What Are the Tax Advantages & Disadvantages of a Sole Proprietorship?

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Starting a business is a big endeavor and one of the most important decisions that will be made as a business owner is what type of entity the business should be registered as. Determining the advantages and disadvantages of the entities can be time consuming and it is recommended to seek out the help of a professional. But, the business formation lawyers at Evolution Tax and Legal can break down the basics of owning a sole proprietorship: tax advantages, disadvantages, and how our team can help.

Tax Advantages of a Sole Proprietorship

A sole proprietorship is the simplest and most common structure chosen when starting a business, and it does come with a fair share of tax advantages. As a sole proprietor, you are able to deduct the cost of health insurance for you, your spouse and any dependents. This is a large deduction from taxes, and is often looked at as one of the big benefits of being a sole proprietor. Other business expenses can be deducted as well, although sole proprietors must be careful to keep detailed documentation to prove that the costs deducted were solely for business purposes. 

Many of the tax advantages are in regards to the paperwork: in a sole proprietorship, there are much simpler and straightforward tax requirements and individuals are not required to file for an EIN, employer identification number, with the IRS. Sole proprietors are taxed as a pass-through entity, which means all business gains and losses are reported on the owner’s personal tax return, which prevents the need for complicated business filings along with unique personal filings. An added bonus is that some sole proprietors can take advantage of the 20% deduction available through the Tax Cuts and Jobs Act of 2017, which allows business owners to deduct 20% of a business’ income from their taxes.

Tax Disadvantages of a Sole Proprietorship

As a sole proprietor, you are both an employer and the employee. As such, it is necessary to pay both employee and employer taxes each year. As an employee, typically you pay for only half of Social Security and Medicare portions of your taxes and the employer pays for the other half. But self-employed sole proprietors must pay both portions of these taxes.

Since the line between necessary expenses for a business and general living expenses can blur easily when one is self-employed, the IRS tends to take extreme care when reviewing sole proprietor tax returns. This scrutiny can cause issues if sole proprietors have included any personal expenses as a tax-deduction, or have deducted business expenses without keeping proper documentation that the cost was solely for a business purpose. The need to keep detailed documentation can be seen as a disadvantage for business owners, and the possibility of an audit can make any sole proprietor wary. Many owners of sole proprietorships recommend opening up a bank account that is dedicated solely to the business: using the expenses here to determine costs for the business as opposed to personal costs, as well as keeping receipts for any and all business expenses, will help keep documentation clear and concise, should the time come when this documentation is needed.

How the Business Entity Formation Lawyers at Evolution Tax and Legal Can Help

The team at Evolution Tax and Legal can help you determine which entity to form your business under, and how to complete the process in a way that will work for you and your business. Our team of experts has experience with entity formation and understands the tax advantages and disadvantages that can make a difference in your business’ journey. We have the legal experience and expertise that is important when forming a business. Contact us online to discuss starting your business today.

Sole Proprietorship FAQ

What is a sole proprietorship?

A sole proprietor is an unincorporated business which is owned and run with no distinction between the business and the owner. The owner is entitled to all profits earned by the business, but also incurs any loss and liabilities incurred by the business.

How does a sole proprietorship differ from other entity structures?

Sole proprietors are the cheapest type of entity, when it comes to operational costs. They are also the least complex of the legally recognized business structures. They are exempt from mandatory state registration laws and don’t require formal paperwork. They don’t require a tax filing separate from the owner’s personal filing, and they don’t shield the owner from any incurred liability.

Can a sole proprietor hire employees?

Yes, a sole proprietor can hire employees as long as they registered an EIN (employer identification number) with the IRS. If the sole proprietor is not hiring employees, they can use their social security number in place of the EIN.

Can a sole proprietorship change to an LLC?

It is possible for a sole proprietorship to change to an LLC (Limited Liability Corporation). In order to do so, the owner must file articles of organization with the secretary of state in the state the business operates in. They must also refile your DBA (Doing Business As certificate) to maintain the trade name and apply for a new EIN with the IRS. The owner should also contact the city or county and inform the proper officials that the business is now operating as an LLC.

Can a sole proprietorship convert to a different business structure and continue to use licenses earned when the business was a sole proprietorship?

It is likely that any licenses or permits that were issued to a sole proprietor will be void if the business changes to another business structure, such as an LLC. The best way to determine for sure if the licenses or permits are void is to contact legal counsel of the issuing party.

Can a sole proprietorship use the word “company” in the name?

No, when registering the trade name a sole proprietorship cannot use the name “company” or any abbreviation of the word to represent their business. They can also not use the words incorporation, corporation, limited liability corporation, limited, limited liability company, limited liability partnership or any abbreviation of the aforementioned words in the trade name.