Paying Yourself and Filing Taxes as a Sole Proprietor

This article explores what you need to know about paying yourself and filing taxes as a sole proprietor. Although your tax obligations may be less than the average corporation, you still need to plan and prepare carefully to cover them.

How to Pay Yourself as a Sole Proprietor

Sole proprietorships are subject to less regulation than most business structures. You can pay yourself informally, depositing money you earn directly into a personal account. However, operating your business without clear delineations can expose your business to risk and make tracking expenses and profits much more complicated than necessary.

Setting Up a System

Set up a business account where you can deposit your earnings and use those funds to pay your expenses, thereby keeping your finances organized. Then, you can pay yourself from the business account, which is an owner's draw. You decide how often to make such withdrawals and whether to set them up as automatic payments to yourself.

Deciding on an Amount

There are two common ways to decide how much to pay yourself. First, you can pay yourself the bare minimum to make ends meet. Second, you can pay yourself your marketplace worth. Or, of course, you can select an amount somewhere in the middle to start off. Typically, calculating these amounts requires budgeting your personal and business expenses. You also need to calculate your expected or actual profits—gross income minus expenses—and you may need to analyze how much employers generally compensate for work like yours.

How to File Taxes As a Sole Proprietor

Although the IRS treats you and your business as one entity, filing taxes as a sole proprietor is not a once-per-year event. When you have an employer, your employer withholds taxes from each paycheck and remits those taxes to the government along with the portion that employer contributes for you. Without an employer, you are responsible for ensuring you pay the taxes–usually through quarterly estimated tax payments–that an employer would withhold and remit.

LLCs Taxed Like Sole Proprietorships

If your business is an LLC that the Internal Revenue Service (IRS) disregards for tax purposes, you file as if you were a sole proprietor. The IRS disregards single-member LLCs unless you affirmatively ask the IRS to tax your business as a corporation. When the IRS disregards an LLC, the company income and expenses are reported on the member's personal tax return.

Estimating Your Taxes

You must pay self-employment taxes if you make $400 or more in self-employment profits. The IRS taxes self-employment at a rate of 15.3%, split between 12.4% for Social Security and 2.9% for Medicare. In 2024, amounts you earn above $168,600 are not subject to the social security tax.

You owe an additional 0.9% Medicare tax if your overall income exceeds certain thresholds:

• $250,000 if you are married and filing jointly

• $200,000 if you are single, head of household with a qualifying person, or qualifying widow or widower with a dependent child

• $125,000 if you are married but filing your taxes separately

Along with your self-employment taxes, you should pay your expected income tax at the standard rates.

To calculate your estimated taxes, the IRS recommends using Form 1040-ES. Estimate your expected profits for the year, determine how much your tax bill will be, and divide that amount into four quarterly payments.

Paying Quarterly Taxes

How does a sole proprietor pay taxes? The IRS recommends paying your estimated taxes online, but you may file Form 1040-ES by mail or pay your taxes by phone. So, when are sole proprietor taxes due? You pay estimated taxes four times per year:

• April 15 for taxes covering January 1 to March 31

• June 15 for taxes covering April 1 to May 31

• September 15 for taxes covering June 1 to August 31

• January 15 for taxes covering September 1 to December 31 of the previous year

Although estimated taxes are called "quarterly," a keen observer will note that payments can be unevenly distributed throughout the year based on when income is actually received. Keep the actual distribution of payments in mind when making your calculations. This can make estimated tax payments easier to handle for a sole proprietor that may have irregular income, especially for a new business. Of course, making four equal estimated tax payments will also work as long as a sufficient amount is paid in total.

You may owe a penalty if you fail to pay, underpay your estimated taxes by $1,000 or more, or pay less than 90% of your current-year or 100% of your prior-year taxes.

Tax Credits

Many consider the lack of benefits to be one of the most significant drawbacks of self-employment. However, you may qualify for credits or deductions to ease that burden. For example, amounts paid by a sole proprietor for health insurance may be deductible as an adjustment to income. In addition, a credit for small employer health insurance premiums might be applicable to the cost of certain coverage for some employees.

Self-employed individuals may be eligible for the Earned Income Tax Credit (EITC) if they have one or more qualifying children and:

• Have earned $63,398 (2023 maximum) or less in income

• Have accrued $11,000 or less in investment income

• Have a valid social security number

• Are a U.S. citizen or lawful permanent resident

• Do not earn income outside the U.S.

You may still claim the EITC without a qualifying child if you meet all the regular qualifications and:

• Maintain a primary home in the U.S. for more than half the year

• Are not claimed as a qualifying child on anyone else's return

• Are aged 25 to 65

You may also qualify for other credits, such as the clean vehicle credit or the credit for small employer pension plan startup costs..

Tax Deductions

When you are self-employed, you can often take several deductions, especially business expense deductions. If you work in a home office, some of your supplies, equipment, and operating costs may be deductible. Examples of this include office supplies, computer equipment, internet service, and a home office deduction if a portion of the home is used regularly and exclusively for the sole proprietorship. Significantly, you may still deduct business expenses if you take the standard deduction.

You may also fund a retirement account, including:

• Traditional or Roth Individual Retirement Account (IRA)

• Simplified Employee Pension (SEP)

• Solo 401(k)

• Savings Incentive Match Plan for Employees (SIMPLE IRA Plan)

• Other defined benefit plans

• Other defined contribution plans

Depending on the plan, you may be able to deduct a portion of your contributions from your net income.

Employment Taxes

Although many sole proprietorships do not have employees, many do and must pay employment taxes. If you have any full or part-time employees, you are responsible for withholding taxes from their pay and remitting those taxes to the government. In addition, you will be responsible for paying and remitting the employer's portion of payroll taxes for your employees. And, if you hire contractors, you will need to file Form 1099-NEC to report payments you make to them.

Keeping Your Finances Tax-Compliant

Running a sole proprietorship can be simpler than other business types. You still have tax obligations, the most significant of which is generally paying estimated taxes. Yet, running a business also comes with many potential tax credits and deductions, which can help offset the costs associated with self-employment taxes.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.