Sub-Chapter S vs. Sole Proprietorship
Being self-employed comes with many challenges. Sure, it all sounds great when you learn that you can write off many business-related expenses. What isn’t so great is when you realize how much you pay in self-employment and other taxes. At a certain point, you may want to turn your sole proprietorship into an S-corporation for the purposes of lowering that tax liability.
The Self Employment Tax Breakdown
Remember that your self-employment tax consists of your Social Security and Medicare payments. While the percentages are subject to fluctuations, they’re currently set at 15.3% total.
- 12.4% for Social Security
- 2.9% for Medicare
Sole proprietorships pay this percentage no matter what. S-corporations have more flexibility.
Filing the Schedule C and SE as a Sole Proprietorship
Sole proprietorships must file a Schedule C (1040) to report their business profits. They must file a Schedule SE to pay their self-employment taxes. You will have to pay self-employment taxes on top of your personal federal income taxes. Depending on your tax bracket, that tax percentage can grow well into the 40% range.
For example, once your net income reaches around $20k, you will find yourself in the 15% tax bracket. That will leave you paying 30.3% total in taxes. If your income reaches over $37,650, you will have to pay 40.3% of it in taxes.
Both of those are some rather large numbers. There is also the possibility of state and local taxes.
Mitigating Your Tax Liability as a Sole Proprietorship
There are a few strategies the self-employed can use to mitigate some of that tax liability.
- Pay your quarterly estimated taxes
- Take advantage of all available deductions
- Home office
- Office supplies
- Travel and meals
- Health insurance
- Keep detailed records
This is really the best way to save on your taxes with this business structure. However, there’s a cutoff point when you will realize you’re paying far too much in taxes than you should.
If your business routinely pays out a third or more of its net income in taxes, you should sit and really think about incorporating. You don’t have to go all the way in with a C-corporation, especially if you’re not fond of the idea of double taxation. Instead, you should consider an S-corporation.
Reduce Employment Taxes with an S-Corp
You can use your S-corp to take advantage of the many tax breaks granted to corporations, while also cutting your self-employment tax obligation significantly.
Write off losses – Under an S-corp, it’s possible to deduct self-employed business loses on your tax return as a shareholder.
Split your business profits – With a subchapter S, you can split business profit between shareholders and the business itself. As a sole owner, you represent the shareholder. You will only have to pay self-employment taxes on your shareholder distribution. The business doesn’t pay self-employment taxes.
The S-corp offers real benefit to sole proprietors that have reached a certain level with their business income.
Should You Switch from a Sole Proprietorship to an S-Corp?
The profitability of your business has a lot to do with it. The more your business earns, the more beneficial it is for you to switch from sole proprietorship to s-corp. You will find it is likely better to pay taxes on a salary, than it is to pay them on your total income.
Dealing with business structures isn’t easy. If you want to do it right, and stay on the right side of the law and tax code, then you should seek professional help. To learn more about business structures, and which will work best for you, speak to the professionals at Fricke & Associates, P.C.