New business owners – and especially Sole Proprietors – seek to maximize their business profits and reducing their costs. That’s why deductions can actually help you. Simply put, more deductions equal less taxes due. It is in the best interests of Sole Proprietors to take advantage of these deductions available to them to be able to invest those savings back into the business.
However, filing taxes as a Sole Proprietor isn’t as easy as you might first have thought. That is due to the IRS’ definition of Sole Proprietorships. The IRS requires that Sole Proprietors file their tax returns for their business expenses on their personal income forms.
To understand that, you need to first establish what is a Sole Proprietor so that you can accurately determine your tax obligations to calculate your deductions.
What is a Sole Properietor?
A Sole Proprietor (also commonly referred to as a Sole Trader) is an individual or business entity run and owned by a single person. In this business structure, there is no legal division between the owner and the business. The owner is personally responsible for all legal and tax aspects of this business.
A Sole Proprietor is the easiest of business structures to set up. The best way to manage your deductions as a Sole Proprietor is through meticulous record-keeping. We’d recommend that you separate your personal and business finances by opening business bank accounts. The most common mistake many businesses and Sole Proprietors make is called “commingling your books.”
Making this mistake can lead to costly penalties and fines from the IRS. Commingling your books occurs when the IRS can’t distinguish between expenses that are business-oriented or personal. Remember, as a Sole Proprietor you need to file your business expenses with your personal income taxes. It is the way in which these business and personal expenses and finances in general are classified and deducted that causes many headaches.
For business expenses paid personally, there needs to be a clear plan. When trying to reimburse yourself personally for business expenses, the IRS might consider those reimbursements as fringe benefits and that has a large tax implication.
A fringe benefit can be loosely defined as payments made to persons for the performance of services and when those payments are made it can be considered as compensation for salary or wages. Strictly defining your business expenses and personal expenses – and creating a separate business account – will help you to avoid incurring tax penalties. Also, develop strict bookkeeping habits to avoid this commingling of your books.
Business Expenses Deductible for Sole Proprietors
We know you’re asking yourself right now if startup costs can be considered as deductibles. According to the IRS, those startup expenses are indeed deductible – but only up to $5,000 in your first year of business.
Every dollar and cent saved through tax breaks helps to keep your business afloat. When establishing your startup, we all know there are major expenses such as advertising, travel, and fees associated with professional services such as lawyers, bookkeepers and accounts that can actually be deducted to save you in taxes. To help startups, the IRS in fact regards those startup costs as capital expenses.
The IRS offers Sole Proprietors more tax breaks through a series of specific Sole Proprietor taxes. There are a number of areas from which Sole Proprietors can deduct expenses, and we’ve identified them as home office, medical expenses, education, car, travel, entertainment, retirement savings, depreciating assets, impairment expenses, and business administration expenses. What follows are the business expenses a Sole Proprietor may deduct from their taxes.
1. Home Office
The majority of Sole Proprietors work from home. This is not only a way to cut down on expenses, but it is often not necessary to rent office or shop space for a Sole Proprietor to conduct their business.
To calculate your home office deductions, the IRS offers two ways: The Simplified Method or The Regular Method. Before we get into that, you first need to be aware of what qualifies as a home office: it is the place where you live and the primary site of your business where you regularly conduct your business.
a. The Simplified Method
The Simplified Method is simplified in that it reduces the amount of record-keeping required to show to the IRS. To calculate the amount of deductions you can take, you need to calculate our home office’s size.
The IRS stipulates that that only $5 per square foot (and up to 300 square feet) are considered deductible. Only in some circumstances will mortgage interest and real estate taxes be eligible for deductions too, but for 99 percent of Sole Proprietors this doesn’t apply.
b. The Regular Method
The Regular Method is used to determine the deduction through the costs of each expense associated with your home office. To calculate the amount of the deduction, you need to work up the percentage of your home used by your home office.
Your deduction is based upon this percentage for your deductibles: rent, mortgage interest, insurance, utilities, depreciation of home, maintenance and repair costs.
These expenses are then required to be broken down further as indirect and direct expenses to calculate the deduction. Direct expenses are costs that arise exclusively for the home office and are fully deductible, while indirect expenses can be calculated by the percentage of the space allocated to the home office.
2. Medical Expenses
Tax planning is vitally important to know what you as a Sole Proprietor can and can’t deduct as medical expenses. Medical costs – which rise each year – create one of the most income-draining aspects of personal and business finances.
Sole Proprietors can deduct medical insurance premiums. They are also allowed to deduct the premiums that were paid by them to provide coverage for their spouses, dependents and their children (up to the age of 27). These are all provided by the Self-Employed Health Insurance Deductions law.
Under the provisions of the Self-Employed Health Insurance Deductions law, Sole Proprietors can deduct their medical expenses in two ways. Both of these methods work by reducing your Adjusted Gross Income (AGI) through subtracting your medical costs monthly from your earnings. What this does is it reduces the total amount of income that you are taxed on, thereby offering you a tax break.
The Self-Employed Health Insurance Deductions system works by allowing you deduct what you pay for in medical insurance premiums and medical costs – up to the limit of your business’ profit. Your business’ profit can be quickly calculated and defined as your business’ income after your business expenses have been deducted.
3. Education Expenses
Of course, you’re wanting to improve the quality of your work and your services. Education and training expenses are deductibles for Sole Proprietors, but only if those courses are directly related and relevant to improving your skills in your business. If you’re studying something not aligned with the core of your business, you can’t deduct those expenses from your taxes.
4. Travel and Entertainment Expenses
You’ll be pleased to know as a Sole Proprietor that your travel and mileage expenses are tax deductible. For your car, you need to calculate the percentage of business use it covers and then that percentage will be your tax-deductible amount. As for business mileage – to and from meetings, conferences, and business events, etc – are also tax deductible, but you need to retain the receipts for gas and parking tickets.
Commuting isn’t deductible, so don’t bother arguing for those school run expenses. What’s more, business meals are also 50 percent deductible and so are coffees purchased at coffee shops – but only when they form part of your meetings.
5. Retirement Plans and Savings
As a Sole Proprietor, you will have to create and manage your own retirement plans as you don’t have an employer contributing and controlling one on your behalf. The IRS allows for a 50 percent rebate of your Social Security monthly payments.
Retirement plans are bit more complex, but we have the basics for you to follow right here. The Roth IRA plans are not deductible by the IRS. Instead, they will allow you to deduct in full your traditional IRA plans such as 401(k). Use these tax breaks to shore up your retirement plans.
6. Depreciating Assets
This is a murky area and is difficult to assess, therefore it is recommended to seek the consultation of a tax specialist to help you to set this up.
The depreciation of your home office equipment and home office fixtures are deductible, but it is the calculation of these that is so complicated. In essence, you are prescribed a certain amount for depreciating assets, and these change from year-to-year.
7. Impairment Expenses
Should you have an impairment, your wheelchair and such equipment, used to help you conduct business are deductible on your Sole Proprietorship taxes.
8. Business Administration
A Sole Proprietor may also deduct interest on loans you’re repaying (as well as on credit card fees) and to deduct these you need to list them under your Sole Proprietor taxes. As with other deductible items, you need to file these as part of your personal taxes and itemize these in well-maintained expense records.