When we talk about sole proprietorships, there are a lot of clichés that get thrown around — things like “hang out your own shingle” or “you and your business are one.”
Sole proprietorships are easy to form. In many cases there’s no special paperwork that has to be filled out — you just start conducting business.
Business income and expenses are reported on the business owner’s tax return on an attachment called schedule C, attached to the owner’s personal 1040.
The business owner will pay income tax on the proprietorship’s net income. Business owners also pay self-employment tax.
What is self-employment tax?
Self-employment tax is something that surprises a lot of newly self-employed people — they know about income taxes but a lot of times they don’t think about the self-employment tax and this can be a big deal because it can cause a big tax hit.
If you ever worked at a job and you looked at your pay stub out, you probably saw amounts taken out for FICA taxes. Self-employment taxes are the self-employed person’s version of FICA taxes.
When you’re an employee, 7.65% of your wages are withheld for FICA taxes. Your employer kicks in another 7.65%.
When you are self-employed, for purposes of FICA taxes, you’re considered both employer and employee so you will have to pay 15.3% (7.65 x 2) self-employment tax on your tax return. This is in addition to the income tax that you will owe.
In Part 2, I’ll look at the advantages and disadvantages of being a sole proprietor.