% on the first $50,000 of profit and 25% on the next $25,000 of profit. These rates are usually lower than shareholders' personal income tax brackets.
For example, if your Web design company wants to build up a reserve to buy new equipment, or your small label manufacturing company needs to accumulate inventory as it expands, you may choose to leave money in the business -- let's say $50,000. If you operate as a sole proprietor, those "retained" profits would be taxed at your marginal individual tax rate, which is probably more than 25%. But if you incorporate, that $50,000 would be taxed at the lower 15% corporate rate.
However, corporate taxation is definitely more complicated than the pass-through taxation of a sole proprietorship, and the savings -- probably a few thousand dollars -- may not be worth the hassle of forming a corporation and filing a corporate tax return. To learn more about how incorporating can reduce your tax bill, see How Corporations are Taxed.
For more information on sole proprietorships and taxes, see The Small Business Start-Up Kit, by Peri H. Pakroo (Nolo).