Determining what type of entity to class your business as is a key moment in starting your self-employment journey. For many small businesses, the obvious choice is the sole proprietorship. Small, and with limited paperwork, the sole proprietorship is often considered the easiest option.
But for long term thinkers, it’s worth considering how might a sole proprietorship have a possible tax advantage? As a pass-through entity, sole proprietorship offers easier taxes and a few potential savings. But for growing businesses, these benefits can be limited. Learn more about sole proprietorship and how it affects your taxes with our guide.
How Might A Sole Proprietorship Have A Possible Tax Advantage?
Under a sole proprietorship, a business owner and their business are classed as the same entity. This bundling affects the financial handling of the business. When it comes to tax season, profits of a sole proprietorship are classed as personal income, and taxed accordingly. A key element to note is that with a sole proprietorship, your business essentially doesn’t pay taxes.
Instead, you pay taxes on your personal income. There are potential tax advantages to the single entity of the sole proprietorship. For a start, as you can report your business profits as personal income, it’s easier to file your tax returns. Second, your income tax rate can potentially benefit from filing as a sole proprietorship.
Tax Advantages Of Sole Proprietorship Single Entity
One of the major advantages of a sole proprietorship for a small business owner is less to do with savings, and more to do with simplicity. A sole proprietorship is considered a pass-through entity. Any losses and profits pass through the business, to be reported on your own personal tax return.
With a sole proprietorship, you won’t have to file both a personal tax return and a separate business tax return. Instead, you can report profits on Schedule C of your 1040 form as personal income. This can save you time, and, if you work with an accountant, it can potentially save you money.
Although a sole proprietorship can be a simple method for filing taxes, this isn’t always the case. As you’re a single entity, business and personal taxes need to be combined, and figuring out how much you owe can be tricky. The IRS even recommends filing quarterly, rather than annually.
But if the potential simplicity appeals to you, it’s worth noting that an LLC is also a pass-through entity. Registering as an LLC will see you and the business classed as a single entity for tax purposes, and separate entities in legal issues.
Tax Rates And Sole Proprietorship
It’s more than just the simplicity of the sole proprietorship that offers a tax advantage. A sole proprietorship can potentially provide you with a better income tax rate. The federal corporate income tax rate in the U.S. is set at 21%. Personal income is taxed at 12% up to roughly $41,000. Married couples filing jointly are taxed at 12% up to roughly $83,000.
These figures are sourced from the Tax Foundation. What does this mean for your sole proprietorship? Essentially, by filing as a single entity, not a corporation, you can potentially take advantage of a lower tax bracket. If you’re filing a joint return as a married couple, you can pay these lower rates even as your earnings increase.
Of course, you will lose some of these tax advantages as the business expands. However, as your business expands, you may find the confines of the sole proprietorship to be limiting anyway.
Tax Breaks For Pass-Through Entities
The 2017 Tax Cuts and Jobs Act (TCJA) offered pass-through entities, such as the sole proprietorship, a potential 20% tax deduction on income. Not all sole proprietorships qualify for the TCJA tax deduction. The total business income must be below a certain threshold to qualify for the full deduction.
The law also limits which businesses can qualify for the deduction over a certain profit threshold (for example, doctors and lawyers won’t qualify for the deduction if their earnings are too high). These tax deductions also apply to S-corporations, LLCs, and partnerships. However, businesses registered as these entities will have to pass different qualifying criteria.
Sole Proprietorship And Potential Health Insurance Advantages
Another potential tax advantage of the sole proprietorship relates to health insurance. As the owner is considered the same entity as the business under a sole proprietorship, they are responsible for their own medical insurance and payments. This means the sole proprietor is able to deduct 100% of their health insurance premiums. This deduction also covers a spouse, and dependents under 27.
There are caveats to this advantage. If your spouse has health insurance with the option of coverage, then you can’t claim the deduction. Furthermore, the premium must not be higher than the total profits of the sole proprietorship. Related to this, a sole proprietor can potentially deduct half the self-employment tax, as this amount would cover Medicare and your Social Security.
Are The Tax Advantages Of The Sole Proprietorship Worth It?
There are tax advantages to forming your business as a sole proprietorship. For the most part, these advantages are because the owner and business are considered a single entity. As a pass-through business, profits are counted as personal income. Taxes are easier to file, and you might come under a better tax rate.
However, while a sole proprietorship can offer potential tax advantages, these benefits are limited. As your business grows, the tax advantages of the sole proprietorship stop. While establishing businesses can benefit from sole proprietorship, it does limit expansion.
A sole proprietorship is a form of pass-through business. The owner of the business, and the business itself, are considered a single entity. Because of this, profits are filed as personal income.
The major tax advantage of sole proprietorship is simplicity, and as profits are personal income, you can save some money. But as your business grows, many of the tax advantages of sole proprietorship are lost. At this point, you may want to consider changing your structure.
Frequently Asked Questions
Does A Sole Proprietorship Come With Tax Advantages?
Potentially, a sole proprietorship can provide tax advantages. As a pass-through entity, your business taxes are filed as personal income, saving time, and, potentially, money. However, as your business grows, these advantages disappear.
Is It Better To File Taxes As A Partnership Or Sole Proprietorship?
Filing your taxes as a sole proprietorship can save you some money, as your taxes are filed as personal income. However, a sole proprietorship offers you less legal protections than a partnership. There are advantages and disadvantages to both, so think carefully before choosing.
How Does A Sole Proprietor Pay Taxes?
The owner of a sole proprietorship pays business taxes as personal income. These are filed on Schedule C in your 1040 form.
Paul Martinez is the founder of EcomSidekick.com. He is an expert in the areas of finance, real estate, eCommerce, traffic and conversion.
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