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How Are Sole Proprietorships Taxed? | Sole Proprietor Taxes

For the most part, handling the taxes for a sole proprietorship is fairly simple. It comes down to filling out just a few forms.

“Pass-Through” Taxation

Sole proprietorships are known as “pass-through” entities. What this means is 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 (Form 1040).

Schedule C

Schedule C is where you will compute the profit or loss from your business. Schedule C is little more than a list of all your revenues followed by a list of all your expenses. The end-result of Schedule C is a figure known as your “Net Profit or Loss,” which will be carried over to your Form 1040 and 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. This 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 self-employment 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, however, there is no employer with whom you can split the bill. As a result, you’re stuck paying the entire 15.3%.

There’s a maximum amount of earnings that can be subject to Social Security tax each year ($142,800 in 2021). So for earnings above that threshold, the self-employment tax rate is only 2.9% (i.e., just the Medicare tax rate) rather than the whole 15.3%.

Deduction for One-Half of Self-Employment Tax

Because you’re paying an additional tax (i.e., the half of Social Security and Medicare taxes that your employer would be paying if you were an employee), Congress decided it would be fair to allow you to claim a deduction (specifically an “adjustment to income”) for the extra tax paid.

Deduction for Pass-Through Income

For tax years 2018-2025, if you have income from a “pass-through” business such as a sole proprietorship, you may qualify for a deduction equal to 20% of your income from the business, subject to several limitations.

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 regular federal income tax. The self-employment tax is calculated as 15.3% of your net earnings from self-employment (2.9% for earnings above the annual maximum for Social Security tax).
  • Schedule SE is the form used to calculate the self-employment tax.
  • For tax years 2018-2025, you can claim a deduction equal to 20% of your income from “pass-through” businesses, including sole proprietorships (subject to several limitations).

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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