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.
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. You can also write off certain start-up costs and the cost of business equipment and other assets you purchase for your business.
Sole proprietors may also qualify for the new pass-through tax deduction established by the Tax Cuts and Jobs Act. Up to 20% of net business income earned by sole proprietors may be deducted as an additional personal deduction. However, sole proprietors with incomes over $315,000 (if married filing jointly) or $157,500 (if single) must have employees or depreciable business property to take this deduction and the deduction is limited to a percentage of employee wages or business property cost. The deduction is not available at all for sole proprietors who provide various types of personal services and whose income exceeds $415,000 (if married filing jointly) or $207,500 (if single). This deduction is in effect for 2018 through 2025. See The New Pass-Through Tax Deduction for more information.
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, Top Tax Deductions for Your Small Business, and Nolo's book, Tax Savvy for 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 estimated 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.
Unlike a sole proprietorship, a regular corporation (also called a “C” corporation) is considered a separate entity from its owners for income tax purposes. Owners of C 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.
The Tax Cuts and Jobs Act dramatically changed the corporate tax rate to a single flat tax of 21%. This replaced tax rates ranging from 15% to 35% that corporations paid under prior law. The 21% rate is lower than individual rates at certain income levels. The top 37% individual rate applies to income over $600,000 for marrieds and $500,000 for singles. However, corporations do not benefit from the up to 20% pass-through tax deduction established by the Tax Cuts and Jobs Act, which can cut the effective tax rate for sole proprietors by 20%.
Nevertheless, corporate owners at higher income levels who need or want to leave some profits in the business can benefit from the 21% corporate tax rate. 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 could be as high as 37%. But if you incorporate, that $50,000 would be taxed at the 21% corporate rate.
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.