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How Are Sole Proprietorships Taxed? | Sole Proprietor Taxes

Much like forming a sole proprietorship, handling the taxes for a sole proprietorship is fairly simple. It really comes down to filling out just a few forms.

“Pass-Through” Taxation

Sole proprietorships are known as “pass-through” entities. What this means is simply that the profit (or loss) from the business is “passed through” to the owner of the business. Therefore, if you run a sole proprietorship, the profit from the business will show up on your regular individual tax return (i.e., Form 1040).

Schedule C

Schedule C is the form that you’ll use to compute the profit or loss from your business. As tax forms go, this one isn’t terribly complicated. For the most part, it’s just a list of all your revenues followed by a list of all your expenses.

Generally, the only time something isn’t straight-forward occurs when you have an expense that doesn’t seem to fit nicely into any of the expense categories listed. And even then, all you have to do is list it on the line for “Other Expenses” and (on Page 2 of Schedule C) give an explanation of what the expense was.

The end-result of Schedule C will be a figure known as your “Net Profit or Loss,” which you then carry over to your Form 1040 to be entered on Line 12 (Business Income or Loss). This income will be added to any salaries or wages that you or your spouse earn and will be taxed at the regular individual income tax rates.

The Self-Employment Tax

In addition to being subject to regular income tax, earnings from a sole proprietorship are subject to the self-employment tax (SE tax). The SE tax is calculated (on Schedule SE) by multiplying your net earnings from self-employment by 15.3%.

At first glance, it may seem unfair to subject somebody to an extra tax simply because they are self-employed. However, the SE tax is really just a substitute for the Social Security and Medicare taxes that are paid on salaries and wages for employees.

For employees, a Social Security tax of 6.2% and Medicare tax of 1.45% are withheld from each paycheck. Then the employer is required to pay a matching amount. As such, the employee is paying 7.65%, and the employer is paying 7.65% for a grand total of 15.3%. When you run a sole proprietorship, you are, in essence, both the employee and the employer, so you get stuck with both halves of the bill.

Deduction for One-Half of SE Tax

Because you’re paying a little bit of extra tax (the 7.65% that your employer would be picking up if you were an employee), Congress decided it would be fair to allow you to claim a deduction for the extra tax paid. As such, after using Schedule SE to calculate your self-employment tax, you get to enter — on line 27 of your Form 1040 — an amount equal to one-half of your SE tax as an “above the line deduction.”

Simple Summary

  • Sole proprietorships are known as “pass-through” entities because the income from the business is passed through to the owner, showing up eventually on his or her Form 1040.
  • The profit or loss from a sole proprietorship is calculated on Schedule C.
  • Earnings from a sole proprietorship are subject to the self-employment tax (in addition to being subject to the regular federal income tax). The SE tax is calculated as 15.3% of your net earnings from self-employment.
  • Schedule SE is the form used to calculate the self-employment tax.

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.
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