Sole Proprietor or S Corporation?
Could a simple entity change save you money on taxes? Let's examine the numbers together to find out.
Sam Houston is Considering an S Corporation Election
Sam's accountant has recommended an S corporation for years. Sam preferred the simplicity of his sole proprietorship—but how much was that simplicity costing him?
Sam Wants to Lower His Federal Tax Bill
Sam's law practice produces $520,000 of business income before wages and employer Social Security and Medicare taxes.
Under his current sole-proprietor treatment, Sam pays an estimated $93,028 of federal income tax and $38,876 of Social Security and Medicare taxes. He wants to reduce that total without changing the business or earning less.
From Self-Employment Tax to Payroll Tax
The election changes Sam's employment-tax treatment.
As a sole proprietor, Sam is self-employed—not an employee of his business. His law practice's profit is reported on Schedule C, and after the statutory 92.35% adjustment, $480,220 becomes net earnings from self-employment subject to Social Security and Medicare taxes under SECA.
After electing S corporation treatment, Sam becomes an employee of the corporation. His $200,000 of W-2 compensation is subject to Social Security and Medicare payroll taxes under FICA. The remaining business profit passes through to Sam for income-tax purposes but is generally not subject to employment taxes.
The election does not change how much the business earns. It changes which portion of those earnings is treated as compensation subject to Social Security and Medicare taxes.
Medicare Taxes Drive the Reduction
The savings are not spread evenly. Social Security stays the same; Medicare makes the difference.
Sole Proprietorship
- Social Security TaxOld-Age, Survivors, and Disability Insurance (OASDI)
- $22,878
- Medicare TaxHospital Insurance (HI)
- $13,926
- Additional Medicare Tax0.9% Medicare Surtax
- $2,072
S Corporation
- Social Security TaxOld-Age, Survivors, and Disability Insurance (OASDI)
- $22,878
- Medicare TaxHospital Insurance (HI)
- $5,800
- Additional Medicare Tax0.9% Medicare Surtax
- $0
Sam reaches the $184,500 Social Security wage base in both cases. His $200,000 S corporation wage therefore produces no Social Security tax reduction.
A $9,245 Federal Tax Reduction
Same business. Same $520,000 business income. A significant reduction in federal tax.
Time Is Money
Naturally, the IRS has some homework to go with the tax savings. An S corporation brings additional filing, payroll, and recordkeeping requirements.
S Corporation Election Requirements
- Make the ElectionObtain an EIN, if needed, and timely file Form 2553.
- Set Reasonable CompensationDocument a W-2 wage that reflects the legal services Sam provides.
- Run PayrollWithhold and deposit taxes and file the required federal and Texas payroll reports.
- File the S Corporation ReturnPrepare Form 1120-S and Schedule K-1 in addition to Sam's individual return.
- Maintain Separate RecordsTrack wages, distributions, expenses, basis, and ongoing Texas filings.
With Comprehensive Planning, these added responsibilities become far easier to handle. A multidisciplinary team of advisors focused on you can coordinate the accounting, payroll, tax, and legal work—helping you capture as much of the tax savings as possible while giving back as much of your time as possible.
Next in the Series
Sam lowered his employment taxes, but the S corporation election cost him a valuable Qualified Business Income deduction. In Part 2, we'll explore how qualified retirement planning may help him bring that deduction—and more tax savings—back.
Continue to Section 199A and YouDetails behind the Illustration
These supporting details are available for readers who want to examine the assumptions and source material behind Sam's entity comparison.
Methodology & Limits
- $520,000 is the business-income figure used throughout the comparison, before Sam's S corporation wages and employer Social Security and Medicare taxes.
- Sam and spouse file jointly, use the $32,200 standard deduction, and have no net capital gain or other material income.
- The model assumes, without determining, that $200,000 is reasonable compensation and includes $14,339 of employer Social Security and Medicare tax. An actual compensation analysis could produce a different wage and tax result.
- The model excludes FUTA, state unemployment, state franchise taxes, retirement contributions, health insurance, and entity-administration costs.
- Differences are calculated using unrounded amounts and may not equal the difference between displayed rounded figures. Actual returns may also differ because of facts not included in this example.
Disclaimer
This article is educational and is not individual tax, legal, accounting, or compensation advice. Entity elections and reasonable compensation should be coordinated with a CPA and attorney.
Model the Whole Return before Changing the Entity
A useful comparison starts with reasonable compensation and ends after the income-tax offsets and operating costs are counted.
- Document the compensation analysis.
- Coordinate the election with tax and legal advisors.
- Revisit the calculation when income or household facts change.