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Tax Planning for Sole Practitioners

Tax Planning for Sole Practitioners

December 02, 2021
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If you’re like millions of Americans, you’ve left the rat race of corporate America to run your own business. Or, you’re still employed by a company and have a lucrative side gig.

Whatever the situation, running your own business as a sole practitioner lets you be your own boss and take charge of your own destiny.

Of course, there are some potential drawbacks. Unless you’re covered by someone else's healthcare plan, you’ll have to pay for your own health insurance. You won’t benefit from company contributions to your retirement plan. And you’ll have to pay your own federal and state taxes if your income exceeds a certain level.

To reduce your tax burden and make sure Uncle Sam doesn’t ding you with penalties for underpaid taxes, it’s important to understand how taxation works when you’re working for yourself.

Understanding self-employment taxes

As a starting point, make sure that you understand (and comply with) your federal tax responsibilities.

Employees generally have federal and state income tax, Social Security taxes, and Medicare taxes withheld from their paychecks. But if you're self-employed, it's likely that no one is withholding these taxes from your income. That means you must pay all of taxes on your own if you have more than a minimal amount of self-employment income.

If you file a Schedule C as a sole proprietor, independent contractor, or statutory employee, the net profit listed on your Schedule C (or Schedule C-EZ) is self-employment income and must be included on Schedule SE, which is filed with your federal Form 1040. Schedule SE is used both to calculate self-employment tax and to report the amount of tax owed.

Make estimated tax payments on time to avoid penalties

If you don’t make any tax payments on income you’ve earned throughout the year, it’s likely that you’ll be hit with a huge tax bill and hefty late-payment penalties if you pay them when you file your tax returns. These late payments may also raise the risk of an audit.

To avoid these risks, you’ll want to make quarterly estimated tax payments on your own (using IRS Form 1040-ES) to cover your federal and state income tax and self-employment tax liability. For more information about estimated taxes, visit the IRS Self Employed Tax Center.

Take full advantage of all business deductions

Because deductions lower your taxable income, you should make sure that your business is taking advantage of any business deductions to which it is entitled.

Almost everything that you spend money on for business purposes may be deducted. This can include: 

  • Office space rentals and home office expenses and utilities
  • Meals for clients and prospects
  • Business-related automobile and travel costs
  • Internet and cell phone charges
  • Costs of office equipment, furniture, office supplies, computer equipment and software
  • Advertising, marketing and website design and hosting costs
  • Depreciation on equipment used for your business such as computers and printers.

It’s critical to keep digital or printed copies of all of these expenses. Why? Because if you’re ever audited, the IRS may ask you to document these expenses. That’s why you may want to keep a log of business-related activities and associated expenses. This is particularly important if you want to deduct vehicle mileage, since you may be asked to document exactly how each mile of road travel was used for business purposes.

Deduct health-care related expenses

If you qualify, you may be able to benefit from the self-employed health insurance deduction, which would enable you to deduct up to 100% of the cost of health insurance that you provide for yourself, your spouse, and your dependents. This deduction is taken on the front of your federal Form 1040 (i.e., "above-the-line") when computing your adjusted gross income, so it's available whether you itemize or not.

Contributions you make to a health savings account (HSA) are also deductible "above-the-line." An HSA is a tax-exempt trust or custodial account you can establish in conjunction with a high-deductible health plan to set aside funds for health-care expenses.

If you withdraw funds to pay for the qualified medical expenses of you, your spouse, or your dependents, the funds are not included in your adjusted gross income. Distributions from an HSA that are not used to pay for qualified medical expenses are included in your adjusted gross income and are subject to an additional 20 percent penalty tax unless an exception applies.

Putting these strategies to work

These are just some of the strategies sole proprietors can use to reduce their self-employed income tax burden. Other strategies include establishing small-business retirement plans that enable you to make tax-deductible contributions far beyond what you can contribute to your own IRA. Meeting with an accountant and a financial advisor can help you figure out how to put any of these strategies to work for you.

 

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.

 

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Dan Flanagan is a financial advisor and Partner located at Canby Financial Advisors, 161 Worcester Road, Framingham, MA 01701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at 508.598.1082 or dflanagan@canbyfinancial.com

 

 

Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2021. Broadridge Investor Communication Solutions, Inc. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances.