A limited liability company (LLC) is one of the most popular business entity forms. An LLC can elect to be treated as a sole proprietorship, a corporation or an S corporation. If no election is made, the default tax status is the sole proprietorship for a single member LLC and partnership for a company with two or more members.
The options for a LLC can be confusing. Tax planning rules are often difficult to follow, but proper adherence is required to ensure the best tax situation. Consider sole proprietorships:
Business tax planning can be one of the more challenging aspects to running a sole proprietorship company. Sole proprietors have to report net income or loss from the business on their personal income tax returns. Following are eight important rules that you, as a sole proprietor, should be aware of for tax planning purposes:
1. You will be allowed to deduct 100% of your health insurance costs as a trade or business expense. Your deduction for medical care insurance won’t be subject to the limitation on your medical expense deduction, which is based on a percentage of your adjusted gross income in other cases.
2. Your residence can save you money on your tax bill. If you work from a home office or store product samples or inventory at home, you may be entitled to deduct a portion of certain costs related to maintaining your home. Also, you may be able to convert nondeductible commuting expenses (of going from your residence to another work location) into deductible transportation expenses.
3. Your income won’t be subject to withholding tax. However, you will be required to pay estimated taxes quarterly. We can work with you to minimize the amount of your estimated tax payments while avoiding any underpayment penalty.
4. For income tax purposes, you will report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether or not you withdraw cash from the business. Your business expenses will be deductible against gross income (i.e., “above the line,” and not as itemized deductions subject to the 2%-of-adjusted-gross-income floor). Losses are deductible against your other income, subject to special rules relating to hobby losses, passive activity losses, and losses in activities in which you weren’t “at risk.”
5. You will be required to pay self-employment taxes. For 2013, you will pay self-employment tax (social security and Medicare) at a 15.3% rate on your net earnings up to $113,700, and Medicare tax at only a 2.9% rate on the excess. An additional 0.9% Medicare tax (for a total of 3.8%) will be imposed on self-employment income in excess of $250,000 for joint returns; $125,000 for married taxpayers filing separate returns; and $200,000 in all other cases.
6. You will have to maintain complete records of your income and expenses. In particular, you should pay attention to record your expenses to be able to take the full amount of your entitled deductions. Certain types of expenses, such as automobile, travel, entertainment, meals, and home office expenses, are subject to special recordkeeping requirements or limitations on their deductibility.
7. If you hire any employees, you will have to withhold and pay over various payroll taxes. Don’t forget this and get stuck with an unexpected tax bill!
8. You should consider establishing a qualified retirement plan. The advantage of a qualified retirement plan is that amounts contributed to the plan are deductible at the time of the contribution, and aren’t considered income until the amounts are withdrawn. Because of the complexities of ordinary qualified retirement plans, you might consider a Simplified Employee Pension (SEP) plan, which requires less paperwork. There is another type of plan available to sole proprietors that offers tax advantages with fewer restrictions and administrative requirements. It is a “savings incentive match plan for employees,” or a SIMPLE plan. If you don’t establish a retirement plan, you may still be able to make a contribution to an IRA.
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Washington DC tax preparation firm Myrick CPA provides clients with professional, personalized tax planning services and guidance in a wide range of financial and accounting needs. Contact us for additional information regarding the tax aspects of sole proprietorships, or if you need assistance in satisfying any of the reporting or recordkeeping requirements.
Note: Originally published on 2014-01-31.