While many businesses have been forced to close due to the COVID-19 pandemic, some entrepreneurs have started new small businesses. Many of these people start out operating as sole proprietors. Here are some tax rules and considerations involved in operating with that entity.
The Pass-Through Deduction
To the extent your business generates qualified business income (QBI), you are eligible to claim the pass-through or QBI deduction, subject to limitations. For tax years through 2025, the deduction can be up to 20 percent of a pass-through entity owner’s QBI. You can take the deduction even if you do not itemize deductions on your tax return and instead claim the standard deduction.
As a sole proprietor, you will file Schedule C with your Form 1040. Your business expenses are deductible against gross income. If you have losses, they will generally be deductible against your other income, subject to special rules related to hobby losses, passive activity losses, and losses in activities in which you were not ‘at risk.’
If you hire employees, you need to get a taxpayer identification number and withhold and pay employment taxes.
For 2021, you pay Social Security on your net self-employment earnings up to $142,800 and Medicare tax on all earnings. An additional 0.9 percent Medicare tax is imposed on self-employment income in excess of $250,000 on joint returns; $125,000 for married taxpayers filing separate returns; and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.
Quarterly Estimated Payments
As a sole proprietor, you generally have to make estimated tax payments. For 2021, these are due on April 15, June 15, September 15, and January 17, 2022.
Home Office Deductions
If you work from a home office, perform management or administrative tasks there, or store product samples or inventory at home, you may be entitled to deduct an allocable portion of some costs of maintaining your home.
Health Insurance Expenses
You can deduct 100 percent of your health insurance costs as a business expense. This means your deduction for medical care insurance will not be subject to the rule that limits medical expense deductions.
Retain complete records of your income and expenses so you can claim all the tax breaks to which you are entitled. Certain expenses, such as automobile, travel, meals, and office-at-home expenses, require special attention because they are subject to special recordkeeping rules or deductibility limits.
Saving for Retirement
Consider establishing a qualified retirement plan. The advantage is that amounts contributed to the plan are deductible at the time of the contribution and are not taken into income until they are withdrawn. A Simplified Employee Pension plan requires less paperwork than many qualified plans. A Savings Incentive Match Plan for Employees plan also is available to sole proprietors and offers tax advantages with fewer restrictions and administrative requirements. If you do not establish a retirement plan, you may still be able to contribute to an individual retirement account.
We Can Help
Contact us if you want additional information about the tax aspects of your new business, or if you have questions about reporting or recordkeeping requirements.