Common Tax Problems When Filing as a Sole Proprietor

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If you have your own business, watch out for these common tax problems when filing as a sole proprietor. If it’s already too late and you’ve gotten a letter from the IRS, get help from an Enrolled Agent or other tax pro.

Not Paying Estimated Taxes

The federal tax system is pay-as-you-go, if you don’t have income tax withholding through an employer, you need to make quarterly estimated tax payments to cover your tax bill.

If you don’t make estimated tax payments totaling between 90 to 110% of your income tax liability (depending on your income and whether you’re using this year’s or last year’s income), you could have to pay additional interest.

And of course, if you don’t have the money by April 15th, you could pay additional interest and penalties on top of that.

Claiming Personal Expenses as Business Expenses

Many new sole proprietors hear that things like mileage and phone bills are deductible and start deducting them in full. In fact, there are very strict rules that you need to follow.

The main rule is that you can only deduct the business portion of the expense. So for your phone bill, you’d need to figure out how much you use it for personal reasons versus how much you use it for business reasons and only deduct the portion of your bill attributable for business reasons. For mileage, you need to learn the rules for what constitutes business mileage and make sure that you’re not deducting commuting miles between the business and your home.

Improperly Claiming the Home Office Deduction

The home office deduction is one of the most heavily audited deductions because most people simply do it wrong. To claim it, you must have a portion of your home that you use for nothing but business and meet other IRS rules. You also must have supporting documentation for both your business use and the expense that you claimed.

Expensing Large Purchases All at Once

Even if you’re a cash-basis taxpayer, you may be required to depreciate large purchases over time rather than deducting the full purchase price in the year of purchase. The good news is that the Section 179 election allows you to skip doing this if you don’t make millions of dollars in revenue, but you need to follow the defined procedures to make the election.

Not Reporting Expenses

Don’t skip reporting expenses because you’re afraid of an audit. An audit isn’t that bad as long as you have your receipts and other documentation.

In addition, the tax laws require you to claim your allowable business expenses. This is to avoid people abusing things like the Earned Income Tax Credit, Social Security, and other income-based benefits.

Mixing Personal and Business Expenses

You’re only required to have a separate bank account if you’re a corporation or other legally-separate entity. However, it’s still a good practice if you’re an individual Schedule C filer.

Keeping a separate bank account makes tracking everything easier and reduces what you need to provide to the IRS if they audit your business expenses.

Forgetting Payroll Taxes

If you’re a Schedule C filer, you don’t need to pay payroll taxes for yourself because you don’t take wages. You pay Social Security and Medicare taxes based on your business profit.

However, if you hire employees, you’ll need to obtain an EIN and make payroll tax deposits anywhere from weekly to quarterly depending on your payroll. Failing to do so can result in severe fines and possibly even criminal charges.