Tax consequences of being a sole proprietor
Sole proprietorships are the most popular form of business in America today, probably because they are so easy to set up. Being a sole proprietor and keeping up, however, is another matter.
Keeping up with self-employment taxes is one of the many challenges that sole proprietorships face. The Small Business Administration estimates that roughly one-third of sole proprietorships close in their first year for a variety of reasons. That’s somewhere north of seven million closings per year and roughly three times the rate of all small business closings overall. The Internal Revenue Service reports that sole proprietorships accounted for about 27 percent of underpaid taxes in 2016, or roughly $125 billion.
If you did not organize as a limited liability company (LLC), S Corp. or C Corp. when you launched your business, you are deemed a sole proprietorship by default by local, state and federal tax authorities.
Being a sole proprietor means you must report income or losses from your business on your personal income tax returns — Line 12 for those filing IRS Form 1040 — in addition to filling out Schedule SE, Schedule C and whatever other forms and worksheets your local, state and federal authorities require. Income from your business will be blended with your other sources of income and taxed at the personal income tax rates that apply where you live.
It’s easy to see the attraction of being a sole proprietor. If you are a U.S. citizen, you don’t need to hire an accountant or lawyer to file paperwork, or obtain an Individual Taxpayer Identification Number, or ITIN, from the IRS. You simply report your business income on your personal tax return under your Social Security number. If you are a nonresident or resident alien and do not have and are not eligible to receive a Social Security number, you can apply for an ITIN by filling out a Form W-7.
You can rely on off-the-shelf tax preparation software to provide all the forms and guidance needed to file annual tax returns and estimate your quarterly self-employment tax payments.
This last requirement is what trips up many sole proprietors. The self-employment tax rate for 2019 is 15.3 percent. That consists of 12.4 percent for Social Security — up to an annual income ceiling, after which no tax applies — and 2.9 percent for Medicare with no income limit or ceiling. That’s roughly double the percentage of income that would be deducted from your paycheck for Social Security and Medicare if you were employed by someone else. The good news is that you can deduct half of your self-employment tax as an adjustment on your personal tax return.
Sole proprietors who expect to owe $1,000 or more in self-employment taxes during the year are expected to pay those taxes quarterly. Sole proprietors can use Form 1040-ES to figure estimated taxes. Failure to meet quarterly payment deadlines will result in fines and interest charges that may add hundreds of dollars to your annual tax bill and result in large sums being due on April 15.
It should be noted that a new deduction in the Tax Cuts and Jobs Act, which will allow some sole proprietors to reduce their business income by 20 percent beginning in 2018, does not apply to self-employment taxes. Those taxes will still be based on the sole proprietorship’s total profits.
It also should be noted that while Congress has cut funding for IRS enforcement by more than 20 percent since 2010, the IRS has continued to beef up scrutiny of sole proprietorships even when such businesses were already three times more likely to be audited than LLCs or corporations. The agency uses algorithms to identify and flag sole proprietors who appear to underpay, and nearly 90 percent of those flagged ultimately prove to owe more money than they reported.
The bottom line is that while it may be easier and more expedient to launch and run a business as a sole proprietorship, it is no less challenging to keep up with self-employment taxes.
So, know your obligations and plan for them.