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Starting a business as Sole Proprietorship: from the business and tax point of views

Updated: Dec 7, 2021

According to the IRS’s record, a sole proprietorship is the most common form of business organization in the U.S. and included over 23 million people. The sole proprietorship represents 73% of all businesses in the U.S today.

The sole proprietorship is a popular business form due to its simplicity, ease of setup, and nominal cost. A sole proprietor need only register his or her name and secure local licenses, and the sole proprietor is ready for business. However, the biggest disadvantage of the sole proprietorship is that the owner personal legal and financial situation and the business financial and legal situations are the same. In other words, business bankruptcy would affect your finances. It also means that any lawsuits against the business can affect you as an individual, or your family.

The sole proprietor’s income from the business is treated as personal income. Therefore, the sole proprietor can declare this income as part of Schedule C, Profit and Loss from a Business or Profession, with a standard 1040 Federal Individual Income tax return.

We will discuss more sole proprietors from the tax prospect, and I would like to share my experience of working with a successful sole proprietor.

Sole Proprietorship’s Taxable Income

As a sole proprietorship, you only need to pay income tax on the net profit from the business, which is gross profit minus all expenses. For you to file your first sole proprietorship (Schedule C) on your 1040, you need to have an accurate profit & loss statement to show what is your exact income and expense during the tax year.

Special Tax Deductions for Sole Proprietors

Health Insurance Deduction

One of the main tax advantages of running a sole proprietorship is that you can deduct the cost of health insurance for yourself, your spouse and any dependents. If you own a sole proprietorship, your health insurance premiums are an “above the line” deduction, meaning you can deduct it one of the common business expenses from your profit. However, your deduction is limited by the amount of your taxable income, so if you take a loss on your business, you can't also take the health insurance deduction. You also can't take a deduction for any months that you or your spouse are eligible for group health insurance with an employer.

Business Mileage

Although the business mileage deduction isn’t limited to a sole proprietorship, sole proprietors often tend to overlook this deduction. In 2018, sole proprietors can deduct 54.5 cents per mile, the business mileage deduct can make a sizeable impact on your tax liability. For instance, you own a company of event planning, and you always have to drive from state to state for a client meeting, so you should keep the record of your business mileage, so you can deduct the business mileage expense from your business profit.

Home Office Deduction

If you run your business out of your home, though, you are entitled to this deduction, and it can have a significant impact on your tax liability. You can only deduct expenses for the percentage of your home you use for your business, and your home office must be used exclusively for business. Click on the link to learn more about home office deduction in detail.

Self-Employment Tax

If you run your own business, you're responsible for self-employment taxes, in addition to regular income tax. For instance, when you are an employee, your employer pays 50% of your social security and medical tax. The other 50% is withheld from your paycheck. As a sole proprietor, you are responsible for 100% of your social security and medical tax. Fortunately, you are allowed to take a tax deduction for half of your self-employment taxes.

Tax form Schedule SE is used to calculate your self-employment tax. Complete your Schedule C first, and then use Schedule SE to calculate the amount you owe for social security and Medicare tax. However, you need to report both the full amount of your self-employment tax due as well as the 50% deduction on your tax return 1040.

Working with a Sole Proprietor

Many people start their business as a sole proprietorship. In my opinion, it is not a wrong decision, and it should always depend on your situation.

I’ve met a talented fashion designer, and she wanted to start her own fashion design business. While she was working as a full-time designer in a fashion corporation, she tried to develop her brand. She didn’t have any client when she reached out to me, and she wanted to start as an S Corporation for her business. However, I wouldn’t recommend her to do it this way, because she doesn’t need the S-Corp at that moment, and the cost to set up and maintain the S-Corp would be higher than what she is budgeted. Therefore, I asked her to start as a freelancer in the form of sole proprietor first, so the business forming process would be simple and cheaper. Once the business is developed into a well-established level, then she can take another step to convert to become an S-Corp or any other business entity.

After a few years, she has worked with another designer as a partner, so they establish a partnership for their business. Their business revenue is increased dramatically, and their client base is far more than the time when she just started her business. Therefore, I highly recommend anyone interested in starting your own business to sell your products or services, to step out of the comfort zone. You can start small and grow bigger in the future. If you have difficulty in managing your finance and plan for your long term business goals, speak to business consulting professional.

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