If you operate as a sole proprietor – whether you’re a freelancer, consultant, independent contractor, or small business owner – you pay self-employment tax at a rate of 15.3% on your net earnings. For 2026, the Social Security portion applies to the first $184,500 of earnings. The Medicare portion applies to all earnings with no cap.
That’s just the self-employment tax. You also owe federal income tax on your business profits, which can push your total tax rate to 37% or higher depending on your income level.
I’ve spent more than 15 years helping business owners navigate federal tax compliance. I’ve seen sole proprietors overpay by tens of thousands of dollars because they didn’t understand available deductions. I’ve also seen them face substantial IRS assessments because they failed to make quarterly estimated tax payments or didn’t properly report their income.
The tax rules for sole proprietors are straightforward in concept but complex in application. You report business income on Schedule C, calculate self-employment tax on Schedule SE, make quarterly estimated payments throughout the year, and claim every legitimate deduction to reduce your tax liability.
But getting it wrong has consequences. Fail to pay enough in estimated taxes and you face underpayment penalties. Miss deductible expenses and you overpay. Incorrectly classify income or deductions and you create audit exposure.
Understanding exactly how sole proprietorship taxes work – what you owe, when you owe it, and how to minimize your tax burden legally – is essential for anyone operating their own business.
What Is a Sole Proprietorship for Tax Purposes
A sole proprietorship is an unincorporated business owned and operated by one person. For federal tax purposes, the IRS makes no distinction between you and your business – you are the business.
This includes:
- Independent contractors – Individuals providing services to clients on a non-employee basis
- Freelancers – Writers, designers, developers, consultants operating under their own name
- Single-member LLCs – By default, the IRS treats single-member LLCs as sole proprietorships (though you can elect corporate treatment)
- Gig economy workers – Drivers, delivery workers, and others earning income through platforms
- Side businesses – Anyone earning business income in addition to W-2 employment
The defining characteristic is simple: you operate a business for profit, you’re the only owner, and you haven’t formed a corporation or partnership.
From a tax perspective, this means all business income “passes through” to your personal tax return. You don’t file a separate business tax return. Instead, you report business profit or loss on your Form 1040 along with any other income you earn.
The $400 Filing Threshold
You must file a tax return and pay self-employment tax if your net earnings from self-employment are $400 or more.
This threshold applies even if your total income is below the standard filing requirement. If you earn $5,000 from your W-2 job and $500 from freelance work, you must file a return and pay self-employment tax on the $500 even though your total income wouldn’t normally require filing.
Net earnings means your gross income minus deductible business expenses. If you had $10,000 in business revenue but $6,000 in legitimate business expenses, your net earnings are $4,000 and you must file.
If your net earnings are less than $400, you may still need to file if you meet any other filing requirement – for example, if you have enough W-2 income to exceed the standard deduction threshold.
Self-Employment Tax: The Double Tax Burden
Self-employment tax is Social Security and Medicare tax for people who work for themselves. It’s the single most misunderstood aspect of sole proprietorship taxation.
When you work as an employee, you pay 7.65% of your wages in FICA taxes (6.2% Social Security + 1.45% Medicare). Your employer pays a matching 7.65%. Combined, 15.3% goes to Social Security and Medicare.
As a sole proprietor, you’re both the employee and the employer. You pay the entire 15.3% yourself.
2026 Self-Employment Tax Rates
Social Security tax: 12.4% on the first $184,500 of net self-employment earnings
Medicare tax: 2.9% on all net self-employment earnings with no cap
Additional Medicare tax: 0.9% on earnings above $200,000 (single filers), $250,000 (married filing jointly), or $125,000 (married filing separately)
The Social Security wage base increased from $176,100 in 2025 to $184,500 in 2026 – an $8,400 increase that raises maximum Social Security tax liability.
How Self-Employment Tax Is Calculated
You don’t pay self-employment tax on 100% of your net earnings. The IRS allows you to reduce your net earnings by 7.65% before applying the tax – effectively putting you on par with employees who don’t pay Social Security and Medicare tax on their employer’s 7.65% contribution.
The calculation works like this:
1. Calculate net earnings from self-employment (gross income minus expenses from Schedule C)
2. Multiply by 92.35% (100% minus 7.65%) to get earnings subject to self-employment tax
3. Apply 15.3% to the result (subject to the Social Security wage base limit)
Example for 2026:
Your net profit from Schedule C is $80,000
$80,000 × 0.9235 = $73,880 (earnings subject to SE tax)
$73,880 × 0.153 = $11,304 (total self-employment tax)
You report this amount on Schedule SE and transfer it to your Form 1040. But here’s the important part – you can deduct half of your self-employment tax ($5,652 in this example) as an adjustment to income on Form 1040. This deduction reduces your adjusted gross income and your income tax liability.
The Additional Medicare Tax
If your combined wages and self-employment income exceed $200,000 (single) or $250,000 (married filing jointly), you pay an additional 0.9% Medicare tax on the excess.
This brings your total Medicare tax to 3.8% on income above these thresholds.
If you have both W-2 wages and self-employment income, the thresholds apply to combined income. If your employer withheld Additional Medicare Tax from your wages, that’s credited against your total Additional Medicare Tax liability.
Federal Income Tax on Business Profits
Self-employment tax isn’t your only federal tax obligation. You also owe regular income tax on your business profits at ordinary income tax rates.
For 2026, federal income tax rates range from 10% to 37% depending on your taxable income and filing status. Your business profit is added to any other income you have (W-2 wages, investment income, etc.) to determine your total taxable income and applicable tax rate.
The total tax burden on sole proprietorship income includes:
- 15.3% self-employment tax (on income up to $184,500 for Social Security portion)
- 10% – 37% federal income tax depending on total income
- State and local income taxes if applicable
A sole proprietor in the 24% federal tax bracket pays 39.3% combined federal tax on business income (15.3% SE tax + 24% income tax). That doesn’t include state income taxes.
This is why deductions matter so much for sole proprietors. Every legitimate business expense reduces both your self-employment tax and your income tax.
How to Report Sole Proprietorship Income
Sole proprietors report business income on Schedule C (Form 1040), Profit or Loss from Business. This form calculates your net profit or loss from your business activities.
Schedule C Requirements
Schedule C requires you to report:
- Gross receipts or sales – Total income your business earned
- Returns and allowances – Money refunded to customers
- Cost of goods sold – If you maintain inventory
- Business expenses – All ordinary and necessary expenses
- Vehicle information – If claiming vehicle expenses
- Other expenses – Miscellaneous business costs
Your activity qualifies as a business (rather than a hobby) if:
- Your primary purpose is income or profit
- You engage in the activity with continuity and regularity
- You conduct the activity in a businesslike manner
The IRS scrutinizes Schedule C filers more than W-2 employees. Overstated expenses, questionable deductions, or lack of documentation create audit risk.
Schedule SE: Self-Employment Tax
After calculating net profit on Schedule C, you transfer that amount to Schedule SE (Form 1040) to calculate self-employment tax.
Schedule SE determines:
- Your net earnings subject to self-employment tax (92.35% of net profit)
- Social Security tax owed (12.4% up to the wage base)
- Medicare tax owed (2.9% on all earnings)
- Additional Medicare tax if applicable (0.9% above thresholds)
- Deductible portion of SE tax (half of total)
The self-employment tax amount from Schedule SE transfers to Schedule 2 (Form 1040) as additional tax owed.
Quarterly Estimated Tax Payments
Unlike employees who have taxes withheld from every paycheck, sole proprietors must pay taxes throughout the year through quarterly estimated payments.
If you expect to owe $1,000 or more in federal taxes when you file your return, you must make estimated tax payments. This requirement catches many new business owners by surprise.
2026 Estimated Tax Due Dates
First Quarter: April 15, 2026 (for income earned January – March 2026)
Second Quarter: June 16, 2026 (for income earned April – May 2026)
Third Quarter: September 15, 2026 (for income earned June – August 2026)
Fourth Quarter: January 15, 2027 (for income earned September – December 2026)
Use Form 1040-ES to calculate your estimated tax payments. The form includes worksheets to help you estimate your total tax liability for the year and divide it into quarterly payments.
How Much to Pay
The safe harbor rules protect you from underpayment penalties:
Option 1: Pay 100% of last year’s total tax (110% if your prior year AGI exceeded $150,000)
Option 2: Pay 90% of current year’s actual tax liability
If your income fluctuates significantly throughout the year, you can use the annualized income installment method to calculate each payment based on actual income earned to date. This prevents overpaying early in the year if most of your income comes later.
Penalties for Underpayment
Fail to pay enough in estimated taxes and the IRS assesses an underpayment penalty. This penalty applies even if you’re due a refund when you file your return.
The penalty is essentially interest on the amount you should have paid. The rate changes quarterly and compounds daily.
You can avoid the penalty if:
- Your total tax liability for the year is less than $1,000
- You had no tax liability in the prior year
- You meet the safe harbor requirements
- You qualify for a waiver due to casualty, disaster, or unusual circumstances
Deductions That Reduce Sole Proprietorship Taxes
Every legitimate business expense reduces both your self-employment tax and your income tax. Understanding which expenses qualify and how to document them properly is critical.
Qualified Business Income Deduction (Section 199A)
The QBI deduction allows eligible sole proprietors to deduct up to 20% of qualified business income.
For 2026, if your taxable income is below $197,300 (single) or $394,600 (married filing jointly), you generally qualify for the full 20% deduction.
Above these thresholds, the deduction phases out for specified service businesses (doctors, lawyers, accountants, consultants, financial advisors, athletes, etc.). Non-service businesses above the threshold may still claim the deduction but face limitations based on W-2 wages paid and property owned.
The One Big Beautiful Bill Act made this deduction permanent and increased the phase-in range from $100,000 to $150,000 for married couples filing jointly (from $50,000 to $75,000 for other filers). This means the complete phase-out now occurs at $544,600 for married filing jointly (up from $494,600) and $272,300 for single filers (up from $247,300).
Example: A freelance writer with $100,000 in net business income and taxable income below the threshold can deduct $20,000 (20% of $100,000), reducing taxable income to $80,000.
This deduction is taken on Form 1040, not on Schedule C. It reduces your income tax but not your self-employment tax.
Home Office Deduction
If you use part of your home regularly and exclusively for business, you can deduct expenses for that space.
Simplified method: Deduct $5 per square foot of home office space, up to 300 square feet (maximum $1,500 deduction)
Regular method: Calculate the percentage of your home used for business, then deduct that percentage of mortgage interest (or rent), utilities, insurance, repairs, and depreciation
The space must be used exclusively and regularly for business. A bedroom that also serves as your home office doesn’t qualify. A dedicated office space used only for business does.
Vehicle Expenses
For 2026, the standard mileage rate has not yet been announced by the IRS (typically released in mid-December). Industry analysts predict the rate will be between 71-73 cents per mile based on current vehicle operating costs. This article will be updated when the IRS releases the official 2026 rate.
Alternatively, you can deduct actual expenses (gas, oil, repairs, insurance, depreciation) multiplied by the business-use percentage of your vehicle.
Document every business trip. The IRS requires contemporaneous records showing date, destination, purpose, and miles driven. Without documentation, the entire deduction is at risk in an audit.
Health Insurance Premiums
Self-employed individuals can deduct 100% of health insurance premiums paid for themselves, their spouse, and dependents.
This deduction is taken as an adjustment to income on Form 1040, not on Schedule C. It reduces your income tax but not your self-employment tax.
You can’t claim this deduction for any month you were eligible to participate in an employer-subsidized health plan (through your spouse’s employer, for example).
Retirement Plan Contributions
Sole proprietors can establish and contribute to retirement plans, deducting contributions from taxable income.
SEP-IRA: Contribute up to 25% of net self-employment earnings (after deducting half of SE tax), maximum $72,000 for 2026
Solo 401(k): Contribute up to $24,500 as employee deferrals plus up to 25% of net earnings as employer contributions, total maximum $72,000 ($80,500 if age 50+)
SIMPLE IRA: Contribute up to $17,000 ($21,000 if age 50+)
These contributions reduce your income tax. They don’t reduce your self-employment tax.
Other Deductible Business Expenses
- Office supplies and equipment – Computers, software, furniture, supplies
- Professional services – Legal fees, accounting fees, consultant fees
- Business insurance – Liability insurance, professional liability, business property insurance
- Advertising and marketing – Website costs, online ads, print advertising
- Education and training – Courses, conferences, subscriptions related to your business
- Telecommunications – Business phone line, internet service (business portion)
- Meals – 50% of business meal costs (100% for meals provided to employees)
- Travel – Airfare, hotels, rental cars for business trips
- Contract labor – Payments to independent contractors for business services
Every expense must be ordinary (common in your industry) and necessary (helpful and appropriate for your business). The IRS can disallow any expense you can’t substantiate with receipts and documentation.
Information Returns: 1099 Forms
As a sole proprietor, you’ll receive 1099 forms from clients and may need to issue them to contractors you hire.
Forms You Receive
Form 1099-NEC: Reports payments of $600 or more for services you performed as a nonemployee
Form 1099-MISC: Reports royalties of $10 or more, rents, prizes, awards, or other miscellaneous payments of $600 or more
Form 1099-K: Reports payments from credit cards, debit cards, and third-party payment processors like PayPal or Venmo
For 2026, Form 1099-K reporting thresholds remain $20,000 in payments AND 200 transactions for third-party payment networks (the IRS has continued delaying the planned $600 threshold).
You must report all business income whether or not you receive a 1099. The IRS matches 1099 forms against your tax return. Failing to report income shown on a 1099 triggers automated notices and potential audits.
Forms You Must Issue
If you paid $600 or more to an independent contractor for services during the year, you must file Form 1099-NEC by January 31.
You need the contractor’s name, address, and taxpayer identification number (Social Security number or EIN). Request Form W-9 from every contractor when you hire them.
You don’t issue 1099s to:
- Corporations (except law firms and medical providers)
- Payments for merchandise or inventory
- Payments to employees (use Form W-2)
- Rent paid to real estate agents or property managers
Penalties for failing to file required 1099 forms range from $60 to $310 per form depending on how late you file.
Sole Proprietorship Taxes for Employees
If you hire employees (not independent contractors), your tax obligations expand significantly.
You must:
- Withhold federal income tax – Based on employee W-4 elections
- Withhold FICA taxes – 6.2% Social Security + 1.45% Medicare from employee wages
- Pay employer FICA taxes – Match employee contributions (6.2% + 1.45%)
- Pay federal unemployment tax (FUTA) – 6% on first $7,000 per employee (reduced by state unemployment tax credits)
- File quarterly payroll tax returns – Form 941 by April 30, July 31, October 31, January 31
- File annual FUTA return – Form 940 by January 31
- Issue W-2 forms – To employees by January 31
- Make payroll tax deposits – Monthly or semi-weekly depending on tax liability
Payroll tax compliance is complex and unforgiving. The IRS imposes severe penalties for late deposits, missed filings, or incorrect withholding. Most sole proprietors with employees use payroll services to handle compliance.
State and Local Tax Obligations
Federal taxes are only part of your obligation. Most states impose income taxes on business profits, and some cities levy additional taxes.
State income tax rates vary from 0% (no income tax states like Florida, Texas, Nevada) to over 13% (California’s top rate).
Some states require quarterly estimated tax payments similar to federal requirements. Others allow annual payments.
Many states also impose:
- Sales tax – If you sell tangible goods or taxable services
- Business licenses and permits – Annual fees varying by state and locality
- Gross receipts taxes – Taxes on total revenue regardless of profit
- Self-employment tax equivalents – A few states tax self-employment income separately
Check your state tax authority’s website for specific requirements.
Record Keeping Requirements
The IRS requires you to maintain records that support income, deductions, and credits claimed on your return.
Keep records for at least three years from the date you file your return (or two years from the date you paid the tax, whichever is later). For some items, the IRS can audit further back.
Essential records include:
- Bank statements showing all deposits
- Receipts for all business expenses
- Mileage logs for vehicle expenses
- Invoices sent to clients
- 1099 forms received and issued
- Credit card statements for business charges
- Asset purchase records and depreciation schedules
- Home office calculations and documentation
Digital record-keeping is acceptable and often preferable. Scan receipts, maintain electronic files, use accounting software to track income and expenses.
Without documentation, the IRS can disallow deductions entirely. “I know I spent it but I don’t have receipts” doesn’t work in an audit.
Common Sole Proprietorship Tax Mistakes
Understanding what not to do is as important as understanding requirements.
Failing to Make Estimated Tax Payments
The most common mistake is not paying estimated taxes throughout the year. Waiting until April 15 to pay your entire tax bill results in underpayment penalties that compound quarterly.
Mixing Personal and Business Expenses
Using your personal bank account for business transactions creates documentation problems and makes it easy to overlook deductible expenses or accidentally claim personal expenses as business costs.
Open a separate business checking account even though sole proprietorships aren’t legally required to do so.
Overstating Deductions
Claiming personal expenses as business costs, exaggerating mileage, or deducting expenses you can’t document creates audit risk.
The IRS targets sole proprietors who report high deductions relative to income. Schedule C filers face higher audit rates than W-2 employees.
Misclassifying Workers
Treating employees as independent contractors to avoid payroll taxes creates significant liability. The IRS can reclassify workers, assess back payroll taxes plus penalties, and disallow business expense deductions for payments made.
Ignoring the Hobby Loss Rule
If your business consistently loses money, the IRS may reclassify it as a hobby. Hobby expenses are deductible only to the extent of hobby income, and only if you itemize deductions.
The IRS presumes an activity is for profit if you show a profit in at least three of the last five years.
When to Consider Changing Business Structure
Sole proprietorships offer simplicity but may not be optimal as your business grows.
Consider forming an LLC or S corporation if:
- Your business generates substantial profits (S corps can reduce self-employment tax)
- You face liability concerns (LLCs provide personal asset protection)
- You want to bring in partners or investors
- You need to retain earnings in the business rather than distributing everything to owners
S corporations allow you to pay yourself a reasonable salary (subject to payroll taxes) and take additional profits as distributions (not subject to self-employment tax). For high-income sole proprietors, this can save thousands annually in self-employment tax.
But S corps require more complexity – payroll processing, corporate tax returns, reasonable compensation determinations, and ongoing compliance costs.
Get Professional Tax Guidance
Sole proprietorship taxes involve more complexity than most business owners realize. Self-employment tax, quarterly estimated payments, business expense documentation, information return filing, and strategic tax planning all require attention throughout the year, not just at tax time.
I’ve spent more than 15 years helping business owners navigate tax compliance and minimize their tax burden. I’ve seen sole proprietors overpay because they missed valuable deductions. I’ve seen them face IRS assessments for failing to make estimated payments or properly report income. And I’ve helped them restructure their operations to legally reduce their tax liability by tens of thousands of dollars.
At Silver Tax Group, I provide comprehensive tax planning and compliance services for sole proprietors and small business owners. Whether you’re just starting out and need guidance on quarterly estimated payments, trying to maximize deductions while avoiding audit risk, or evaluating whether to change business structure, I offer the expertise you need.
Contact Silver Tax Group today for a consultation on your sole proprietorship tax situation. We’ll review your specific circumstances, identify missed deductions, ensure you’re meeting all compliance requirements, and develop strategies to minimize your federal and state tax liability.
Because when you’re paying both sides of the employment tax and facing federal income tax rates up to 37%, every dollar of legitimate deduction matters. And every compliance failure creates IRS exposure that can cost far more than proper planning would have.
Call us or visit our website to schedule your consultation. Stop overpaying on taxes and start using the tax code strategically to keep more of what you earn.
