During this time of the year, we get a lot of questions from sole proprietors as to whether they should change the way they are taxed and whether they should look at becoming an s-corporation. And when I say sole proprietors it can be any type of entity that files their business taxes on their individual return. This would include single-member limited liability companies. So that is what I want to talk about today.
What is the difference between a sole proprietor and a single-member LLC?
- In the eyes of the IRS, there is no difference as they consider both these entity types to be disregarded entities.
- This means that all the income and expenses from the business are in the same pot as the owner’s wages, interest, dividends, etc.
- From a legal point of view, the LLC gives you an extra layer of protection not afforded to sole proprietors.
How is the net income from these businesses taxed?
- They are subject to income tax and self-employment tax which is essentially Social Security and Medicare x2.
- As an employee, you pay SS and Medicare tax. Your employer also pays this on your behalf.
- But when you own your business, you are essentially the employer and employee, so you pay both shares.
How much is the self-employment tax?
- 15.3% up to the first $147,000 and 2.9% after that.
- So the SE tax on $100,000 of income is $15,300 plus your normal income tax.
- So as you can probably tell, people are looking for ways to reduce this amount.
Is that where s-corporations come in?
- Yes, this is exactly when they come into the conversation.
- As a sole proprietor, you do not pay yourself a wage, so all your income is subject to the SE tax as we just talked about.
- But as an s-corporation, you only pay the “SE Tax” on any wages paid to yourself.
Can you give us an example?
- Using an example of $100,000 of income, your self-employment tax would be $15,300.
- But if you were a corporation and paid yourself a salary of $75,000 you would only pay the “SE Tax” of $11,475 or a savings of about $3,800.
- The income tax paid under either entity would remain the same, so the savings is only from the SE Tax.
So why don’t all businesses become s-corporations?
- Complexity mostly
- Need to file a separate return
- Need to do payroll including filing quarterly reports and year-end W-2
- The savings in many instances is eaten up by administrative costs which is why $100,000 of net income is usually the time to look into this entity change
Be sure to talk to a tax professional if you have any questions about S-Corporations.
As a partner, I have thorough experience providing tax services to individuals, privately held businesses, nonprofit entities and estates and trusts. I also provide compilation and review services.
