Strategies for tax optimization as a sole proprietor

As a sole proprietor, you are the driving force behind your business whether you have a team or not. Scaling your business will come with both financial and tax challenges.  Understanding business tax law from day 1 will put you in a better position to succeed and allow you to keep more of your profits.

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Business tax law can be complicated but we have found business owners that understand the fundamentals can make more strategic and informed decisions.  Too often, small businesses appear to be humming along, only to be hit by the tax freight train.  Understanding and planning will avoid tax headaches and allow you to scale more efficiently. 

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In this article, we will explore tailored strategies and insights to optimize your tax position as you scale your sole proprietorship. 

Understanding the basics of sole proprietorship taxes

A sole proprietorship is the default business structure in the US.  For example, if a child sets up a lemonade stand and begins selling on the weekends, they have created a sole proprietorship. You do not need an LLC to be considered a sole proprietorship.  Simply start selling.  

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Unlike corporations or partnerships, there are no separate legal entities. Setting up a sole proprietorship is easy, requiring no formalities beyond starting the business. However, sole proprietors face unique tax implications which often surprise new business owners.  Sole proprietorships are considered “disregarded” for federal tax purposes.  The business income is reported on their personal tax returns instead of a separate business income tax return.

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The proprietor is subject to ordinary income taxes at their overall income tax rate (taking into account all income in your personal name) and self-employment taxes, consisting of FICA and Medicare. 

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In practice, we have found many new sole proprietors are caught off guard by the tax burden that can be created without active planning or cash flow management.  If you are married, do not forget to take your spouse’s income into account.  For example, if you have a sole proprietorship earning $30,000 and your spouse earns $800,000, unfortunately, the $30,000 is taxed at your overall family income tax rate, which could be as high as 37%. 

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Further, there is a misconception that you can reduce or defer your sole proprietorship tax liability by “keeping the money in the bank”.  This is simply not true as you are taxed on your profit, not your distribution.  As a simple example, if you earn $30,000 and keep $29,000 in your sole proprietorship bank account, you are taxed on all $30,000.

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If your business is profitable, you may be required to pay estimated taxes (both federal and state) each quarter.  Since you are not withholding taxes as a sole proprietor, the IRS will require you to pay in your estimated tax liability (both income and self-employment taxes) each quarter.  Failure to do so may result in “estimated tax penalties” which are tied to IRS interest rates.  If your business is operating at a loss, you will not be liable for quarterly estimated taxes. 

What tax forms are needed for sole proprietors? 

As a sole proprietor, you will need to complete specific forms within your individual income tax return (Form 1040). It should be noted that sole proprietors have some of the highest business audit rates by the IRS.  Why is this?  The IRS knows many sole proprietors may not fully understand tax law and make rudimentary mistakes on their tax returns which are easily detected by IRS computers.

Reporting your business income (or loss):

Schedule C: Profit or Loss from Business (Sole Proprietorship)

‍Schedule C is the default business tax reporting form for sole proprietors.  Schedule C is where you will report your business profit & loss statement and report basic information to the IRS.  Although the form seems very simple on the surface, there can be nuances and complexities to the form. 

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It is important to note that your sole proprietorship may or may not have an IRS EIN.  You can choose to report the business under your personal social security number or apply for a separate EIN with the IRS.  We always recommend clients obtain an EIN which will allow you to open a separate business bank account. 

Schedule SE: Self-Employment Tax

‍Sole proprietors are subject to self-employment tax, which covers Social Security and Medicare contributions. If your sole proprietorship earned more than $400 in a tax year, you are required to file Schedule SE. This form most often catches new business owners off guard.  If you are transitioning from a W2 job, you may not realize that the employer pays 50% of your Social Security and Medicare taxes.

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As a sole proprietor, you are now responsible for both sides of the equation.  You do receive a deduction for 50%, which slightly lowers this burden. 

What tax deductions can sole proprietors claim?

Although small business ownership comes with complexities, it also opens you up to the business side of the tax code.  The US Tax Code strongly favors business owners over employees.  Employees have very few deductions to arrive at their taxable income, while business owners have substantial opportunities to deduct expenses.  Understanding how this “incentive system” works will allow you to keep more of your profits.

1. Ordinary and necessary expenses: Contrary to popular belief, there is not a set list of deductions you can take.  IRC 162 governs business expenses which must be BOTH ordinary and necessary.  With thousands of niches and industries, it would be impossible for the IRS to list every possible deduction.  However, business owners should be prepared to defend every deduction as both ordinary in the industry they operate and a necessary expenditure to better their business.  

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2. Self-employed health insurance: Sole proprietors can deduct the premiums for health insurance covering themselves, their spouse, and dependents. This deduction, found on Schedule 1 of Form 1040, allows them to reduce their taxable income, especially when they are not covered by a group insurance plan.  In addition, sole proprietors are eligible for Section 105, medical expense reimbursement plans if they have any employees, including any family members. 

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3. Business use of a vehicle: If a sole proprietor uses a vehicle for business purposes, they can deduct the associated costs. This deduction can be calculated using either the standard mileage rate method or the actual expense method.  Generally speaking, we recommend that a business owner uses the actual expense method if they have a more expensive vehicle and drive fewer miles.  If you have a cheaper vehicle and drive substantial mileage, the mileage rate will often produce a better return on investment.  The actual method will allow you to depreciate your vehicle so long as it is used 50% or more for business purposes.  

In all cases, the business mileage must be tracked contemporaneously.  The IRS can request your proof of mileage to substantiate your business vs personal mileage upon audit.  

4. Home office deduction: Sole proprietors who operate their business from a home office may qualify for a deduction of a portion of their housing expenses including rent or mortgage interest, taxes, and recurring home expenses.  The deduction takes a ratio of your 100% dedicated business home office space square footage over your total home square footage multiplied by your expenses.  Alternatively, you can elect a simplified deduction at $5 per square foot (up to a cap).  

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5. Qualified Business Income Deduction (QBI): Introduced under the Tax Cuts and Jobs Act of 2017, the QBI deduction allows eligible sole proprietors (and other pass-through business owners) to “take a haircut off the top”.  In its simplest form, the QBI deductions allows businesses to deduct 20% of their net income, so they are only taxed on 80% of their profits.  However, there are multiple exceptions and complexities to this law, including if you are designated as a “Specified Service Trade or Business” or your income is over certain thresholds. 

In addition to business tax deductions, sole proprietors are also entitled to tax credits, which are more lucrative than deductions.  Credits are often dependent on the industry you operate in but we often see business owners unaware of general business credits that can drastically reduce their tax burdens.  Examples include retirement plan enrollments or match credits, business electrical vehicle credits, research & development credits or even work opportunity tax credits. 

Start with the basics then go to the professionals

Sole proprietors have both challenges and opportunities within the tax code.  By understanding the basics, you will be ahead of the majority of new business owners who are caught off guard.

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As your sole proprietorship grows, it often makes sense to have a conversation with a CPA or tax strategist to determine if a formal entity and tax structure make sense.  Tax strategy has several layers but mastering the basics is always step one.

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Remember, budgeting for income taxes and self-employment taxes throughout the year can reduce stress, avoid estimated tax penalties, and ensure you are not caught off guard when filing your tax return.

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If you run into confusion or headaches, CPAs, Enrolled Agents, and tax professionals are there to help you and your business. 

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The information provided in this article does not constitute accounting, legal or financial advice and is for general informational purposes only. Please contact an accountant, attorney, or financial advisor to obtain advice with respect to your business.

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