Have you recently started consulting, opened an online or physical store, picked up freelance work, or started a side gig? Congratulations, you’re now a business owner! Even if you haven’t formed a business entity, such as a limited liability company (LLC) or S corporation, you’re running a sole proprietorship.
One of the best parts of being a sole proprietor is that you don’t have to file a separate business tax return. Instead, you’ll report your business income and expenses on a Schedule C (Profit or Loss from Business), and the information gets carried over to Form 1040 — your personal tax form.
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What new forms might you see?
If you’ve never filed a tax return as a sole proprietor before, you may be surprised to see a few new forms. Here are some of the common ones:
- Schedule C: The Schedule C is where you’ll report your business’ income and expenses. Your net earnings or losses will carry over to your Form 1040. Alternatively, you might be able to fill out the simpler Schedule C-EZ if you’re reporting a gain, don’t have employees, and you had less than $5,000 in expenses.
- Schedule SE: As an employee, you pay half of your Social Security and Medicare taxes, and your employer pays the other half. When you’re self-employed, you must pay both parts, a combined 15.3 percent, on your business’ net earnings. The Schedule SE (which stands for self-employment) calculates how much this will be. You can deduct half of these self-employment taxes from your income on your Form 1040.
- 1099-Misc: You won’t receive a W-2 from the companies or clients you worked with throughout the year. Instead, they might send you a 1099-Misc with the total amount they paid you for your services. You must include your 1099-Miscs when you’re preparing your tax return, and the earnings will contribute to your business’s income.
- 1099-K: The 1099-K covers income from third-party payment network and card transactions, such as credit card, debit card, and PayPal transactions. You may receive one of these if you accept debit or credit cards, sold items online, or were a rideshare driver. Like with the 1099-Misc, your 1099-K earnings get added to your business’s income. However, the 1099-K reports your gross income, not the net profit after discounts, fees, refunds, or other adjustments. Make sure you find and record these business expenses on your Schedule C, or you could wind up overpaying.
- 1040-ES: Because your clients don’t withhold taxes from your payments, you may have to file estimated quarterly tax payments throughout the year. If you don’t, and you expect to owe at least $1,000, you may wind up paying a penalty when you file your annual tax return. You can make estimated tax payments online using Form 1040-ES.
New tax forms aren’t generally something people look forward to dealing with. Don’t worry, though — tax preparers and tax preparation software can walk you through the process and fill out the forms for you. But before you get to that point, you’ll need to have your documents and records in order.
What will you need to file your tax return?
Compared to employees, sole proprietors may need to take a few extra steps before filing a tax return.
“It’s advisable for business owners to maintain good records of their revenues and expenses,” says Rashad Phillips, an accountant and small business advisor in Charlotte, North Carolina. You’ll need these numbers to prepare your tax return, and you should also hold on to them and corresponding records (such as receipts) in case the IRS audits you, says Phillips.
You’ll need to independently track your income from all your business activity, as companies and customers aren’t always required to send you a 1099-K or 1099-Misc. For example, if a client pays you less than $600 during the year, it doesn’t need to send you a 1099-Misc. However, you still need to report that income on your Schedule C.
Phillips warns that even if a company does create a 1099-Misc or 1099-K for you, it may not mail you a physical copy. It could email you a copy or make your 1099 available on the company’s app or website. Be sure to look for these forms before you file your tax return.
You’re also responsible for tracking the business expenses that you want to deduct from your business’ income. Only expenses that are “ordinary and necessary” qualify, meaning they need to be common, helpful, and appropriate for your line of work. IRS Publication 535 goes over the potential business expenses, deductions, and rules.
Business expenses could include:
- Materials or supplies
- Subscriptions to business software
- Payments to subcontractors
- Rent for an office space
- Interest on a business loan or line of credit
- Insurance premiums
- The use of a vehicle for work
It’s up to you how you want to track and store your records. Some people use accounting software, such as Xero, FreshBooks, or Quickbooks to track their finances, while others can do everything with a spreadsheet.
Don’t miss (or claim the wrong) deductions
As a sole proprietor, you may be eligible for a variety of deductions that can help lower your tax bill. However, you need to know when and how to qualify. Otherwise, you may miss a deduction and pay more than you need to, or you may claim the wrong deduction and risk an audit.
For example, unlike an employee, you may be able to deduct your health insurance premiums if you aren’t eligible for an employer-sponsored plan through a job or from a spouse’s company. The self-employed health insurance deduction is especially valuable because it’s an above-the-line deduction, which means it can lower your adjusted gross income and help you qualify for other credits or deductions.
On the other hand, there are deductions that you may want to take but shouldn’t. For example, you can’t deduct the cost of training as a business expense if it qualifies you for a new line of work or it’s a minimum requirement for a job. The home office deduction is also commonly misunderstood, and you may want to read the rules carefully to verify you qualify.
Filing your return
Once your records are in order, preparing a tax return as a sole proprietor isn’t much harder than a non-business return. All your business activity will wind up on your Schedule C, and your net business profits will carry over to your Form 1040 — the same one you would file even if you didn’t have a sole proprietorship.
You can hire a tax preparer to complete and submit your return, or you can try the DIY approach with downloadable or online tax software. There are even some free software options for sole proprietors.
If you want to learn more about filing taxes as a sole proprietorship, the IRS has a nine-part video series on small business taxes. You may also want to hire a tax attorney or preparer who is familiar with your business and can help you optimize your tax strategy for the coming years.
This article was originally written on November 14, 2018 and updated on July 18, 2022.
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