Many freelancers work as a sole proprietorship, which means that they are not incorporated with the secretary of state. Though a sole proprietor can register as a business, it is not required. The sole proprietor works under his or her own name. A sole proprietor can also be a married couple working together. According to Fundera, about 23 million sole proprietorships exist in the United States.
Taxes for Sole Proprietors
The IRS taxes a sole proprietor as a pass-through entity. This means that you claim your income and profits on your personal tax return and are subject to the individual income tax rate. Some of the pros and cons of a sole proprietorship include:
You don’t need to register with the secretary of state, so setup is easy. Simply get the business permits and licenses required by your state, county and/or city. If you choose to operate under a trade name instead of your own name, you do have to register the trade name with the state. This is commonly referred to as a DBA name or “doing business as” name.
You have little to no legal requirements, such as creating meeting minutes, resolutions, bylaws and other business documents.
You have complete control over all aspects of your business.
Filing taxes is relatively easy. Most sole proprietors file a Schedule C with their 1040 and you don’t have to figure out different owner percentages of income and losses.
Most sole proprietors have a 20 percent income tax deduction under the Tax Cuts and Jobs Act of 2017, also known as the Trump Tax Plan.
If someone sues you, you are personally liable for any judgment against you.
You are personally liable for any debts and liabilities, which means that the court can go after your personal assets to pay a judgment.
In general, sole proprietorship taxes are higher than taxes for corporations and LLCs.
In addition to income taxes, you also pay self-employment taxes on the total amount of income you make.
It’s easy to burn out when you are doing all of the work.
The Importance of Keeping Records
As with any company, you need to keep good records for anything you take a deduction for, including office improvements, renovations, office supplies and equipment, advertising expenses, vehicle expenses, and other deductible expenses.
If you claim a deduction and the IRS audits you later, you will have to show proof of that deduction via an invoice or receipt, especially if it results in a large deduction for your self-employment taxes or results in a loss for the year. Technically, you could show a loss, but still have some profit if you have enough depreciation.
Contact a Professional Accountant
When you are a sole proprietor, you should use a professional accountant to help you with your accounting and taxes. Tax laws change frequently, which means that deductions also change. You could easily miss a deduction that could save you a lot on your tax bill – or you could claim something that you shouldn’t, in which case, the IRS will ask you to amend your tax return, and you could owe a significantly higher amount. Additionally, a skilled business accountant keeps copies of your receipts and invoices, and also keeps a general ledger and other financial statements to maintain a higher degree of protection for your business. When filing the next year’s taxes, you often need to import depreciated assets and other information from your previous year’s return. A professional accountant maintains this information to import into this year’s taxes. And, more importantly, a business accountant also lets you know if you are making a profit — and where your losses are, so that you can adjust your business model for the next year.