It’s a warning label that should be emblazoned across the Google results for sole proprietorship:
“ROADBLOCKS IN SELF-EMPLOYMENT MAY BE LARGER THAN THEY APPEAR”
In spite of rumors swirling around the internet, self-employment won’t allow you to:
- Write off the entirety of your extravagant monthly restaurant bill as a business expense
- Deduct the cost of buying your entire friend group season tickets to your favorite NFL team
- Claim all of your ever-rising gasoline bills and airplane tickets as a business expense
- Write off the entirety of your mortgage or rent for a residence that contains your home office
We get it, the entrepreneurial American dream is still alive and well. And that’s not a bad thing.
But the reality is, every new business venture doesn’t end like Microsoft or Amazon. Yes, there are some real benefits and joys to self-employment, but it’s important to remember that there are an equal, or even greater, number of hurdles sole proprietors face as well.
Let’s take a look at some commonly-overlooked pitfalls.
THE DOUBLE PLAY
STRIKE ONE: Payroll Taxes
Self-employed individuals are responsible for paying both the employee and employer portions of payroll tax. That means on paper, self-employed workers are taxed “double” or 7.65% more than those who earn regular W-2 income.
When you were an employee, your employer paid half of your Social Security tax and half of your Medicare tax. You paid the other half of both through withholdings your employer made out of your salary. But now that you’re self-employed, you cover both halves out of your own pocket.
Through self-employment tax, the U.S. Treasury collects Social Security and Medicare taxes on non-wage income from business-related activities. For 2022, the self-employment tax rate is 15.3% on the first $147,000 of net self-employment income.
That 15.3 percent rate includes:
- 12.4 percent for the Social Security tax component of the self-employment tax plus
- 2.9 percent for the Medicare tax component.
Above the $147,000 threshold, the Social Security tax component goes away, but the 2.9 percent Medicare tax continues to grow even more complex. You’ll probably need a finance degree to decode it, so we won’t bore you with the details.
Suffice to say, if your business is doing well, so is the government’s Medicare pot.
STRIKE TWO: Non-Tax Disadvantages
Of course, you’ll also be facing plenty of non-tax disadvantages as a sole proprietor as well. You’ll be paying out-of-pocket for things that were formerly provided by your employer.
That means a new buffet of health insurance, retirement plan contributions, and company car expenses (if you were lucky enough to have one in the first place). It also means no more business trips with elements of personal pleasure, or free meals when you work late at the office.
That’s not to say it’s all bad, though.
THE FLIP SIDE OF THE COIN: Tax Deductions for the Sole Proprietor
Smart Tax deductions are a way for savvy sole proprietors to lower their tax bill. Here are four examples:
Vehicle Tax Savings
If your business requires frequent travel, your work car can provide significant tax advantages if it meets certain requirements. Vehicles that weigh over 6,000 pounds (but less than 14,000) may qualify for a full write-off if placed in service by 12/31/2022.
For example, let’s say you buy a $50,000 van to be used exclusively for business purposes. With this strategy, as long as the weight requirements are met, you could write off the full $50,000 in the first year. You could also write off the insurance premiums paid.
Employing a Child
In Michigan, children from ages 5 to 18 can work in the family business and receive income while giving the business significant tax advantages.
You may be asking yourself, what kind of job could I hire my kid to do? As long as it’s a legitimate task for the business, it typically qualifies. Examples could include cleaning your office space, posing for advertising material, packing orders, or testing products.
When your child gets paid, any compensation under $12,950 can be fully deducted from business revenue to lower the taxable income on the business side. Plus, if they’re paid under $12,950 (the standard deduction in 2022), they would not owe taxes on the money they’ve earned. Keep in mind, that the compensation you pay your child must be reasonable for the work completed. At a 15% tax rate, this would be a savings off your bottom line of $1942.50 per child.
Also read: Good Business – Hiring Your Kids
Travel Expenses
For those who need to travel as part of their business, the IRS gives favorable tax benefits. In general, both domestic and foreign travel is 100% deductible. This would include the cost of getting to and from your destination, as well as meals along the way. As long as the expenses are exclusively for business purposes, they can typically be written off in full.
Renting Your House to Your Business
If you own your primary residence, you may be able to use it for a few days out of the year to earn some tax-free income. Business owners can host meetings or a conference, or a company retreat, and rent out their house to the business for no more than 14 days per year, completely tax-free. You can think of your home as your very own event venue.
A key piece of this strategy is making sure that the rate is reasonable compared to other venues in the area. For example, let’s say the average rental rate ranges between $1,000 and $2,500 a day to rent an entertainment space in your area. If you hold a company retreat or conference at your home, you could rent your house to the business for $1,500/day for up to 14 days out of the year, and that rental income is tax-free and the business can deduct the expense.
Also read: Good Business – The Augusta Tax Rule
THE BOTTOM LINE
If you make good money, your self-employment tax burden can be a massive blow. You’ll also need to include what you owe for self-employment tax with your quarterly estimated federal income tax payments to avoid an IRS underpayment penalty.
There are, however, some low-hanging tax deductions you can take advantage of to reduce your tax bill.
Don’t wait until April of next year to address these strategies, though, or you’ll likely be leaving a lot of money on the table. By planning ahead, you can integrate these strategies, and more, into your business to ultimately help you keep more money in your pocket.
Here at TreMonte, we can help you determine the right strategies and deductions to implement into your business’ tax plan. Reach out to a member of our team today!
Check out these resources for more information:
Good Business: Choosing Your Entity Structure
Good Business: A Tax Guide to Conservation Easements
Best Practices for Small Business Record Keeping