Sole proprietorships are often the default business option for a business owner. These businesses only have one owner, after all. They require no business name. They don’t require their owners to open a separate bank account. They don’t create paperwork.
“[It’s] the easiest and most affordable way to organize a business because there is no separate legal entity created and no other business owners to consider,” says the blog of accounting firm Drucker & Scaccetti in Philadelphia.
Easy? Yes and no.
For instance, sole proprietorship owners have to deal with special tax burdens. They have to estimate and pay quarterly taxes, for instance. They also have to pay a self-employment tax, something that would otherwise be covered by an employer on behalf of an employee, says Jon Ekoniak, managing partner at Bordeaux Wealth Advisors in Menlo Park, Calif.
Also, sole proprietors can’t turn to other owners to shoulder the burdens of taxes, debt and estate planning. And when sole proprietors have no designated successor, their businesses die with them.
Yet these entities also offer their owners tax breaks: They are pass-through entities, so their owners can deduct up to 20% of net business income from their taxes, with some restrictions on income and other factors.
Though income is reported directly with the owner’s personal income tax return in the year it’s earned, with no additional paperwork, sole proprietors’ business income is subject to an additional 15.3% self-employment tax for contributions toward Medicare and Social Security, Drucker & Scaccetti notes.
“Most people understand their personal tax situation from the viewpoint of the employee,” Ekoniak said. “They often lack a deep understanding of the obligations and benefits of the employer. The sole proprietor is the HR, accounting and benefits department all wrapped into one, so it’s difficult to keep up on all of those responsibilities and run a business.”
He noted other areas where sole proprietors can take advantage of tax breaks. “We rarely see [them] taking full advantage of their retirement planning opportunities,” he says, adding that the Simplified Employee Pension (SEP) IRA has been “the go-to retirement plan for sole proprietors for many years due to the low startup and maintenance costs and the [owner’s] ability to contribute 25% of income” up to a maximum of $61,000 for 2022.
The solo 401(k) is also overlooked: It, too, has low startup and maintenance costs but allows owners to make contributions “as both an employee and an employer,” Ekoniak says. The total maximum contribution is the same as the SEP IRA, but “the employee can contribute up to 100% of their income with a maximum of $20,500 to their solo 401(k) as an employee … and then approximately 25% of their income as the employer,” he says.
“When you get into higher levels of income for older employees, a defined benefit plan may allow you to contribute even greater amounts, up to $245,000 for 2022,” Ekoniak says. “There are more reporting requirements and maintenance costs for a defined benefit plan, so it makes the most sense for those with higher income levels. One can also combine a defined benefit plan and a solo 401(k).”
These business operators do need to track and document deductible tax expenses precisely. “When one is working from home, work and personal lives tend to blend,” Ekoniak says. “It’s important to be very diligent in tracking exactly what’s used for the business.”
Sole proprietors are also personally liable for business debts—even their personal assets are on the line when it comes to satisfying claims against their business, something single-member limited liability companies don’t have to worry about.
LLCs (like corporations) can limit that liability, though they may be taxed as sole proprietorships if owned by one individual, according to the IRS. The agency says that the number of sole proprietorship returns showing LLC status has jumped more than 16 times in the past two decades.
The warning to sole proprietors is clear: “Make sure you’re protected from an insurance and liability standpoint,” Ekoniak says.