When embarking on a small business endeavor, many entrepreneurs opt to begin as sole proprietors. However, it's crucial to grasp the tax implications associated with this decision. Here are nine key tax considerations a sole proprietor must evaluate.
1. Pass-through Deductions
The 20% pass-through deduction, also known as the Qualified Business Income (QBI) deduction, is a significant provision introduced by the Tax Cuts and Jobs Act (TCJA) in 2017. It allows certain pass-through businesses, such as sole proprietorships, partnerships, S corporations, and some trusts and estates, to deduct up to 20% of their qualified business income from their taxable income. The deduction is taken “below the line,” meaning it reduces taxable income, rather than being taken “above the line” against your gross income. You can claim the pass-through deduction even if you choose to take the standard deduction instead of itemizing deductions. This can be beneficial for those who may not have enough itemized deductions to surpass the standard deduction threshold. Note that this deduction is only available through 2025, unless Congress acts to extend it.
2. Schedule C of Form 1040
Your business's financial outcomes, including both earnings and costs, are documented through Schedule C within Form 1040. Your net earnings are subject to taxation irrespective of whether you withdraw funds from the enterprise. When it comes to expenses, they are subtracted from gross income directly, rather than being categorized as itemized deductions. If your business incurs losses, they can typically be offset against your other income, though there are specific regulations concerning hobby losses, passive activity losses, and losses from ventures in which you didn't have a financial stake.
3. Self-Employment Taxes are Paid by You
For 2024, self-employment tax (Social Security and Medicare) is at a 15.3% rate on your net earnings up to $168,600, and Medicare tax is at a 2.9% rate on the excess. There is an additional 0.9% Medicare tax (for a total of 3.8%) imposed on self-employment income in excess of $250,000 for joint returns, $125,000 for married taxpayers filing separate returns, and $200,000 for all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.
4. Quarterly Estimated Tax Payments
If you operate as a sole proprietor, it's your responsibility to estimate and report your quarterly tax payments. For 2024, these are due April 15, June 17, September 16, and January 15, 2025.
5. 100% of your Health Insurance Costs can be Deducted as Business Expenses
Your deduction for medical care insurance will not be subject to the rule that limits medical expense deductions.
6. Home Office Deductions
If you conduct business activities from a home office, handle management or administrative tasks there, or store product samples or inventory at home, you might qualify to deduct a proportionate share of certain expenses. These expenses can include mortgage interest or rent, insurance, utilities, repairs, maintenance, and depreciation. Additionally, you may be eligible to deduct travel expenses incurred from a home office to another work location.
7. Keep Complete Records of your Income and Expenses
As a sole proprietor, it's crucial to meticulously track your expenses to ensure you claim all eligible tax deductions. Specific expenses like automobile, travel, meals, and home office expenditures require particular attention due to their adherence to special recordkeeping rules or limitations on deductibility.
8. The Responsibilities of Hiring Employees
If you plan to expand your business and hiring employees, you will need to obtain a taxpayer identification number (TIN) and withhold and pay payroll taxes.
9. Establishing a Qualified Retirement Plan
The advantages of establishing a retirement plan are that the amounts contributed to it are deductible at the time of the contributions and aren’t counted towards income until they’re withdrawn. You might consider a SEP plan, which requires minimal paperwork. A SIMPLE plan is also available to sole proprietors and offers tax advantages with fewer restrictions and administrative requirements. If you don’t establish a retirement plan, you may still be able to contribute to an IRA.
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