Sole proprietors report income and expenses on Form 1040, Schedule C, and the net earnings are subject to income tax and self-employment taxes. The self-employment tax consists of Social Security (12.4%) taxes up to the annual wage base limit, and Medicare (2.9%) taxes on all self-employment earnings.
Employees of companies are paid wages that are also subject to income tax and payroll taxes (Social Security and Medicare tax), but the cost of the payroll tax is divided equally between the employee and employer.
S corporations are a separate taxable entity that pay wages to working owners, which are subject to income tax and payroll tax. However, the net income of the S corporation, after paying expenses and the owner salary, is only subject to income tax, potentially resulting in lower payroll tax than self-employment tax.
Advantages of an S corporation entity over sole proprietor
- Lower payroll taxes. As demonstrated in the examples below, allocating the earnings of the business between S corporation distributions of income and wages paid to the single shareholder can result in significantly lower payroll taxes over the self-employment taxes incurred as a sole proprietor.
- Employee stimulus benefits. Recent tax legislation favors employees and many benefits are based on wages paid, which makes it difficult or impossible for sole proprietors to qualify. Forgivable paycheck protection loans, employee retention credits, and COVID-19-related unemployment benefits are a few examples of tax stimulus worth thousands of dollars per employee.
- W-2 employee benefit planning. Certain excludable tax benefits are available to employees that may not be available to sole proprietors, including dependent child care reimbursements and some life insurance premiums. In addition, health insurance and retirement contributions, two of the biggest deductions for a sole proprietor, are deducted as adjustments to income after paying self-employment tax on the earnings, which penalizes sole proprietors over an employee of an S corporation (see second example below). Employing a spouse or children can also assist with some tax saving strategies. S corporation wages may help optimize the qualified business income deduction for some taxpayers.
- Business planning. An S corporation is a separate legal entity, and is required to maintain separate accounting records, which many sole proprietors don’t do. Separating business and personal records can help advisors and owners apply more financial rigor to grow revenue and profits, create an emergency cash fund, and apply tax planning strategies.
Risks and considerations
- Payroll reports. Employers that pay wages must file quarterly payroll reports and make payroll deposits that are not required by sole proprietors who don’t pay wages. Payroll regulations can be complex. Consider using an outsourced payroll service such as QuickBooks® Online Payroll that guarantees accurate filings to mitigate risk.
- State taxes. Some states impose a tax on S corporations or S corporation income that may partially offset the payroll tax savings. Research state and local taxes to mitigate risk.
- Sole proprietor strategies. Changing to an S corporation would eliminate the option for certain tax strategies available to sole proprietors. For example, it may be easier to deduct net losses as a sole proprietor or exclude payroll taxes on children employed in the business.
- Audit risk. The IRS may look closer at an S corporation with aggressive strategies. For example, it might trigger an IRS inquiry if the business makes $500,000 in one year, but only designates $20,000 as salary. The guiding principle is that the S corporation must designate a “reasonable” amount of income as wages.
- Additional costs for S corporations. An S corporation has startup, and ongoing legal and accounting costs.
- Distributions based on stock ownership. S corporation distributions of income are based on stock ownership. This strategy compares a sole proprietor changing to a single shareholder owner, but if the S corporation has multiple shareholders, additional planning may be necessary.
- A sole proprietor with no other employees, reporting net income from schedule C of $50,000, would generally pay $7,065 of self-employment tax (50,000 x .9235 x Social Security and Medicare tax rates of 15.3%), plus income tax on the earnings. If the same business was organized as an S corporation, paid the owner shareholder a salary of $20,000, and deducted $1,530 of employer payroll taxes (wages x 7.65% Social Security and Medicare tax rate), the net distributable income would be about $28,470. In this case, the wages and net income are subject to income tax, but the employee and employer FICA taxes on the wages would only be $3,070, resulting in payroll tax savings of $4,005.
- Extending the example above, assume the business had an additional $30,000 of revenue, additional owner expenses of $15,000 for health insurance, and $15,000 for a retirement plan contribution resulting in the same net earnings of $50,000. The sole proprietor would pay an additional $4,239 of self employment tax on the $30,000 of Schedule C earnings, and the health insurance and retirement contribution would be deducted as an adjustment to income. The S corporation and employee would not pay any additional tax, resulting in S corporation tax savings of $4,239.
- Generally, the payroll tax savings increase as total earnings increase. A sole proprietor with no other employees and reporting net income from schedule C of $175,000 would generally pay $22,394 of self-employment tax (Social Security wage base of $142,800 x 12.4% + Medicare wage base $175,000 x .9235 x 2.9%), plus income tax on the earnings. If the same business was organized as an S corporation, paid the owner shareholder a salary of $70,000, and deducted $5,355 of employer payroll taxes (wages x 7.65% Social Security and Medicare rate), the net distributable income would be about $100,000. In this case, the wages and net income are subject to income tax, but the employee and employer FICA taxes on the wages would only be $10,710, resulting in payroll tax savings of $11,684.
One strategy to help sole proprietors reduce self-employment tax is to organize as an S corporation, and divide the net earnings of the business between the shareholder salary (subject to Social Security and Medicare taxes) and S corporation distributions (not subject to Social Security and Medicare taxes) from earnings. Both are subject to income taxes.
The taxable entity selection of a business can make a substantial difference in the tax liability, depending on the facts of the business. As taxable income from the business increases, a sole proprietor may pay higher Social Security and Medicare taxes than a shareholder-employee of a company.
Setting up an S corporation entity can help move tax preparation-only clients into higher value, quarterly advisory services. Compliance services are required, but not desired by clients. Instead, they value proactive tax saving strategies and business advisory. Generally, advisors can provide more tax saving strategies to S corporation clients with owner-employees than to Schedule C sole proprietors.
To communicate the tax savings for this strategy, calculate the difference between the self-employment tax as a sole proprietor, and the payroll taxes by employer and employee of an S corporation. This is a recurring tax savings strategy.
Annual limits and phase out range
For 2021, the self-employment Social Security tax of 12.4% is applicable to the first $142,800 earnings and the Medicare rate of 2.9% is applicable to all earnings.
For 2021, the employer and employee Social Security tax of 6.2%, each, is applicable to first $142,800 earnings and the Medicare rate of 1.45% each is applicable to all earnings.
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