The Big Hidden Tax Benefits of Sole Proprietorship

Last Updated: Feb 13, 2014
Wh you start a business you’re faced with the decision of what type of business to form: sole proprietorship, LLC, S-Corp, and others. The most basic business tity, the sole proprietorship, may offer you more tax befits than any other business type. out what they are here.

I once taught a graduate tax class about choosing betwe an LLC and an S corporation. Probably for this reason, frequtly ask me about which tity form they should chose. “Is an S corporation better than an LLC?” they ask. “What about a C corporation?” others query.

Options such as S corporations, C corporations and LLCs can be the right choice in certain cases. But the lowly sole proprietorship-an tity you form automatically merely by starting business-is oft best for tax reasons. And here’s why:

The $500-to-$1000-A-Year Tax Befit: Easy Returns

A sole proprietor reports his or her business profit to tax authorities on simple one- or two-p form called Schedule C. For y sole proprietorships, in fact, all the IRS requires is a crude listing of revue and expses. In comparison, a corporation tax return is at least eight ps in lgth-and the return (typically either an 1120 or 1120S form) can it can be much larger if there’s a bunch of complexity.

Corporate tax returns, by the way, practically force you to use full-blown accounting software such as QuickBooks.

Now, admittedly, the “easy tax return” may seem like a small point. But the extra work and complexity of a corporation return doesn’t just mean more hours. It probably means you’ll need to pay someone like me to do your return. That cost can be anywhere from a few hundred to a several thousand dollars annually in extra costs-costs that are over and above what the return would cost if your business operated as a sole proprietorship.

The $1500-to-$2,000-Per-Kid-Per-Year Tax Befit: Hiring Junior

Here’s another oft-missed tax-saver unique to sole proprietorships. A sole proprietor can hire his or her minor childr and not pay any payroll taxes. Other employees and employees of corporations would trigger payroll taxes-typically of at least 7.65% of ws p.

In addition, the earned income of minor childr typically isn’t subject to federal income taxes if the child earns less than $6,000 a year because of the child’s standard deduction. (In 2014, the standard deduction amount for single taxpayers is $6,200 but the amounts rises each year before of inflation.)

If your minor kids help out in your business and the business is operated as a sole proprietorship, the family tax bill can drops by one to two thousand dollars annually for each child employed.

Here’s how the math works: If you just keep your last $6,000 of sole proprietorship profit, you’ll very likely pay roughly 15% in self-employmt taxes on the profits. So that’s roughly $750 of tax. You’ll probably also pay at least another $750 in income taxes and quite possibly another $1250 in income taxes on the profit you keep yourself.

If you pay your ter that last $6,000 because they’re actually doing work for you-the paymt needs to be reasonable-neither the ter nor the business nor the part will pay any income or employmt taxes. Total tax savings? $1500 to $2000 annually.

The $5,000-a-year Tax Befit: Reimbursemt Arrangemts

One other uniquely powerful tax befit for sole proprietorships exists: reimbursemt arrangemts, or HRAs. A reimbursemt arrangemt (also known as a IRC Section 105(b) plan) is an employer plan to reimburse employees for medical costs, including medical and dtal , deductibles, co-pay amounts, and any other legitimate expse.

Sole proprietors, partners in partnerships, and S corporation shareholder-employees can’t participate in HRAs. But there’s a loophole in the law: A sole proprietor’s spouse can be covered. And that cover can include both the employee and the employee’s family. Ev though the spouse-employee’s family includes the sole proprietor!

What this means is that if your proprietorship employs your spouse, the sole proprietorship can establish an HRA that reimburses all or some huge portion of employee’s family medical costs. The reimbursemt is a business deduction for both income tax and self-employmt tax purposes. That double deductibility oft saves big taxes.

Let’s say that your family pays $9,000 a year for health and another $9,000 for uncovered medical expses. Say a family member has an expsive long-term illness. Or simply that you’ve got ters with big orthodontia bills.

Because you’re self-employed, you would get to use the $9,000 of as a business income tax deduction in most cases anyway. (Self-employed individuals can write off medical if their business is profitable.) However, with an HRA, you’ll also be able to use the $9,000 of as a self-employmt tax deduction. That saves you roughly $1350 annually.

In addition, you’ll be able to fully deduct the other $9,000 of uncovered costs as both an income tax deduction and as a self-employmt tax deduction. This deductibility could easily save you another $1350 in self-employmt taxes and th another $2250 in income taxes. Total savings: $4950 annually.

A quick caution: A HRA needs to be nondiscriminatory, so you would have to provide it to all employees.Furthermore, under the Affordable Care Act, palties for discrimination are extreme. (As much as $36,500 per employee per year! Ouch.)  y sole proprietors, therefore, want to offer a full reimbursemt plan only if family members were the only employees. You should confer with a tax advisor, probably, if you want to set one of these plans up.

Author and tax accountant Steph L. Nelson CPA has writt more than 150 books. Formerly an adjunct tax professor at Gold University’s graduate tax school, Nelson is also the author of QuickBooks for Dummies and authors the Evergreen Small Business blog.