Tax aspects of self-employment


A growing number of people who have been downsized, and unable to find work,  have ventured into their own business as a sole proprietor. Here are some of the tax aspects of a sole proprietorship.

As a sole proprietor, you will report net income or loss from your business on your personal income tax return. However, there are several important rules that you should be aware of:

(1) For income tax purposes, you will report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses will be deductible against gross income (i.e., “above the line,” and not as itemized deductions subject to the 2%-of-adjusted-gross-income floor or the 3%/80% reduction rules). If you have any losses, the losses will generally be deductible against your other income, subject to special rules relating to hobby losses, passive activity losses and losses in activities in which you weren’t “at risk.”

(2) If you are working from an office in your home, performing management or administrative tasks from a home office, or storing product samples or inventory at home, you may be entitled to deduct an allocable portion of certain of the costs of maintaining your home. And if you have a home office, you may be able to convert nondeductible commuting expenses (of going from your residence to another work location) into deductible transportation expenses.

(3) You are also be required to pay self-employment taxes at a rate of 15.3% on your net earnings from self employment of up to $106,800 for 2009 ($102,000 for 2008), and at a rate of 2.9% on the excess. (The maximum amount will be reduced by any non-self-employment wages you earn.) One-half of your self-employment taxes is deductible as a trade or business expense (that is, as a deduction against gross income, not subject to the limits that apply to itemized deductions).

(4) You will be allowed to deduct 100% of your health insurance costs (due to self-employment) as a trade or business expense.This means your deduction for medical care insurance won’t be limited by the normal 7.5%-of-AGI floor on itemized medical expenses.

(5) Your income won’t be subject to withholding tax. However, you will be required to pay estimated taxes quarterly.

(6) You will have to maintain complete records of your income and expenses.In particular, you should pay attention to recording your expenses in order to be able to take the full amount of the deductions to which you are entitled. Certain types of expenses, such as automobile, travel, entertainment, meals, and home office expenses, are subject to special recordkeeping requirements or limitations on their deductibility and require special attention.

(7) If you hire any employees, you will have to get a taxpayer identification number and will have to withhold and pay over various payroll taxes.

(8) Consider a limited liability company (LLC) which is somewhat of a hybrid entity in that it can be structured to resemble a corporation for owner liability purposes, but still a sole proprietorship federal tax purposes. This duality can provide the owner with the best of both worlds.

(9) Consider establishing a qualified retirement plan.The advantage of a qualified retirement plan is that amounts contributed to the plan are deductible at the time of the contribution, and aren’t taken into income until the amounts are withdrawn. Because of the complexities of ordinary qualified retirement plans, you might consider a simplified employee pension (SEP) plan, which requires less paperwork. Another type of plan available to sole proprietors that offers tax advantages with fewer restrictions and administrative requirements than a qualified plan is a “savings incentive match plan for employees,” i.e., a SIMPLE plan. For those who are looking to max out their contributions to a deductible retirement account, consider a solo 401(k) plan. If you don’t establish a retirement plan, you may still be able to make a contribution to an IRA.

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About Don James, CPA/PFS, CFP
Don is the Tax & Financial Planning partner with Kiplinger & Co., CPAs headquartered in sunny Cleveland, Ohio since 1982. He partners with business owners and families and specializes in goal achievement solutions, tax minimization strategies and serves in the role of gatekeeper of sound financial advice.

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