As a sole proprietor, you are in charge of your own business. You'll face additional taxes and reporting requirements, but you may also be eligible for certain business tax deductions.
The article below is accurate for your 2017 taxes, the one that you file this year by the April 2018 deadline, including a few retroactive changes due to the passing of tax reform. Some tax information below will change for your 2018 taxes, but won’t impact your 2017 taxes. Learn more about tax reform here.
As a sole proprietor, you are in charge of your own business. As far as the tax code is concerned, you and your business are a single entity. While this entails certain freedoms, it also creates added responsibilities. You'll face additional taxes and reporting requirements, but you may also be eligible for certain business tax deductions.
Health insurance deduction
One of the main tax advantages of running a sole proprietorship is that you can deduct the cost of health insurance for yourself, your spouse and any dependents. Better still, you can take this deduction even if you don't itemize deductions on your tax return. The health insurance deduction is an "above-the-line" deduction, meaning it is taken off your gross income before you reach your adjusted gross income. Other deductions, such as itemized deductions, are "below-the-line" deductions.
Your deduction is limited by the amount of your taxable income, so if you take a loss on your business, you can't also take the health insurance deduction. You also can't take a deduction for any months that you or your spouse are eligible for group health insurance with an employer.
Every business has operating expenses, and a sole proprietorship is no different. As long as your expenses are "ordinary and necessary," in the parlance of the Internal Revenue Service, you can claim them on your tax return. In addition to health insurance, common deductions include equipment, charitable contributions, entertainment, travel, capital assets and meals.
If you operate your business out of your home, you can claim the home office deduction. Certain everyday expenses, such as rent and utilities, can be deductible. However, you must use this section of your home exclusively for your business.
If you run your own business, you're responsible for self-employment taxes, in addition to regular income tax. Self-employment taxes are the equivalent of the Social Security and Medicare taxes that all employers and workers have to pay. When you work for an employer, you only pay the employee's portion of these taxes and the employer pays the other half. As a sole proprietor, you have to pay both the employer's and the employee's portions. You are allowed to take a tax deduction for half of your self-employment taxes.
Records and audits
The IRS tends to take a closer look at tax returns filed by sole proprietors because it can be easy to blur the line between business and personal expenses. Even though your business and your personal tax return are combined, the IRS still expects you to keep accurate and distinct business records. If you deduct the full price of a computer, for example, the IRS may want to see records proving that the computer is used for business purposes only.
If your expenses exceed your income, you can expect additional IRS scrutiny, particularly if you haven't turned a profit in at least three of the most recent five years. You shouldn't be afraid to take a deduction you are legitimately entitled to, but be sure to keep detailed records to support your claims, particularly the home office deduction.
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