Tax Planning for Sole Proprietorships With Tax Planning Software

The first article in our Deep Dive into Entity Selection series focuses on sole proprietorships.

A sole proprietorship is an unincorporated business run by a single individual where both state law and the IRS view a proprietor and their business as one entity. This means that the individual can claim the business’s revenues but is also liable for its tax, legal, and financial obligations.

A sole proprietorship is the simplest structure a business can take, and most tax experts agree that sole proprietorships have the simplest taxes. But being a good mentor for your clients extends well beyond preparing a tax form. While Schedule Cs are simple two-page forms, getting the information on those forms may take a bit of strategizing. You can use tax planning software to examine all available strategies to decrease your taxes owed. This article will help you select the approach that best fits your needs and goals.

To help you as best you can, let’s review sole proprietorships from the ground up.

Formation

To establish a sole proprietorship, an individual must simply begin operating their business. They can operate under their own name or they can select a fictitious name for their business, but regardless how they are named, they need not take any legal action to form an entity. While you may need to apply for licenses or permits, there is no requirement to register a sole proprietorship with the state as a separate entity.

You may even have a sole proprietorship without realizing it. In recent years, the unemployed and underemployed have increasingly looked to the gig economy for work. Freelancers, temporary workers, contractors, and gig workers may choose to operate under an LLC, but most simply begin doing the work and think about their taxes later. For example, if you chose to supplement your income by providing some sort of service – consulting others in their field, submitting expert content to publications, or creating an online course – your side business could qualify as a sole proprietorship.

Liability

Sole proprietorships are simple to form, but this simplicity comes at a cost: sole proprietors have unlimited personal liability for their business. Because there is no legal distinction between the proprietor and the business, creditors can seek debt collection from both the business’s assets and the owner’s personal assets.

If you hire employees into their business, they may also be subject to vicarious liability. This means that the proprietor may be personally liable for the actions of their employees. If the employee was acting within the scope of their employment and they cause harm, damage, or break the law in some way, the owner may need to pay those fines from their own pocket. Business insurance can help alleviate some of this liability, but once insurance proceeds are tapped, the law permits the creditors or plaintiffs to go after the business owners themselves.

Taxes

Most sole proprietors report their earnings on a Schedule C. While earnings from some side hustles can be reported directly on Line 8 of the tax return as Other Income, you will likely save money if you report your business activity on Schedule C. Doing so will allow your to deduct legitimate business expenses like office supplies, equipment purchases, and travel costs from your earnings. A tax planning software like the one Corvee offers can show just how much of an impact these deductions can make on your overall tax liability.

In addition to income tax, sole proprietors should be concerned with self-employment tax. Self-employment tax is an additional 15.3% tax on the earnings of a self-employed individual: 12.4% for Social Security and 2.9% for Medicare. Though half of this tax is deductible, the additional tax will surprise some business owners come tax time.

Sole proprietors are required to pay their Federal and state income tax liabilities in four quarterly installments throughout the year. Federal estimated tax payments are due April 15^th, June 15^th, September 15^th, and January 15^th of the following year. A good tax software will estimate your tax liability and help you prepare those payment vouchers. Those who pay their estimates late or do not make the appropriate payment will be subject to underpayment penalties and interest.

If you have employees, you will also need to think about payroll taxes.You may need to file some (or all) of the following payroll tax forms:

• Form W-2, Wage and Tax Statement
• Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return
• Form 941, Employer’s Quarterly Federal Tax Return
• Form 944, Employer’s Annual Federal Tax Return

If you have employees, you should consider forming an LLC for your business. Doing so would limit your legal liability, and unless you make an election to be taxed as a corporation, they can keep their taxes simple by continuing to report their business activities on Schedule C.

Advantages

Sole proprietorships have many advantages over other business forms.

They are easy to form.

Your don’t need to do anything to establish a sole proprietorship other than commence operations. This will save you money on administrative charges and legal fees.

Their taxes are simple.

Schedule Cs are generally simpler to prepare than Forms 1120 (C corporations), 1120-S (S corporations), or 1065 (partnerships).

The owner has full control over the business.

Having unrestricted operating freedom may be desirable for you.

They allow for straightforward banking.

Because the business is disregarded for legal and tax purposes, the business owner will not be punished for commingling business and personal funds. A separate bank account may still be advisable, but there will be less focus on your banking practices should they be audited.

They are often a good starting point for a small business.

Sole proprietorships are a good starting point for individuals who want to get a business up and running quickly and effortlessly.

Disadvantages

Sole proprietorships also have a few disadvantages compared to other business entities.

It can be difficult to raise money.

As a single owner, sole proprietors must contribute funds to get the business operational, or they must personally underwrite a small business loan. They cannot accept equity investment from others.

The owner is subject to unlimited liability.

A lawsuit can bankrupt both the business and the proprietor.

The business owner is the only responsible party.

Many individuals find it stressful to be the only person responsible for the success or failure of a business.

Health insurance can be costly.

Sole proprietors will likely have higher insurance costs than larger businesses because they lack purchasing power in the healthcare marketplace.

There is no business continuity.

The business itself retains no value. When the owner passes away, the business is dissolved.

Next steps

Many individuals operate sole proprietorships in perpetuity and have no desire to establish a separate business entity. But if you are concerned about liability, you may want to establish an LLC. Transitioning from a sole proprietorship into a single-member LLC will protect your personal assets, but you can continue to report your business activities on Schedule C (unless you make an election otherwise).

Entity selection is never a straightforward process, and even taxpayers who have had successful businesses for years may be operating under an entity type that isn’t serving them. That’s why a tax planning software like Corvee’s is so helpful. Our software will state plainly what your tax liability would be if you changed tax entities. These reports can be a great way to save you and your business money.