A sole proprietorship is a form of unincorporated business that acts as an alter ego of the owner and reports its related business income or losses on the owner's individual income tax return. Like other forms of business, it can claim ordinary and necessary business expenses as tax deductions, including depreciation.
Depreciation is a business expense that reflects the natural reduction in value of physical assets over time. The IRS recognizes this economic reality and permits tax deductions under its rules for depreciation expense, despite the inherent nature of depreciation being a cashless expense. Although various business types are required to file various income tax forms and are not taxed uniformly, the IRS depreciation rules are consistent across the various business forms and tax treatments, ranging from sole proprietorships to corporations.
A sole proprietorship can depreciate business assets, such as vehicles, equipment, computers, furniture and real property, purchased for the business. Sole proprietors, like other business owners, often have a choice regarding how to depreciate an asset. For instance, the tax law allows an immediate Section 179 depreciation deduction for the cost of new or used equipment up to a certain dollar amount. Also, there is a 50 percent first-year bonus depreciation tax deduction for qualifying purchases that can be carried forward to offset future taxable income.
Since depreciation is a paper loss as opposed to a cash outlay, the choices a sole proprietor taxpayer makes regarding depreciation methods and the depreciation calculation can drastically impact the amount of net taxable income and total taxes due. In particular, the 50 percent first-year bonus depreciation tax deduction can result in a net operating loss that can be applied to other sources of income, resulting in a lower overall tax burden for the sole proprietor taxpayer.
Additional Tax Advantages
Sole proprietors who own their own home, have a dedicated home office and choose to take a home office tax deduction may incorporate a portion of the home's depreciation into the home office deduction. This can be an advantageous tax deduction for a sole proprietor, but just as with other deductions, it should be carefully calculated and only claimed when it applies since it has been the subject of abuse by some aggressive taxpayers.