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Should I Be a Sole Proprietor? (Also: 3 Tax-Saving Ideas!)

Be a sole proprietor or form a business entity?When you decide to start a new business, one of the first questions that comes to mind is:  do I need to form an LLC or Corporation?

There’s no shortage of “advice” out there – some good, some bad!

Creating and maintaining an entity can add significant cost and complexity to your life.

You should carefully evaluate your situation with a qualified advisor before making any decisions in order to fully understand the pros and cons.

There are many factors to consider, not the least of which is legal liability protection offered by certain entity structures.  There are also several tax considerations.

If you’re starting a small business without forming a separate entity, you are a sole proprietor.

Let’s look at the advantages and disadvantages of being a sole proprietor and some tax planning ideas that may help you save tax while you’re building your business.

Advantages

  • Proprietorships are easy to form
  • They are simple to operate
  • You can easily sell the assets of the business
  • There are not many paperwork burdens
  • There are no separate tax filings (you’ll report your activity on your 1040 with Schedule C – Profit or Loss from Business)

Disadvantages

  • Limited sources of capital
  • There is no limited liability
  • There is no business continuity beyond you if you should die or want to sell the business (you can only sell the assets)
  • In addition to income tax, all of your business net income is subject to self-employment tax (currently an additional 13.3%, perhaps soon to revert back to 15.3%)

Is a Sole Proprietorship Right For You?

So you’ve considered the pros and cons, but you’re still not sure what you should do?

Although sole proprietorships often are good for new businesses, as your business grows, forming a business entity might make sense.

Let’s take a more in-depth look at if operating as a sole proprietor is right for you!

Sole Proprietorship May Be Appropriate When:

  • Your business has no employees besides family members (i.e. you only hire independent contractors or family members)
  • Your business is not very risky
  • You can buy adequate insurance to cover your business risk
  • Banks would require you to personally guarantee business debts even if you used a separate business entity
  • You are a new or fairly new business with relatively low profits

Sole Proprietorship May Not Be Appropriate When:

  • The nature of your business exposes you to significant product, environmental or other liabilities
  • Your business will incur substantial debts to creditors, vendors and suppliers
  • You have employees
  • Your employees can create liabilities for you through their actions (think a delivery driver having an accident in your truck)
  • Your business provides advice or acts as an agent for others (e.g. attorney, psychologist, accountant)
  • You are in a hazardous line of work (using heavy equipment or toxic chemicals, for example)
  • You would like to eventually transfer ownership of your business to your kids or employees through gifts or a sale
  • The business may need outside capital to expand (and you’ll need to bring in additional equity partners/owners)

BONUS: 3 Tax Saving Ideas For Sole Proprietors!

You’ve decided to operate as a sole proprietor.  Great!

Once you’re generating some profits, there are a few strategies we can implement to save you money in taxes.

Let’s take a brief look at three ways to save tax as a sole proprietor:

1.  Employ your children in the business.  I discussed this in my last blog post: Employing Your Child In Your Family Business or Farm

    • Children’s wages are not subject to Social Security or Medicare taxes (if they’re under 18)
    • They may be exempt from Federal Unemployment tax (if they’re under 21)
    • Paying wages reduces your net income and self-employment tax
    • The wages must be reasonable for the work performed
    • You’ll have payroll reporting requirements (annual or quarterly 941 tax returns, annual W-2s, etc.)
    • Tip: This works best with older kids that are able to perform more skilled tasks

2.  Rent property from your spouse.

    • Your spouse (or you and your spouse jointly) own property that can be used in your business (like a building or land)
    • Your business can deduct the rent that you pay to your spouse, which reduces your self-employment income
    • The rent income your spouse claims is not subject to self-employment tax
    • Even though your income tax doesn’t change, you’re saving the difference in self-employment taxes
    • Tip: If you own the property jointly, you will only be able to deduct half of the rent you pay

3.  Hire your spouse as an employee.

    • You can get a health plan in your spouse’s name and add yourself as a dependent
    • Your business can reimburse your spouse for all of your medical expenses, tax-free
    • Your business can deduct the medical reimbursements, thus reducing your income and self-employment taxes
    • Tip: The reimbursement plan can cover your entire family, so all of your out-of-pocket medical expenses get paid with pre-tax dollars
    • Tip: The business must provide the medical benefits to all of its qualifying employees.  So this might be too expensive if you’ve got other employees

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