As a sole proprietor, you are in charge of the day-to-day operations, from paying the bills to making sales calls. You are also responsible for paying taxes on your earnings and any other taxes that may apply to your business. It’s important to understand how you’ll be taxed as a sole proprietor so that you know what to expect when it comes time to file.
What Is A Sole Proprietorship?
Sole proprietorships are the most common type of business as a business owned and operated by one person. It's the simplest business structure, as there is no legal distinction between the owner and the business itself.
It's important to note that sole proprietorships are unincorporated businesses, meaning they're not considered a separate legal entity from their owners. From an accounting perspective, that means profits are taxed as personal income instead of at corporate tax rates.
One of the most common questions we receive from insurance agency owners is when they should incorporate the business to file taxes as an S-Corporation. There are many benefits to incorporating your insurance agency, from receiving limited liability protection and lessened tax responsibilities when you elect a pass-through entity to establishing credibility with clients. If you’re on the fence about whether or not to incorporate, here are some factors you should consider.
How Are Sole Proprietorships Taxed?
Sole proprietorships are pass-through entities, which means the business does not pay taxes on its profits as a corporation or LLC would. Instead, the individual owner, or sole proprietor, reports their business income and expenses on Schedule C (Form 1040) or C-EZ of their personal tax return.
In addition to reporting business income and expenses on Schedule C, sole proprietors may have other sources of taxable income such as employment income, investments or rental properties. Taxable income from all sources is reported on Form 1040 and taxed at individual rates set forth by the IRS.
Sole proprietors are also subject to self-employment tax, based on the amount of net income earned from their business. This includes Social Security and Medicare taxes that employees and employers would typically split.
Club Capital is the largest accounting and advisory firm for insurance agency owners in the country providing a one-stop financial infrastructure including monthly accounting, integrated payroll, CFO services, and tax preparation.
Tax Deductions for Sole Proprietorships
You can file your income and take deductions on the federal Form 1040, "U.S. Individual Income Tax Return." Sole proprietors must also file Schedule C, "Profit or Loss From Business." On this form, you report your business income and expenses. A sole proprietorship is not a separate business entity from the owner; you are simply reporting your personal business activities on Schedule C as part of your personal tax return.
The IRS allows certain exceptions to income; expenses that qualify for an exception are known as tax-deductible, or just deductions. Deductions reduce the amount of your total income subject to taxes because the IRS only taxes what is known as taxable income — so if you have $80,000 in total income and $10,000 in deductions for the year, then you only pay taxes on $70,000 of actual (taxable) net profit from your business.
Deductions can be divided into two groups: standard deductions and itemized deductions. An individual taxpayer qualifies for either a standard deduction or itemized deduction but not both each year they file their return.
Standard and Itemized Tax Deductions
Sole proprietors have the option of taking standard or itemized deductions to reduce your taxable income. Standard deductions are one-size-fits-all amounts that are subtracted from your business income, whereas itemized deductions require that you keep track of and add up your expenses for the year. The IRS publishes tables each year with both standard deduction amounts and income limits for who can claim them. You'll want to consult these tables when filling out your tax return, as well as determining which option is best for your situation.
Club Capital provides monthly accounting, tax, and CFO services for insurance agency owners. With 100% of our clients in the insurance industry, we are built to help you grow your agency faster with industry-specific accounting, tax, and CFO services.
Business Expense Deductions for A Sole Proprietorship
As a sole proprietorship, you'll be able to deduct many of your business expenses from your taxes. However, it's important to know what is and isn't deductible. Many people erroneously assume that every expense can be deducted – for example, if you buy a new computer for use in your business, you might figure that the full price is deductible. In reality, you can only deduct the cost of the portion of the computer that is used for business purposes.
Similarly, if there is any personal use of the item at all—perhaps you occasionally check your email on the computer—then it cannot be fully deducted from taxes. The amount of the deduction depends on how much time and money was spent using it for personal reasons versus for business reasons – so in this example, if you use the computer half an hour per day just to check email or social media and half an hour per day to work on your website and marketing materials, then 50% of its cost would be tax-deductible.
There are many types of expenses you may deduct if you are a sole proprietor, including:
- Legal fees
- Business travel
- Advertising and marketing
- Insurance (general liability and property insurance)
- Wages and fees paid to employees or contractors
- Interest on loans used for business purposes
State and Local Taxes for A Sole Proprietorship
Many small business owners are surprised to learn that they have to pay state taxes, even if they don’t work in the state where their business is incorporated. As a sole proprietor, you must pay state and local taxes on any income you earn from your business. The type of tax and the tax rate will vary by state, but some common types of taxes for a sole proprietorship include:
- Net Income Tax - A tax based on a percentage of your business' net income.
- Gross Income Tax - A tax based on a percentage of your business's gross income.
- Gross Receipts Tax - A tax based on a percentage of your gross receipts (sales) in the state.
Sole Proprietorship: Taxes Explained
A sole proprietorship is responsible for paying any taxes that arise due to its business activities, including federal and state income taxes, Social Security, Medicare and unemployment taxes. The amount of each tax that pertains to the sole proprietor depends on how much money was earned by the business during the year and how much was taken out of the business in salary payments.
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For the past 5 years, Club Capital has helped insurance agents better manage their agency's finances through best-in-class monthly accounting and tax services. Schedule a demo today!