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Planning for the Sole Proprietor

A brief roadmap to business formation and tax planning tips for the sole proprietor.

Sole Proprietor


Just like any businessperson operating through a closely-held corporation or partnership, the sole proprietor faces many of the same financial challenges, perhaps even more so. The sole proprietor does not have the benefit of a partner to help shoulder the workload in the event of disability or other life events that might prevent the business owner from their duties. Likewise in the event of the proprietor's death, there's no line of succession to continue running the business after its single member dies. The problem of the sole proprietor lies in their vulnerability, in other words, the fact that everything they've built up can be undone in short order.


Business Entity Selection


The first thing a sole proprietor should evaluate is their business's entity type. Perhaps you're starting a new business from scratch, or maybe you've operated your business as a side-hustle in conjunction with working a full-time job. Whatever the case may be, you should consider filing letters of organization with your state as a Limited Liability Company (LLC). While this will not save you money from a tax perspective or solve your succession problem, you will address any liability concerns you'd otherwise have if you were operating simply as a sole proprietor. As a single-member LLC, you would file Schedule C Profit & Loss from Business on your 1040 Individual Income Tax Return. In doing so, you're eligible for the 20% Qualified Business Deduction provided you do not exceed certain income thresholds.


Electing S-Corporation Status


Single-member LLC's pay Self-Employment Tax (SE Tax) on net profits recognized in a given tax year. Self-Employment tax is a 15% tax paid by sole proprietors, single-member LLCs, and partnerships in lieu of paying federal payroll taxes. This can become a costly burden for business owners who begin to enjoy significant profits. One can lessen this burden by electing S-corporation status. Taxed similarly to a partnership, income and deductions "pass through" to the owner(s) of the business on Schedule K-1, which gets reported on the respective owner's individual tax return. To elect S-Corp status, individuals must file Form 2553 with the IRS. Net profits from an S-Corp are not subject to SE tax, however, the business owner must pay themselves a reasonable salary, as well as file quarterly federal and state payroll tax returns. So while you're required to pay some payroll tax, you still can reap significant savings that you otherwise would not have if 100% of your profits were hit with SE tax.


Retirement Plan


If you're not motivated to make a change in the form of doing business, the next area that should be addressed is to establish a retirement plan. A qualified retirement plan can serve to shelter your retirement savings from income taxes. Sole proprietors and other self-employed individuals can enjoy essentially the same qualified plan benefits as corporate employees. The proprietor can contribute in

2022 the lesser of $61,000 or 100% of compensation to a defined contribution Keogh plan, a SEP-IRA, or a single participant 401k plan (Solo 401K). The sole proprietor should be wary when selecting a retirement plan if they have employees. In this case, a SIMPLE IRA might be a good option as well.


Under IRC Section 219(g)(3), participation in a qualified plan will deny the sole proprietor deductions for IRA contributions if his or her adjusted gross income (AGI) exceeds certain limits. For 2022, if an individual who files a single or head-of-household return is covered by a qualified retirement plan, his or her IRA deduction begins to phase out when AGI reaches $68,000 and is completely eliminated once income reaches $78,000. For 2022, the phase-out begins for a married individual who is covered by a qualified plan when income reaches $109,000 on a joint return and is complete when income reaches $129,000.


The phase-out range is higher for a married individual who is not covered by a qualified plan, but whose spouse is covered. The IRA contribution deduction opportunity for a married individual not covered by a qualified plan phases out if the AGI ranges from $204,000 and $214,000 on the couple’s joint return for 2022. If the AGI on the joint return exceeds $214,000, there is no IRA contribution deduction allowed. For married individuals filing separately, the phase-out range is $0 to $10,000.


If AGI is above the phase-out range for IRA deductions, the sole proprietor can still make nondeductible IRA contributions. In this event, their contributions can then be rolled into a Roth IRA.


Insurance Needs


The possibility of disability remains a real concern for the sole proprietor. This concern is especially exacerbated for businesses concentrating in personal services. When the business owner is disabled, the business can no longer render services to its customers. Outstanding accounts receivable may be able to keep the business afloat for a period of time, however, the business is likely to fail if the owner is unable to resume working in a timely manner. The business owner should consider carrying disability insurance and even some amount of business interruption insurance. The proceeds for this type of insurance are taxable, however, the premiums paid are tax-deductible. Disability insurance proceeds are tax-exempt but premiums are non-deductible. As and aside, life insurance should be considered as a means of covering the loss of value in the business if the owner dies.


Conclusion


There are a number of considerations that the sole proprietor faces when operating a business. It's a good idea for the sole proprietor to consult an attorney when forming a business, and also when making estate planning considerations to make sure their business and its assets go to those who they intend it to go to. In addition, the sole proprietor should consult with a CPA for guidance on entity selection, tax strategies, and the need for any accounting services. Finally, consulting with a financial planner would be prudent before setting up your company's retirement plan. For more insights, subscribe to our newsletter, and feel free to contact us with any questions or about booking a consultation.







IMPORTANT DISCLOSURES AVL CPA Firm, LLC. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.




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