Unlock Your Financial Potential; A Guide to Maximizing Deductions for Sole Proprietorships
Article Highlights:
Taxes and Interest
Insurance
Self-Employed Health Insurance Deduction
Supplies, Tools, and Depreciation
Bonus Depreciation and Section 179 Expensing
Entertainment, Meals, and Travel
Vehicle Use
Home Office
Pension Plans
Pension Start-Up Credit
Research Credit
Section 199A deduction
Start-Up Expenses for New Businesses
Self-Employment Tax Deduction
As a sole proprietor, understanding and leveraging the myriad tax deductions and credits available to you is crucial for minimizing your tax liability and maximizing your business's profitability. The tax landscape is ever evolving, and staying informed about the latest changes and opportunities can significantly impact your financial success. This comprehensive guide will delve into various strategies, from taxes, interest, and insurance to more complex areas like depreciation, Section 179 expensing, and various tax credits, providing detailed examples to help you navigate the complexities of tax planning for 2024.
Taxes and Interest - For sole proprietors, the ability to deduct taxes and interest is a fundamental aspect of tax planning. You can deduct various taxes directly attributable to your business operations, including state and local sales taxes on items purchased for business use, real estate taxes on business property, and personal property taxes on business assets.
Interest expenses incurred from business loans or credit used exclusively for business purposes are also deductible. For example, if you take out a loan to purchase new equipment for your business, the interest on that loan is fully deductible. (Limitations on deductible interest apply for 2024 if your average annual gross receipts are more than $30 million for the 3 prior tax years. If so, please contact this office for further information.)Insurance - A range of insurance premiums are deductible for sole proprietors, if they are deemed necessary and ordinary for your business operations. This includes health insurance, liability insurance, property insurance, and auto insurance for vehicles used in your business.
Self-Employed Health Insurance Deduction - The self-employed health insurance deduction is particularly beneficial, allowing you to deduct 100% of your health, dental, and vision premiums for yourself, your spouse, and dependents. Premiums paid on a qualified long-term care insurance contract are also allowed, but for each person covered, the amount is limited based on the person’s age at the end of 2024, as shown here:
§ Age 40 or younger — $470
§ Age 41 to 50 — $880
§ Age 51 to 60 — $1,760
§ Age 61 to 70 — $4,710
§ Age 71 or older — $5,880
This deduction is taken from your adjusted gross income rather than as an itemized deduction, making it more accessible and beneficial and you don’t need itemize your deductions to claim it. For instance, if your annual health policy premium is $6,000, you can reduce your taxable income by the same amount. However, the amount deductible is limited to the net profit of the self-employment business.Supplies, Tools, and Depreciation - Everyday supplies and tools necessary for your business operations are fully deductible in the year they are purchased. However, for larger assets that have a useful life beyond a single year, such as machinery, equipment, and furniture, you must capitalize and depreciate these assets over their useful lives according to IRS guidelines unless they qualify for Bonus Depreciation or Sec 179 expensing, covered next.
Bonus Depreciation and Section 179 Expensing - The benefits of so-called bonus depreciation and Section 179 expensing allow businesses to immediately deduct a larger portion of the purchase price of eligible assets. Bonus depreciation, which allowed 100% deduction for most business assets purchased starting in 2018, is phasing out and for 2024, bonus depreciation is 60% (down from 80% in 2023) for qualified property acquired and placed in service during the year.
The portion of the purchase price not deductible as bonus depreciation is deductible using the regular depreciation calculation. For example, if you purchased equipment for your business in January of 2024 that is assigned a 5-year recovery period and cost $5,000, the depreciation deduction would be $3,400 (($5,000 x 60% = $3,000) + ($5,000 - $3,000 = $2,000 x 20% = $400)). If the bonus depreciation didn’t apply, the depreciation deduction would only be $1,000.
On the other hand, Section 179 expensing allows you to immediately deduct the full purchase price of qualifying equipment up to a limit of $1,220,000 (subject to inflation adjustments), with a total equipment purchase limit of $3,050,000 before the deduction begins to phase out. So, in the example, electing Section 179 expenses would allow the entire $5,000 purchase cost of the equipment to be deducted.
Choosing the method that results in the highest deduction for the year may seem to be the obvious choice, but other factors need to be considered such as the impact on future years’ deductions, whether the asset will continue to be used 100% for business in later years, and other factors.Entertainment, Meals, and Travel - The Tax Cuts and Jobs Act of 2017 made significant changes to the deductibility of entertainment and meals. While entertainment expenses are no longer deductible, business meals remain 50% deductible if they are directly related to or associated with the active conduct of a business. For example, if you spend $200 on a meal with a potential client discussing business, you can deduct $100.
Travel expenses for business are fully deductible. This includes airfare, hotel stays, meals (at 50%) and other transportation costs incurred while traveling away from home for business purposes. For example, if you attend a conference in another city, your flight, hotel, meals, and taxi fares are deductible.
Vehicle Use - Sole proprietors can deduct vehicle expenses using either the standard mileage rate or actual expenses. For 2024, the standard mileage rate is 67 cents per mile. Alternatively, you can deduct actual expenses, including gas, repairs, insurance, and depreciation. Keeping detailed records is crucial for substantiating these deductions, whichever method you use.
Home Office Deduction - To be eligible for the home office deduction, sole proprietors must use a part of their home exclusively and regularly for business activities. This space must be your principal place of business, where you conduct most of your business tasks, or a place where you regularly meet with clients or customers. The IRS emphasizes the importance of the space being used exclusively for business; even minimal personal use can disqualify you from claiming the deduction.
There are two ways to calculate the home office deduction: (1) the simplified method and (2) actual expense method. The simplified option allows a deduction of $5 per square foot of your home used for business, up to a maximum of 300 square feet, capping the deduction at $1,500 for the year. The more traditional approach requires calculating the actual expenses of your home office. This includes a proportionate share of mortgage interest, real property taxes, insurance, utilities, repairs, and depreciation. The deduction is based on the percentage of your home's total square footage used for business.Pension Plans - Contributions to retirement plans, such as SEP IRAs or solo 401(k)s, are deductible. These plans allow for significant contributions, reducing taxable income while saving for retirement. For example, in 2024, the contribution limit for a SEP IRA is up to 25% of compensation (20% of the net business profit) or $69,000, whichever is less. If you have employees, your contributions to their retirement plans are deductible from your business income. However, your contributions to your own plan, while deductible from your adjusted gross income, are not an expense of your self-employment business.
Employee Payroll - Wages paid to employees, including salaries, bonuses, commissions, and certain fringe benefits, are deductible business expenses. This encompasses all forms of compensation given to an employee for services performed, regardless of how the compensation is measured or paid. In addition. employers can also deduct the costs associated with payroll taxes. These taxes include the employer's share of Social Security and Medicare taxes, federal unemployment taxes (FUTA), and state unemployment taxes.
Hiring Your Children – Where they can provide meaning services, hiring your children can be a smart move for both your business and your family. Not only does it provide your children with valuable work experience and instill a strong work ethic, but it also offers significant tax advantages. By employing your children, you can shift income from your higher tax bracket to their lower one, potentially reducing your taxable income and saving on taxes.
Accountant and Bookkeeping Fees - Including those related to tax preparation, payroll services, bookkeeping and other financial management activities, are generally deductible expenses for businesses. These costs are considered necessary and ordinary expenses incurred in the operation of a business.
It's important for business owners to maintain detailed records of these expenses to substantiate their deductions during tax filing. Consulting with a tax professional can provide further insights into how to maximize these deductions while adhering to the IRS guidelines.Pension Start-Up Credit - Where a small employer does not already have a pension plan, there is a tax credit for the costs of establishing a retirement plan, up to $500 per year per eligible employee for the first three years of the plan, maximum $5,000 per year. This can include setup and administrative costs.
Research Credit - The Research and Development (R&D) Tax Credit allows businesses to deduct expenses related to research and development activities. This can include wages, supplies, and contract research expenses. For a sole proprietor developing a new product, the costs associated with design, testing, and prototyping could be eligible for this credit.
Section 199A deduction - The Section 199A deduction is a tax break introduced by the Tax Cuts and Jobs Act at the end of 2017. It allows owners of certain types of businesses including sole proprietorships to deduct up to 20% of their business income from their taxes. Let's say you made $100,000 in profit. With the Section 199A deduction, you might be able to reduce the amount of profit you pay income taxes on by 20%, which in this case would be $20,000. So, instead of paying taxes on the full $100,000, you'd pay taxes on $80,000. Figuring out exactly how much you can deduct can get a bit complicated due to the various rules and exceptions.
Start-Up Expenses for New Businesses - For new businesses, the IRS allows you to deduct up to $5,000 in start-up costs and $5,000 in organizational expenses in your first year of operation, with the remainder amortizable over 15 years. These expenses can include market research, advertising, legal fees, and certain other costs incurred before you officially open your doors.
Self-Employment Tax Deduction – Sole proprietors with more than a minimal amount of profit from their business are required to pay self-employment tax (their contribution to the Social Security and Medicare programs, similar to the payroll taxes of employees). There is a deduction element to this tax. As a self-employed individual you may deduct 50% of your SE tax liability for the tax year. Like the self-employed health insurance deduction, the SE tax deduction is claimed as an above-the-line-deduction in computing adjusted gross income (AGI). You do not need to itemize deductions to claim the deduction.
Inflation and Other Adjustments – The various values used in this article are for 2024. Many of the values change from year to year. Many are adjusted for inflation or for other reasons. Some provisions are set to expire after 2025, unless extended by Congress.
For sole proprietors, the tax code offers numerous opportunities to reduce taxable income through deductions and credits. By carefully planning and documenting your expenses, you can take full advantage of these provisions to significantly lower your tax bill.
Please contact this office to ensure compliance with the latest tax laws and to tailor these strategies to your specific business situation. With the right approach, you can turn tax season from a time of stress into an opportunity for financial optimization.