Many start-up businesses move from hobby status to a business when they start to make a profit. The tax entity typically used is a sole proprietorship. Taxes on this business activity type flow through your personal tax return on a Schedule C. Here are some benefits to consider if you’re trying to decide if being a sole proprietor is right for you:
You can hire your kids and decrease your tax bill. As a sole proprietor, you can hire your kids and avoid paying Social Security and Medicare taxes for their work. While there are exceptions, this can generally save your small business over 7.65% on their wages.
Your kids can benefit, too. Any income your kids earn that’s less than $12,950 isn’t taxed at the federal level. So this is a great way to build a tax-free savings account for your children. Remember, though, that their work must reflect actual activity and reasonable pay. So consider hiring your kids to do copying, act as a receptionist, provide office clean up, advertising or other reasonable activities for your business.
Fewer tax forms and filings. As a sole proprietor, your business activity is reported on a Schedule C within your personal Form 1040 tax return. Other business types like an S corporation, C corporation or a partnership must file separate tax returns, which makes tax compliance a lot more complicated.
More control over revenue and expenses. You often have more control over the taxable income of your small business as a sole proprietor. This can provide more flexibility in determining the timing of some of your revenue and business expenses, which can be used as a great tax planning tool.
Hire your spouse. If handled correctly, a spouse hired as an employee can work to your advantage as a sole proprietor. As long as the spouse is truly an employee of the business, the sole proprietor can benefit as a member of their employee’s (spouse’s) family benefits. This can include potential medical expense reimbursements.
Funding a retirement account. You can also reduce your business’s taxable income by placing some of the profits into a retirement account like an IRA. As a sole proprietor, you can readily manage your marginal tax rate by controlling the amount you wish to set aside in this pre-tax retirement account.
It’s not all roses. While there are many benefits of running your business as a sole proprietor, don’t forget the drawbacks. One of the most significant drawbacks is the lack of personal legal protection, which is a feature in other business forms like corporations and Limited Liability Companies. Most sole proprietors address this with proper business insurance, so do not overlook the need to find coverage for yourself.
Please call if you have questions about your sole proprietor business.
Life can alter your taxes with little to no warning. Here are several situations where you may need to schedule a tax planning session:
Getting married or divorced. You could get hit with a Marriage Penalty in certain situations when the total taxes you pay as a married couple is more than what you would pay if you and your partner filed as Single taxpayers. The opposite can also occur, when you benefit from a Marriage Bonus. This often occurs when only one spouse has a job or earns income in other ways such as a business. Another situation when tax planning becomes critical is if you and your future spouse both own homes before getting married.
If you’re going from Married to Single, make the process include tax planning. Under divorce or separation agreements executed after 2018, alimony is no longer deductible by the spouse making payments and isn’t considered taxable income for the spouse receiving payments at the federal level. The opposite is true for divorce or separation agreements executed before 2019 – alimony is generally deductible by the spouse making payments and must be reported as taxable income by the spouse receiving payments.
Child support is also not deductible by the spouse making payments, and isn’t considered taxable income for the spouse receiving payments. In addition, not all assets are taxed the same, so their true value will vary.
Growing a family. Your family’s newest addition(s) also comes with potential tax breaks. You’ll need a Social Security number for your newborn child and to understand the impact this little gem will have on your full-year tax situation. These include breaks to help pay for child care or adoption-related expenses, the child tax credit, and the Earned Income Tax Credit.
Changing jobs or getting a raise. Getting more money at work is a good thing. But it also means a higher tax bill. So you may need to review your tax withholding to ensure there are no surprises at the end of the year. And when leaving an employer, expect a tax hit for severance, accrued vacation, and unemployment income payments.
Another potential tax problem if you get a raise or otherwise earn more money is that you may no longer qualify for certain tax breaks, as most tax deductions and tax credits phase out as your income increases. Consider scheduling a tax planning session to discuss the phase out thresholds that may affect you in 2024.
Buying or selling a house. You can exclude up to $250,000 ($500,000 if married) of capital gains when you sell your home, but only if you meet certain qualifications. A tax planning session can help determine if you meet the qualifications to take advantage of this capital gain tax break, or other home-related tax breaks such as the mortgage interest deduction or credits for installing qualified energy-efficient home improvements.
Saving or paying for college. There are many tax-advantaged ways to save and pay for college, including 529 savings plans, the American Opportunity Tax Credit, and the Lifetime Learning Credit. As you plan your future, understanding how these expenses can be managed often happens long before you begin your college journey.
At the end of the day, when in doubt please reach out. There is no reason to pay more than you need to and a simple tax planning session can make all the difference.
