Sole Proprietorship Taxation
How is a sole proprietorship taxed?
If you’re a sole proprietor or planning to become one, understanding the taxation of a sole proprietorship is one of the essential things you need to know.
In this guide, we’ll provide a simplified and clear overview of the taxation of private business operator, also known as sole proprietorship.
If you plan to read the entire text, set aside about 15 minutes. This may seem like a long time, especially when dealing with tax matters.
However, after investing this time, we promise you’ll have a better understanding of the core aspects of sole proprietorship taxation.
- A nutshell view on sole proprietorship taxation
- Sole proprietorship “salary” and its impact on taxable income
- Sole proprietorship prepayment tax – what does it mean?
- The importance and payment of Value Added Tax (VAT) in brief
- Tax deductions for a sole proprietorship – what expenses can be deducted?
- What does entrepreneur deduction mean?
Private business operator’s (sole proprietorship) taxation in a nutshell
When you’re a sole proprietor, the taxes that mostly concern you are income tax and VAT. Income tax, as the name suggests, is taxed on the profit of the sole proprietorship.
To start with the basics, it’s important to understand that the profit and revenue of a sole proprietorship are two different things. Revenue means all the money you invoice for your sole proprietorship during the financial year, minus the VAT. When you subtract your business expenses from the revenue, you get the profit.
For a simplified example: Yrjo Entrepreneur sets up a sole proprietorship and bills his customers €30,000 + 24% VAT, totaling €37,200. €30,000 is Yrjo’s revenue, and €7,200 is VAT, which Yrjo (or his accountant) should forward to the tax authority.
Imagine that Yrjo made purchases for his business during the financial year, totaling €10,000 + 24% VAT or €12,400 in all. Yrjo can deduct the VAT of €2,400 included in the purchases from the VAT he has to remit, leaving €4,800 to be forwarded.
What about the profit? It’s calculated by deducting the €10,000 of expenses from the €30,000 revenue. Therefore, Yrjo’s profit is €20,000.
Had Yrjo been in business longer, he might have had losses from previous years to deduct. However, there were none in this case.
Next, the tax authority kindly deducts a 5% entrepreneur deduction from Yrjo’s taxable profit. Thanks to this, Yrjo’s tax is based on a slightly reduced sum.
The entrepreneur deduction is a tax relief for small business owners. In this case, it amounts to 0.05 x €20,000 = €1,000. After the entrepreneur deduction, the taxable profit is €19,000.
How is the profit of a sole proprietorship taxed?
As mentioned earlier, the most significant taxes for sole proprietors are typically income tax and VAT.
We use the phrase “typically” because up to 20% of the sole proprietorship’s net assets from the previous year can be taxed as capital income. In the first year, the net assets are calculated based on the end of the financial year.
Net assets = business assets – debts + 30% of wages paid to employees. If there are no employees, you can ignore the last part. Business assets can mean machinery, owned business premises, or inventory. Bank balances are not included in net assets.
As a sole proprietor, you can request on your tax return form that the portion taxable as capital income be set at 10% or 0%. If set at 0%, the sole proprietorship’s income would be fully taxed as earned income.
This is often beneficial if the business profit is low and the entrepreneur has no other earned income, e.g., from a salary.
This is because the capital income tax rate is a flat 30% for capital incomes below €30,000. Earned income tax, on the other hand, is progressive; as income increases, so does the tax rate.
Especially for new sole proprietors, it’s often more beneficial to demand that all income be taxed as earned income since the benefits of capital income taxation become apparent only when both income and net assets grow. With low incomes, the earned income tax rate remains low.
Let’s take another example: suppose the sole proprietorship’s profit is €20,000 and net assets are €5,000. In this case, €1,000 (0.20 x €5,000) of the €20,000 could be taxed as capital income. The remaining €19,000 would be taxed as earned income.
When you get an accountant, they’ll be able to advise on the most tax-efficient approach for your specific situation.
How do other possible incomes affect the taxation of a sole proprietorship?
Remember at this point that a sole proprietor is taxed based on all their earned and capital income. In addition to your business, your other incomes – such as wages from your main job – affect your taxation.
So if you earn, for example, 40,000 euros a year in salaried work and make an additional 10,000 euros on the side with your sole proprietorship, these incomes are combined for tax purposes. This means that in this case, a relatively large portion of the 10,000 euros you earned with your sole proprietorship goes to taxes.
As a part-time entrepreneur, you can also estimate your sole proprietorship income on your tax card and pay taxes this way. So, in practice, you estimate the income of your sole proprietorship, add this amount to your main job’s salary, and put that figure on your tax card.
Otherwise, you pay tax in advance on your sole proprietorship’s income as prepayments.
What is a prepayment? We’ll return to that soon, but let’s briefly go through the concept of “sole proprietorship salary” and its impact on taxable income.
Sole Proprietorship “Salary” and its Impact on Income
All the money you take from your sole proprietorship is instead called private withdrawals. This “salary” of the sole proprietorship, often used colloquially, refers to these private withdrawals.
Private withdrawal simply means you take money from your sole proprietorship account for personal use – it’s not actually a salary. You can make these withdrawals whenever you want, and they aren’t taxed separately.
It’s essential to understand that when you withdraw money from your sole proprietorship account for personal use, it doesn’t reduce the income of your sole proprietorship. The money you take isn’t an expense or cost. Let’s take an illustrative example to clarify:
Let’s pretend you’re a top-notch consultant who, after a long stint, bills a client 30,000 euros plus value-added tax (24% or 7,200 euros) for your sole proprietorship. Your sole proprietorship account now has 37,200 euros, of which 30,000 euros is your earnings and 7,200 euros is value-added tax, which you’ll duly transfer to the state treasury later.
The 30,000 euros has been earned, and to celebrate, you treat yourself. You take the 30,000 euros from your sole proprietorship account for personal use and head off to enjoy a lavish life in Bali, spending every last cent. So, you’ve made a 30,000 euros private withdrawal from your sole proprietorship account and blown it all.
You wisely left the value-added tax portion (7,200€) in your account, so you can pay it off without a hitch. The 30,000 euros private withdrawal for personal use isn’t an expense for your business, so from the taxman’s perspective, you still have that 30,000 euros as your sole proprietorship income, and you need to pay taxes on this amount.
Remember, this was a simplified example, not considering the consultant’s other incomes, nor expenses deducting from the profit (etc.).
I hope you got the basic idea: when you bill clients and then use that money for personal use, always remember to set aside enough euros to pay your taxes.
Next, we’ll go over how to pay these taxes in practice. We’ll first deal with income tax payments, and then move on to value-added tax matters.
Sole Proprietorship Prepayment
The basic principle is that as a sole proprietor, you pay tax based on your business income. We’ve already explained: if you earn something, you naturally have to pay taxes.
Prepayment essentially means that this income-based tax is paid in advance – hence the name prepayment. So, once again: prepayment is the term for the advance income tax.
You might be wondering how you can know the amount of prepayment for a sole proprietorship. After all, when starting your sole proprietorship, how can you be sure of your exact future income?
The answer is that prepayments are made based on estimates.
When you establish your sole proprietorship, you estimate your income for the tax authorities for the first fiscal year. You make prepayments based on this estimated income. So, if you estimate your earnings will be 30,000 euros, you make prepayments accordingly.
Later on, taxation is adjusted according to the real – i.e., actual – situation. If you paid too much in prepayments, you get the excess back as a tax refund. If, on the other hand, you paid too little, you cover the missing taxes by paying additional prepayments..
What happens if I estimate my income incorrectly?
If you overestimate your income, you’ll pay too much in prepayments. In this case, you’re effectively paying tax on money you didn’t earn. You will, of course, get your money back as tax refunds, but this takes time, and during the first year of operation, money might be tight anyway.
If, however, you underestimate your income and end up earning more than anticipated, the prepaid tax amounts will be insufficient.
It’s often challenging to estimate income in advance. If your income estimate seems off, don’t worry – you can always contact the tax authorities and adjust the estimate on the OmaVero service
After applying for prepayments, you can always see the size and due dates of the next payments in the OmaVero service.
When you start your activity, prepayments are made based on your estimated income. As your entrepreneurship continues, the tax authority estimates based on the real incomes of previous years. They assume that your income will remain roughly the same.
If this isn’t the case, you can always rectify the situation.
Estimate the amount of advance tax for your sole proprietorship with the tax rate calculator
With the Tax Administration’s tax rate calculator you can roughly estimate, how much your advance tax will be. At the same time, you can draw conclusions about how many instalments you will have to pay.
- Enter the estimated profit of your sole proprietorship (not turnover but profit) on the second page of the tax rate calculator in the “Income subject to advance tax” section.
- You can see the estimated tax amount on the last page under the “Calculation of taxes and charges” section.
Do not take into account the entrepreneur deduction, as the tax rate calculator calculates it itself. Remember that other possible incomes also affect the amount of tax you will have to pay.
What is a prepayment register?
The prepayment register is crucial when it comes to paying advance taxes for your sole proprietorship. You can register when setting up your sole proprietorship.
Being part of the prepayment register simply means that as an entrepreneur, you take care of paying advance taxes yourself and do not leave the obligation to withhold tax to the payer, i.e., your customer. By being in the register, you show that you are an entrepreneur, not an employee, so no withholding tax needs to be made from the money paid to you.
You can find a detailed description of the prepayment register and its significance behind the previous link.
Value-added tax of a sole proprietorship and its payment
Value-added tax was briefly discussed at the beginning of this guide. However, as is well known, repetition is the mother of learning.
Value-added tax means just that – whenever value increases, you have to pay the state value-added tax. With this tax, it’s easiest to think that it’s not your money at all but belongs to the state.
If you invoice 1000 euros (+ VAT 24%) i.e., 1240 euros to your account, it’s easier to think that the thousand is yours, and 240 euros belong to the state.
At this point, you might notice that you have made purchases for your sole proprietorship that also include value-added tax. For example, if you bought a machine for yourself costing 500 euros (+ VAT 24%) i.e., 620€, you could deduct its value-added tax from the amount you should remit to the state.
So, 240 euros minus 120 euros, resulting in 120 euros. After that, you would remit 120 euros to the state because the value has only increased that much. You had to acquire something to produce that added value, and that is taken into account in your VAT taxation.
The general VAT rate is 24 percent. However, certain services and products benefit from a reduced VAT rate, with figures being 14 or 10 percent. Some activities are also completely exempt from VAT.
VAT is usually paid monthly to the state. Entrepreneurs and companies with a small turnover, however, can apply for a longer reporting period – then you can pay VAT to the state quarterly or annually.
- If your turnover is less than 30,000 euros, you can pay VAT only once a year.
- With a turnover of less than 100,000 euros, you can choose to make payments quarterly if you wish.
You can report and remit VAT in the OmaVero service. Reporting on paper is only possible in special cases. You can handle VAT calculation and payment yourself or delegate it to your accountant.
You can read more about applying for a longer tax period on the Tax Administration’s website.
When is a sole proprietorship liable for VAT?
A sole proprietor must be liable for VAT if the turnover for a 12-month fiscal year exceeds 15,000 euros.
Exceptions are those businesses that are outside the scope of VAT liability. VAT-liable sole proprietors can register in the VAT register immediately upon establishment.
If you don’t join the VAT register, you obviously sell your services or products without the portion of VAT.
Remember that for the first fiscal year, turnover is adjusted to reflect 12 months’ turnover. The 15,000-euro VAT threshold is clearly exceeded, for example, if you set up a sole proprietorship in the middle of the year, and the turnover for your first fiscal year (e.g., 1.7.–31.12.) is 9,000 euros. The first fiscal year can be shorter or longer than 12 months, and then the turnover is adjusted to reflect a year-long period. If your accounting is done on a single-entry basis, the maximum length of the fiscal year is always 12 months.
If you don’t register for VAT, but your turnover exceeds 15,000 euros, you will have to pay VAT retrospectively on all sales for the entire fiscal year.
On the other hand, if you join the register but the turnover is less than 15,000 euros, you can recover the VAT you paid through the VAT threshold reduction. The VAT threshold reduction is a tax relief aimed at small entrepreneurs, which you can apply for with a turnover of less than 30,000 euros. You can read more about this on the Tax Administration’s website.
It is therefore advisable to join the VAT register, especially if you believe that your turnover might exceed the 15,000 euro threshold. Being in the register, you can also deduct the VAT included in your purchases from the VAT included in your sales.
If the VAT included in the purchases is greater than that included in sales, you will receive a VAT refund from the tax authorities. This can happen, for example, in the early stages of operations when you have to make many purchases for your business, but sales are not yet accumulating.
Sole proprietorship tax deductions – what expenses can a sole proprietorship deduct?
In sole proprietorship taxation, you should utilize all the deductible expenses of your business. These expenses reduce the result of your sole proprietorship. When the result decreases, you pay tax on a smaller amount. Consequently, the amount of tax you owe will also be smaller in euros.
To ensure all expenses are accounted for, remember to provide your accountant with every receipt or other proof related to your business expenses. If you handle the accounting for your sole proprietorship yourself, then in this case, you should keep the necessary materials well stored.
Tip: If you have an accountant, you can send receipts to them even with your smartphone. This way, all receipts are likely to be captured and sent immediately, and you won’t lose valuable deductions or waste time looking for lost receipts.
In the best case, the invoice from your accounting firm will also decrease when your accountant does not have to waste time entering receipt data manually or calling for missing proofs.
But back to the expenses: what costs can a sole proprietorship deduct?
Below we have listed the most common expenses for a sole proprietorship. Many of them might be obvious to you, but let’s go through the list anyway.
Tools and office supplies
You surely have plenty of these. There are folders, stacks of paper, and larger equipment like printers and computers. You can immediately deduct purchases likely to last up to three years or if the purchase price is at most 1200 euros – in the latter case, it’s a minor purchase.
Mandatory YEL insurance premiums
You must have YEL insurance if your annual work income exceeds 8261.71 euros and other insurance requirements are met. Remember, YEL income does not mean the same as your actual earnings. You can read more from the previous link.
Software and hosting and domain fees for your website
A domain fee is the annual charge for a .fi or .com extension. You can also deduct hosting costs related to maintaining your website.
Deducting marketing expenses
You can deduct digital advertising costs, newspaper advertisements, agency fees, and so on.
Sole proprietorship phone and internet expenses
You can deduct phone and internet costs for business use. Separating personal and business use might be challenging, but fortunately, you have a good accountant to ask for help.
Sole proprietorship establishment costs
Registering a business with the trade register costs 60 euros electronically. You can also deduct this in the sole proprietorship taxation.
Occasionally you might need to entertain and represent, and you can deduct 50% of these expenses.
Deduction for a sole proprietorship workroom
If you work from your own home, you can either deduct actual costs or use a pre-determined amount by the tax authority. The first option requires more effort but is often more tax-efficient.
Deductibility of work clothes for sole proprietorship
Work clothes are deductible if they are clearly only for work use. A painter probably wouldn’t wear their overalls during leisure. On the other hand, regular everyday and office clothes can’t be called work clothes, so you can’t deduct them.
You can deduct travel expenses related to your business.
Sole proprietorship car expenses in taxation
If over half of your annual kilometers are for personal use, the car is considered personal property. You can either deduct the actual costs arising from the car’s business use or make an additional deduction – deducting an amount corresponding to mileage allowances. Remember that trips between home and your main workplace are not deductible – instead, you can deduct them on your personal tax return.
If over half of the kilometers are for business use, the car is considered business property, and then the car-related expenses (fuel, insurance, etc.) are costs to be recorded in the accounts. You differentiate between private and business drives by keeping a driving journal.
What does entrepreneur deduction mean?
In January 2017, the entrepreneur deduction was introduced, applicable to sole proprietors, as well as general partnerships and limited partnerships. The entrepreneur deduction is five percent of the result, and the tax authority calculates this part for you. The entrepreneur deduction is still in force, although its removal was publicly discussed in 2019.
Example of the entrepreneur deduction: Sole Proprietorship Pekka Perusjamppa’s result is 35,000 euros. The entrepreneur deduction is 5% of the result, so in this case (0.05 x 35,000€) = 1,750€. Therefore, Pekka’s taxable income is not 35,000 euros but 33,250 euros, so Pekka pays taxes on a slightly smaller amount.
The background of the entrepreneur deduction dates back to 2014 when the corporate tax paid by limited companies dropped from 24.5% to 20%. Afterward, sole proprietors and personal firms wanted the same benefits, and eventually, the entrepreneur deduction was introduced in early 2017.
Summary of sole proprietorship taxation
When you become a sole proprietor, the most relevant taxes for you are typically income tax and VAT. You pay income tax in advance, referred to as prepayment. The amount of prepayment is based on your estimated business result when establishing your sole proprietorship.
If your business has accumulated assets, capital gains tax also applies to you. However, on your tax return, you can request that the portion taxed as capital gains be reduced to zero, and very often the income of new sole proprietors is taxed entirely as income. We have detailed all these matters above.
If you believe you can’t handle taxation matters alone, get an accountant from the start.
Remember, even if you outsource your accounting to an accounting firm, you still need to be aware of the practices related to sole proprietorship taxation and accounting. All business is easier when you master the basics of these matters.