Thinking about starting a small business or a side hustle? Good for you!
If your business is unincorporated and you’re the only owner, the IRS will automatically consider it to be a “sole proprietorship." This means that, at tax time, you’ll need to report your business’ income and expenses on your personal taxes and pay personal income tax on all your self-employed earnings.
Since basic sole proprietorships require less upfront paperwork than corporations, DBAs or LLCs, they’re a good option for many businesses of one, like self-contractors, freelancers and consultants. But, while it might be easy to get up and running as a sole proprietor, you’ll still need to actively manage your business’ accounting so you can file your taxes properly, make important decisions and more.
Use this comprehensive guide to find out why bookkeeping is so important for sole-proprietors, what you should (and shouldn’t!) do, and what resources are available to help you.
The many benefits of good bookkeeping for sole proprietorships
Being a good bookkeeper can help you keep track of your business’ assets, liabilities, income, equity, and cash flow.
This is important because it’ll help you have a clearer snapshot of what to expect when you file your taxes each year. For example, if your sole proprietorship made money after adjusting for expenses, that money will be taxed as personal income – but if it lost money after adjusting for expenses, this amount will offset any earnings that you made elsewhere and lower your total personal income. Having a realistic view on these figures long before you file can help you maximize your tax return and avoid any surprises.
Accurate and up-to-date bookkeeping is also important because it helps you understand how profitable and efficient your business is so you can make decisions about if, when and how to grow it. Plus, it also helps you budget effectively so you can plan for future expenses.
Sole proprietor bookkeeping 101
Now you know why you should keep your financial records organized, but what’s the best way to go about it?
1. Track the cash flows into and out of your bank account. Be sure you’re tracking all your revenue and expenses so you can easily create an income statement to use at tax time. Depending on your business type, you may also need to create a balance sheet that tracks your sole proprietorship's assets, liabilities, shareholder equity and retained earnings.
2. Use a spreadsheet, bookkeeping software, or app. Organizing everything in one place will help you evaluate your finances and share with an accountant. If you want to use bookkeeping software or an app like Quickbooks or Freshbooks, the program should prompt you to provide the info it needs. If you’d rather go it alone, check out our accountant-approved guide to taxes for a basic spreadsheet template.
3. Reconcile your accounts on a regular basis. Reconciliation is essentially double-checking that the actual amounts you earned and spent match the amounts coming and going from your account. This helps you monitor for fraud, validate your data entry and identify any errors on your financial statements.
4. Keep your personal income separate. Sole proprietors aren’t legally required to have a separate bank account for business, but even if you’re just freelancing on the side, it’s easier to track invoice payments and minor expenses if they’re not sprinkled around your personal transactions. If you don’t want to go this route, invest in a solid bookkeeping system or hire an accountant to ensure things don’t get out of hand.
Best accounting software for sole proprietorships
Here are a few reliable tools you can use to keep track of your business accounting:
Benji: This app is geared to help you save at tax time. It will track your personal and business expenses and identify everything you can deduct. Plus, it’s free to use until you’ve found a minimum of $1,000 in tax write-offs.
Expensify: This program has two plans for small businesses – “Track” which enables you to scan and save up to 25 expenses in their app for free each month, and “Collect” which provides automated invoicing and payment collection services for $5/month.
Freshbooks: This well-known small business accounting software is a cloud-based, one-stop shop to help with invoicing, recording your revenue and expenses, generating financial reports, time tracking and more. You can try Freshbooks free for the first 30 days, and memberships start at $17/month after that.
Note: If you’re planning to freelance, check out our list of specific criteria to look for in your financial accounting software (including our top 5 software options).
Self-employment tax obligations as a sole proprietor
In addition to submitting your personal 1040 income tax return, if you’re a sole-proprietor, you’ll also need to provide your business’ revenue and record your expenses by category on a Schedule C tax form. If you’ve been tracking your expenses closely, or using a bookkeeping software program, then this should be easy.
The IRS will use your Schedule C form to calculate your net business profit (which is essentially your gross profit less your expenses) – and this net income is what you will be taxed on. As a result, maximizing your deductible business expenses is key to keeping more money in your pocket, so be sure you're claiming all your:
- Operating costs, including payroll and business bank account fees
- Product and advertising costs
- Travel expenses
- Business-related meals (most are 50% deductible)
- Business equipment or other necessary assets for the business
Common mistakes and how to avoid them
Even if you’re familiar with the bookkeeping basics, there are still a few things you’ll want to avoid:
1. Forgetting to keep your receipts. Even if you’re tracking your expenses meticulously, you still need to keep you receipts in case you’re audited. If saving the paper copies sounds tedious, try taking photos of them to save into a specific folder on your phone.
2. Not accounting for sales tax. This is another mistake that can cost business owners hefty penalties and fines. Properly report the appropriate sales tax and pay the right amounts on time.
3. Claiming for personal expenses. Many people confuse certain personal expenses with business ones. They try to deduct their cost of commuting to work, for example, or all of their household expenses (instead of just a portion) because they work from home. Try to familiarize yourself with what is and isn’t allowed or use accounting software to guide you.
Good bookkeeping can go a long way
From optimizing your tax return, to avoiding unnecessary penalties, making sound business decisions, time tracking and more – good bookkeeping is key to your success as a business owner. Take time to get a good system in place, and once that’s done – think about other key elements that could benefit your business, like a customer relationship management (CRM) tool. At Practice, we offer an end-to-end CRM system to save you time and ensure your clients have a positive experience that keeps them coming back. Check it out today!