Income Tax, Sales Tax, State Tax, Quarterly Tax? Talk about confusing
Often times it is the “simple” questions that can feel the most confusing when it comes to taxes. Today I'm sharing with you the very basics of what and how taxes are paid as a sole proprietor. You are a Sole Proprietor as long as you have no business partners, and are not registered as a corporation (S-corp or C-corp), if you are a single member LLC and have not elected to be taxed differently, then you are a sole proprietor for tax purposes.
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Income tax is something that everyone who receives income has to deal with in America. Whether you are an employee, self-employed, or earn all your income from investments, you will probably be paying income tax. You will most often hear people referring to your “tax bracket” because the USA has a tiered income tax system. You pay based on your income levels so the more taxable income you have, the higher the amount of taxes you pay.
Here is just an example of the tax brackets for a person who files single for 2017:
As you can see the highest earners can pay a lot in income taxes. This is why high earners do what they can to strategically, and legally, reduce their taxable income.
This chart is just for Federal Taxes. Each state may also have an income tax and those rates vary significantly. I happen to live in California which has the highest marginal tax rates in the country. Yeah it sucks, but we have the beach and stuff.
This tax only applies to those who are self-employed, sort of… When you are an employee on payroll, your employer takes three types of federal taxes out of your paycheck: income tax, social security, and medicare. When you become self employed you become responsible for all three of those taxes.
Self-employment tax goes towards your social security and medicare taxes. One nice thing about this tax is that it is calculated on your businesses profit, which means after all your business expenses are deducted. SE Tax is approximately 15.3% of your business profit. It is calculated on our annual income tax return when you file.
Sales Tax and Use Tax
Sales tax usually applies to those who sell physical products, but more states are catching on and taxing digital products. Sales tax returns are completely separate from your income tax return so make sure to register with your state and file those on time. If you need help in this area I recommend using a service like TaxJar.
Many states also have what's called Use Tax, which is a way of collecting sales tax on items purchased from out of state. California loves this one for people who order from “tax free” online retailers. Most of your major retailers will add sales tax on theses days, but others won't so keep an eye out.
If you have employees then you are responsible for withholding taxes from their paychecks and sending those taxes to the IRS and State (if applicable). I mentioned up above that Self-Employment tax went towards Social Security and Medicare, and a sole proprietor is responsible for the whole shebang.
When there is payroll involved, the employee is responsible for 1/2 of those taxes and the employer picks up the tab for the other half. If your business involves payroll, I recommend using a payroll service that will help you navigate all the complexities, like Gusto.
Quarterly Taxes and Estimated Taxes
These terms can often be used interchangeably, but they can also refer to completely different things.
The income tax system in the US is a pay as you go system. Which basically means that you are supposed to be making payments towards your taxes throughout the year, and not just when you file your annual income tax return. When you are an employee, your employer does this on your behalf through payroll withholdings.
When you are self-employed it becomes your responsibility to pay into the tax system throughout the year, which is what we call estimated payments. Estimated payments are due four times a year, hence the term quarterly. you don't actually file any tax return every quarter, instead you either make a payment online or mail a payment in with form 1040-ES.
Figuring out how much to pay is the more complicated bit. You could just do what random internet friends say which is send in 25%. You can use a worksheet like the IRS has here. You can use a software like QuickBooks Self Employed which has some built in calculators. The best option though is to talk to a real tax professional who can do a more accurate calculation based on your whole tax situation. Some people may be in business for multiple years before they reach the point of having to send in estimated payments, others may need to start pretty quickly because of the profits their business is generating.
Need more guidance on all these confusing taxes? Let's connect to get you on track.