When starting out in business, most business owners opt for running their company as a sole proprietorship. A sole proprietorship doesn’t require any formal tax registration for your business. It’s a simple tax model that allows ordinary people to have their own small business.
Regardless of whether you’re running your company in your spare time as an employee, or if you work full time for your own business, you’ll need to pay tax on your profits. Knowing how to file tax as a sole proprietor, will help you pay your taxes the right way.
What is a Sole Proprietorship?
A sole proprietorship (often called a sole trader or individual entrepreneurship) is a business model where the business owner and the business are viewed as a single entity. What this means, legally speaking, is that the business owner will still operate as an individual when making business choices. The business and its owner also share financial responsibility, as the business isn’t viewed as a separate legal entity from its owner.
What this means is that business debt and personal debt will be one in the same thing. If a sole proprietorship is running at a loss, it will inflict serious harm to the owner’s personal finances.
Can an LLC Also Be a Sole Proprietorship?
For a lot of aspiring small business owners, the risk of combining business finances with their personal money matters is too much to place on the line. To avoid extra risk, many sole proprietors register their businesses as an LLC. By registering as an LLC, the business will be a separate legal entity from its owner. As a result, there will be a larger level of financial independence between the business owner and the business entity.
Registering a business as an LLC doesn’t necessarily mean you won’t still be taxed as a sole proprietorship, however. This is because registering as an LLC has more to do with establishing your business as an entity for legal protection rather than tax. A business can, for all practical purposes, be both a sole proprietorship and an LLC.
To change the way your business is taxed, you’ll need to register for tax under a different taxation model, such as a corporation or partnership.
Are Sole Proprietorships Always Run by One Person?
No. A sole proprietorship is always owned by one person. If a business is owned by two or more people, it will have to be taxed either as a corporation or a partnership.
This doesn’t mean that sole proprietorships are always run by one person though. Sole traders are allowed to have employees, as long as tax obligations regarding employment are fulfilled. Employees could fill any role within the business, even high up positions such as managers. The only rule is that employees may not hold any share in the business, as this would be considered a partnership.
Filing Tax as a Sole Trader
Filing tax as a sole trader is similar to filing tax personal income taxes, seeing as the owner and business aren’t taxed separately. To file tax as an individual entrepreneurship, you’ll need to fill in a form called a Schedule C form for your business.
If you’re working while also running a company, filing tax as a sole proprietor could push up your taxable income, which could cause you to classify for a higher tax bracket.
To calculate the taxable income from your business, you’ll need to know how much profit you’ve made. To calculate your profits, you’ll need to use the following mathematical principle:
Total business income – Business expenses = Profit made
As an example, if a business made a total income of $10 000, but the owner spent $3500 on expenses to keep the business operating, then the business made a taxable income of $6500.
This principle seems simple, but following through with it means a lot of bookkeeping to monitor income and expenses.
Calculating Your Tax Deductions
In tax, business expenses can also be called tax deductions. Tax deductions are expenses that a business owner incurred to keep the business running. For a photography business, this could be a new camera. For a coffee shop, this could be supplies like coffee beans, kitchen equipment or more.
A lot of everyday expenses your business incurs will qualify as tax deductions. As long as a tax deduction is a business expense, it doesn’t have to be essential to keep your company going. Employee gifts or beverages or new décor to modernize your premises could also qualify, as these expenses are still towards business.
To maximize your business income, it’s best to deduct as many eligible expenses from your total income as possible. Doing so will reduce your tax liability so you don’t pay tax on income that isn’t profit.
Working with a tax professional to help you navigate what you can and can’t deduct from your income is key. There are some expenses that you may believe are tax deductible, only to learn they aren’t.
Expenses such as business meals, for instance, will only be 50% deductible. As of the 2018 tax year, expenses like employee entertainment aren’t deductible at all. Consulting a qualified accountant or bookkeeping firm will help you learn more about what expenses you can legally deduct from your taxable income.
Paying Tax as a Sole Proprietor
Sole proprietors usually pay tax on a quarterly basis. These payments are calculated based on the estimated profits on the business for each quarter. To estimate quarterly profits, good bookkeeping is essential. Bookkeeping helps business owners get a good oversight on the financial matters of their company.
Using the average income of a business over a long period of time can help business owners spread their tax liability equally over each quarterly payment. This is preferable to paying a large sum when the business is more profitable over one quarter, only to pay a small amount with the next payment if the business didn’t perform well.
One of the problems with estimating tax in advance of filing is that you’ll run the risk of late filing penalties if (upon filing) it’s found that you should’ve paid more tax. If your payment was $1000 or more under the amount you actually owed, then you’ll be liable for late payment fees.
This, once again, stresses the importance of good bookkeeping, as this will help you get accurate estimates for making quarterly tax payments.
Hiring a Professional Accountant
Filing your taxes and completing your tax form is easy enough if you have a good bookkeeping system in place. A little tax help can make a huge difference to how you run your business. Advice and guidance regarding business taxes can clear up a lot of confusion and take a large amount of stress off your shoulders.
Tax laws are always changing, which means that staying on top of your obligations won’t always be predictable. Determining your taxable income is a dynamic problem, where the answer to your questions might often change based on current regulations.
While it’s possible to run a successful business without help from a professional bookkeeper or accountant, it’s definitely more risky. From accidental late payments based off inaccurate income, to counting on deducting expenses that aren’t eligible, doing your own tax can soon become a nightmare.
The average cost of accounting fees can range anywhere between $75-$600 based on the needs of your small business, but it’s a small price to pay for the peace of mind and professional help you’ll be getting.