Advantages And Disadvantages Of A Sole Proprietorship
The main benefits of a sole proprietorship are the pass-through tax advantage mentioned before, the ease of creation, and the low fees of creation and maintenance.
With a sole proprietorship, you do not need to fill out a tremendous amount of paperwork, such as registering with your state. You may need to obtain a license or permit, depending on your state and type of business. But less paperwork allows you to get your business off the ground faster.
The tax process is simpler because you do not need to obtain an employer identification number from the IRS. You can obtain an EIN if you choose to but you can also use your own Social Security number to pay SSN taxes rather than needing an EIN.
In addition, because you are not required to register with your state, you do not need to pay any fees associated with renewing your registration or any other fees associated with the process. This saves you a lot of money, which is important when starting your own business.
With a sole proprietorship, you dont need a business checking account, as other business structures are required to have. You can simply conduct all your finances through your own personal checking account.
There are 32.5 million small businesses in the United States.
Thus, entrepreneurs begin as an entity with unlimited liability. As the business grows, they often transition to a limited liability entity, such as an LLC or LLP, or a corporation .
Deductions To Keep In Mind As A Sole Proprietorship
Tax deductions can go a long way in reducing your overall tax burden, and sole proprietorships are no different. According to the IRS, some credits and deductions available to all types of businesses include items like the Manufacturers Energy Efficient Appliance Credit and the Plug-in Electric Drive Vehicle Credit, among other things.
Other tax deductions that exist for sole proprietorships include health insurance deductions for yourself, your spouse and any dependents in your home. Even if you dont itemize deductions on your tax return, this deduction can still happen as an above-the-line item, according to Intuit. Keep in mind, however, that this deduction is limited by your taxable income.
Business operating expenses found to be ordinary and necessary by the IRS can also be deducted on your tax return. Things like equipment, capital improvements and other reasonable expenses can be considered for potential deduction. Furthermore, if you work out of your home, some home-office costs, including rent and utilities, can be deducted if you have a part of your house dedicated solely to your business.
If your sole proprietorship makes more than $415,000 or $207,500 , then your business is not eligible for the TCJA pass-through tax deduction.
Key takeaway: Save money on your taxes by taking advantage of tax deductions that reduce your tax burden.
Top 9 Tax Deductions And Credits For Sole Proprietors
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Of the 150 million workers in the United States, 16 million or roughly 10% are self-employed. Although self-employed workers do share a few key characteristics, Americas sole proprietors are a diverse group that varies in age, ethnicity, gender and education level.
Many businesses start off as sole proprietors, as they are relatively easy to set up, even for the inexperienced, and they offer individuals the freedom to set their own schedule and work as they want. As an added benefit, sole proprietors are eligible for a host of deductions and credits that individual taxpayers cannot claim.
Here are nine of the most helpful deductions and tax credits for sole proprietors.
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Filing Your Sole Proprietorship Taxes
Your sole proprietorship’s profits are treated as simple income on your personal income tax return, but with a few caveats. First, you will be taxed for the full profits of your business, even if you have not personally withdrawn the money. Second, in addition to a traditional personal income tax statement, you will have to fill out a Schedule C and a Schedule SE which you submit alongside your 1040 income tax return to the IRS.
In a sole proprietorship, you can take business deductions just like with other forms of business. This means that you can deduct things such as operating expenses and advertising, as well as business-related travel and entertainment . Start-up costs, such as buying business equipment, can also typically be deducted.
To take advantage of deductions, however, you will need to keep meticulous records. If you’re going to take a deduction, you should be able to demonstrate to the IRS that it was a legitimate business expense.
Finally, it is smart to keep separate accounts for your personal and business expenses. This will help you maintain clear, business-only records. Just as importantly, this will also demonstrate to the IRS if they ever audit you that you tried to separate your business expenditures from your personal ones.
Publications And Subscriptions Deduction
The cost of specialized magazines, journals, and books directly related to your business is tax deductible as supplies and materials.
A daily newspaper, for example, would not be specific enough to be considered a business expense. A subscription to Nations Restaurant News would be tax deductible if you are a restaurant owner, and Nathan Myhrvolds several-hundred-dollar Modernist Cuisine boxed set would be a legitimate book purchase for a self-employed, high-end personal chef.
Tax Tips For Sole Proprietors
As a sole proprietor, you are in charge of your own business. You’ll face additional taxes and reporting requirements, but you may also be eligible for certain business tax deductions.
As a sole proprietor, you are in charge of your own business. As far as the tax code is concerned, you and your business are a single entity. While this entails certain freedoms, it also creates added responsibilities. You’ll face additional taxes and reporting requirements, but you may also be eligible for certain business tax deductions.
Complete Control As The Business Owner
Sole proprietorships arent just easy to set up, theyre also much easier to run than other businesses. Because its just you, you have complete control over business proceedings. When you have a sole proprietorship, you dont have to worry about things like company officers or registered agents that are included in LLCs or corporations. As the sole owner of your company, you have total control over decisions, finances, and other aspects of how your business functions.
A sole proprietorship allows you to attain a level of privacy and autonomy that is largely unachievable with other business structures. This is namely because the government does not require you to disclose or report information about your business as it does for corporations or LLCs, meaning you are mostly free to run your business as you wish.
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Determining Sole Proprietorship Income Tax Liability
Sole proprietors do not pay taxes on the full amount of the businesss income. Instead, they will only pay sole proprietorship taxes on the profit of the business. This means theyll get taxed on all profits regardless of how much money they withdraw from the business. Therefore, the sole proprietorships taxable income will be close to the net income or net profit number at the bottom of the profit and loss statement, but with a few adjustments.
Like any business, sole proprietors can deduct business expenses on their return however, theyll want to ensure that theyre managing their bookkeeping correctly to report taxable income and any applicable deductions accurately.
A common mistake that sole proprietors make, for example, is recording cash activity, such as owners withdrawals, cash deposits from loans or investments, and debt paymentsas expenses or income on their profit and loss statement when these activities do not impact taxable income. These incorrectly recorded transactions will mess with the total profit calculation and can result in either paying too much or too little on taxes.
Paying too much is obviously a disadvantage because thats money that a new business owner could be using to grow their operations. Paying too little could result in fines from the IRS, definitely not what a small business owner wants.
Discuss The Pros And Cons Of Sole Proprietorships With A Skilled Attorney
Selecting an appropriate business entity is only the first of many important decisions that a business owner must make. Many decisions have important legal and financial implications that you should understand and for which you should prepare. The Weisblatt Law Firm works with all types of companies to provide legal guidance, and we work with you to resolve any issues or questions that may arise. Attorney Andrew Weisblatt has decades of legal experience helping both large and small businesses. To find out more about our Houston business law firm, please email us through our website or call 666-1981.
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Difficult To Take On Additional Debt
Consider this scenario: Your business is growing steadily and things are going great. Theyre going so great that you just received the largest purchase order in your businesss history. Only theres a problem: You cant afford the materials to fulfill this order.
You can apply for a loan or other financing, but operating as a sole proprietorship means you cant secure a loan for the business as a separate entity. Lenders will scrutinize your personal credit score, debts and other financial obligations before approving your application.
If your personal financial situation doesnt meet the lenders standards, you might not be able to obtain financing.
Many More Deductions And Credits Are Available
These are just a few of the most helpful deductions and credits for sole proprietors. A few other common deductions are for internet, interest on business loans, subscriptions and fees, professional services, education and training costs and business insurance. An additional list of small business tax credits can be found here.
These deductions and credits can significantly change a sole proprietors tax liability, so its worth taking the time to explore each option. With Corvees Tax Planning software, you can see how much of a benefit each incentive will give you so you can determine for yourself which ones are worth pursuing.
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How Do Owners Draw Taxes
An owners draw is not taxable on the businesss income. However, a draw is taxable as income on the owners personal tax return. Business owners who take draws typically must pay estimated taxes and self-employment taxes. Some business owners might opt to pay themselves a salary instead of an owners draw.
The Advantages And Disadvantages Of Sole Proprietorship
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Starting a small business can be an intimidating process: You need to come up with a business strategy, solicit customers and manage short- and long-term finances. Plus, sorting through the paperwork, forms and registration steps to legally set up your business can be even more frustrating. If you’re still trying to determine which business entity type is best for you, you might be interested in the advantages of sole proprietorship.
Although this structure won’t be right for every business, there are numerous benefits of sole proprietorship for many entrepreneurs. This type of business entity is easy to set up, is straightforward and requires fewer procedural steps than other entities like corporations. In particular, one-person companies benefit specifically from the advantages of sole proprietorship, especially if their business doesnt require a complex legal or financial setup.
However, there are both advantages and disadvantages of sole proprietorship, so it’s important to know when the benefits are overshadowed by their limitations, particularly with regard to personal liability.
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A Growing Business Needs The Right Business Structure
With so much to consider in building a businessincluding writing a business plan, raising capital, staying inspired, and knowing when to invest full-time in your startup dreamthe ease of sole proprietorship can feel like a relief. You can begin work without formal registration, and there are minimal upfront costs involved in securing your business name and the appropriate licenses.
Yet be sure to do your homework when you begin to take advantage of the ease of launching a sole proprietorship. Eiko Nakazawa, the founder of early childhood education startup Dearest.io, began her company as a side project while she conducted research and small-scale tests over four months. Talk to other founders with similar business models, as well as people in your industry and investors, she told Ideas by WeWork. If you are open about what youre working on and are able to reach out to many people, you should be able to get relevant feedback and advice. Not only are these helpful for you to plan the next steps, but also useful for you to understand potential pitfalls and challenges.
As you grow, however, its essential to be cognizant of the risks associated with sole proprietorships. Be sure to protect yourself and your personal assets in hiring staff or entering into debt, and consider transitioning to an LLC or corporation if the potential toll becomes too high.
For more tips on launching and scaling a startup, check out all our articles on Ideas by WeWork.
No Corporate Business Taxes Or Double Taxation
One of the tax benefits of sole proprietorship is that your business avoids paying taxes on profit .
Because sole proprietorships are directly connected with their owners, business income is earned by and directly passed to the owner. As a result, sole proprietorship taxes are paid as part of your personal income taxes.
Even though you are taxed through your personal tax return, sole proprietors must also file IRS forms Schedule C and Schedule SE. While both are categorized as 1040 formsthe long form for U.S. Individual Income Tax ReturnsSchedule C is a record of your businesss profits and losses from the most recent fiscal year, while Schedule SE is used to determine how much you owe in self-employment taxes.
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When Are Verbal Agreements Not Enforceable
There are some types of contracts which must be in writing.
The Statute of Frauds is a legal statute which states that certain kinds of contracts must be executed in writing and signed by the parties involved. The Statute of Frauds has been adopted in almost all U.S states, and requires a written contract for the following purposes:
- The sale of real estate or vehicles
- Real estate leases lasting longer than one year.
- Property transfer following the death of the owner.
- The case of a party agreeing to pay debt for someone else.
- Any contract that requires more than a year to fulfil.
- A contract involving and exceeding a specified amount of money .
Typically, a court of law won’t enforce an oral agreement in any of these circumstances under the statute. Instead, a written document is required to make the contract enforceable.
Contract law is generally doesn’t favor contracts agreed upon verbally. A verbal agreement is difficult to prove, and can be used by those intent on committing fraud. For that reason, it’s always best to put any agreements in writing and ensure all parties have fully understood and consented to signing.
Sole Proprietors Pay Taxes On Business Income On Their Personal Tax Returns
As a sole proprietor you must report all business income or losses on your personal income tax return the business itself is not taxed separately.
Here’s a brief overview of how to file and pay taxes as a sole proprietor — and an explanation of when incorporating your business can save you tax dollars.
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Llc Sole Proprietorship Or S Corp
A limited liability company, or LLC, is a legal separation of a business from its individual owners. It automatically does what its name implies: it limits an owners personal liability in their business. A business formation service can help you with the filing process. Once you choose and register a unique name with your Secretary of State, designate a registered agent and business address, and file an Articles of Organization form, your LLC is its own legal entity.
Then, your LLC can obtain an employer identification number from the IRS, open business bank accounts and lines of credit and take out insurance policies separate from those you own as an individual.
Creating an LLC for your sole proprietorship helps limit the amount you are personally liable for:
Estimated Tax And The Self
If youve collected any income from your business, youre going to pay taxes on it. Since youre the only person in the business, you wont have an employer to withhold your taxes and send you a W-2 for tax filing purposes. As such, youre going to have to handle this entirely on your own, making sure you save enough money to cover your business and income tax responsibilities.
Generally, youre going to want to estimate how much you will need to pay in taxes and commit to making quarterly tax payments to the IRS based on that estimation. Youll need to check on whether you must make quarterly payments to your state as well, as that requirement varies by state.
Through the use of the IRS 1040-ES form, you can calculate how much your estimated tax liability will be. According to the IRS, youre required to pay an estimated tax if both of the following statements are true:
1. You anticipate owing at least $1,000 in taxes after subtracting your withholding and refundable credits.
2. You expect your withholding and refundable credits to be less than the smaller of:
- 90% of the taxes to be shown on your upcoming tax return, or
- 100% of the taxes shown on your tax return from the previous year, if that return covers all 12 previous months.
Key takeaway: As a sole proprietor, you are required to pay income taxes. You must also pay self-employment taxes which are your Social Security and Medicare contributions that you pay as both employer and employee.
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