Deductible Expenses in a Sole Proprietorship

By Jeff Franco J.D./M.A./M.B.A.

When you earn income through a sole proprietorship, you report it on a tax return a little differently than an employee reports wages. The Internal Revenue Service still expects to see all business earnings on a 1040, but unlike an employee, you separately report business income on a Schedule C. One of the main benefits of filing a Schedule C is the long list of deductible expenses you can report to reduce the income tax you owe.

Business Expense Overview

As a sole proprietor, you only pay income tax on your net profit, which is equal to total earnings less all allowable deductions for business expenses. To be allowable, each expense must satisfy an “ordinary and necessary” requirement. Essentially, a business expense is ordinary if it’s of the type that other businesses commonly incur. Necessary, however, only requires the expense to be helpful to your business, regardless of whether it’s essential or not. Though certainly not an exhaustive list, some common deductible expenses include rent payments to lease office or retail space, advertising costs, equipment, supplies, salaries you pay to employees and amounts paid to independent contractors.

Timing of Deductions

Not every deductible business expense you incur will be entirely deductible on your next tax return. The tax code has created a separate category of expenses called “capital expenses” that are deducted over a number of years through depreciation. These costs generally relate to the acquisition of business assets that have useful lives beyond one year. Each type of asset will fall under a “class life” that tells you how many years you’ll need to take a depreciation deduction in order to deduct the full cost of an asset. Take, for example, the purchase of a computer, which is classified as a “5-year property” under the tax law. This means you’ll report a depreciation deduction for part of the cost on your next five tax returns. However, you may want to evaluate whether certain expenses qualify for a full deduction under Section 179 of the Internal Revenue Code.

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Home Office Deduction

If you operate a business out of your home, which many sole proprietors do, the IRS allows you to take a home office deduction for some of your housing expenses. To qualify, you must use an area of your home regularly and exclusively for business. In other words, it needs to be your principal place of business, a place where you store inventory or the place where you regularly meet with clients and customers. When you qualify, you can deduct a percentage of your overall housing expenses, such as rent and utilities, based on the ratio of square footage you use for business to the total square footage of your home.

Separating Business from Personal

Since there isn’t a legal separation between you and your business in a sole proprietorship, you’re personally liable for all debts and obligations of the business, which includes the payment of income taxes. For practical purposes, however, you can set up separate bank accounts using an employer identification number, or EIN, instead of your Social Security number.

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