There have been a lot of big changes with the Trump Tax Plan (Tax Cuts and Jobs Act) and strategies. If you haven’t already done so, now is the time to look at the business structures you’re using.
In the past, I’ve never recommended Schedule C (Sole Proprietorships). That’s the default if you don’t form a business structure for your business. I am giving them a second look now, but with a few conditions.
First, let’s review why I said they were bad (pre-2018 tax law):
- No credit building,
- Higher audit risk, and
- Self-employment tax of 15.3%.
Those are all still true, if you use just a regular Schedule C (Sole Proprietorship). Instead, I recommend that you form a single member LLC that has not elected tax treatment if you want the Schedule C tax treatment. That is called “disregarded for tax purposes.” In other words, it will report just like a Schedule C return.
With the single member LLC, you have asset protection and you should be able to also start building business credit. (Make sure you properly register your business.)
You DO still have a higher audit risk and that is something you will need to take into account. It is a real liability, but one you can prepare for with good records and a plan if you’re audited. That’s the type of thing we will talk about soon in a coaching session. The audits have changed and that means audit survival preparation and survival strategies have changed.
The last issue is still true, self-employment tax. But there is another factor to take into account. That’s the 20% income deduction, Section 199A. You get a better deduction with a Sole Proprietorship than you do with either a C Corporation (there is no deduction at all) or an S Corporation (it is limited).
Let me go through the details of that new deduction.
The deduction is available for QBI (qualified business income). If you have a Schedule C, the total net income is QBI. If you have an S Corporation, the income from the business is QBI. The amount you take out as salary is not QBI. A C Corp is not eligible for QBI.
So, for purposes of this example, we’ll assume that we’re just comparing a Schedule C and an S Corporation.
The second assumption in the following examples is that your taxable income is under the income threshold. That is $315K if you’re married, filing jointly or $157.5K if you’re single. If your taxable income is over the income threshold, then you are subject to wage limitation rules. In those cases, you will be better off with an S Corporation versus a Sole Proprietorship (Schedule C).
For now, we’ll assume your taxable income is under the threshold.
If you have a loss in the business, the 20% deduction doesn’t apply. So we’ll also assume that it is moot in that case. An S Corporation would have a loss that flows through to you. You have to pay to have a second tax return prepared, but other than that, it doesn’t really matter for costs on whether you have a Sole Proprietorship or an S Corporation.
To recap, in these examples, you have business with net income and your taxable income is under the income threshold.
As long as you’re under the income threshold, the QBI from the Sole Prop would be eligible for the 20% deduction. In the case of the S Corporation, the net income after your salary would be QBI.
You are required to pay a salary to yourself from your S Corporation. The salary needs to be reasonable based on the amount of work you do. However, you don’t need to take that amount if your business can’t support it. That generally ends up being 1/3 – ½ of your net income in the business. We’ll use the calculation here based on ½ of your net income. The payroll has payroll tax, which ends up being the same as self-employment tax.
So, the trade-off between the Schedule C and S Corporation is that on one hand (Schedule C), you pay more self-employment tax (payroll tax) and get more of a 20% income deduction. On the S Corp. side you get less of a 20% income deduction and pay less payroll tax.
Example #1: 12% tax bracket, $50,000 income from the business (before the required S Corp salary)
Schedule C S Corp
Self-emp/payroll tax 7,650 3,825
Income tax 4,800 5,400
The S Corp saves (in total) $3,225 in taxes.
Example #2: 22% tax bracket, $100,000 income Schedule C S Corp
Self-emp/payroll tax 15,300 7,650
Income tax 17,600 19,800
The S Corp saves $5,450 in taxes.
Example #3: 24% tax bracket $200,000 income
Schedule C S Corp
Self-emp/payroll tax 30,600 15,300
Income tax 38,400 10,500
The S Corp saves $10,500 in taxes.
The brackets, based on taxable income, are:
$9,526 – $38,700 12%
$38,701 – $82,500 22%
$82,501 – $157,500 24%
Married, filing jointly:
$19,051 – $77,400 12%
$77,401 – $165,000 22%
$165,001 – $315,000 24%
Okay, so far, the Schedule C is more costly, but that has a number of assumptions:
The payroll is 50%. If your payroll needs to be more than that, then the Schedule C quickly becomes a better choice.
There is no accounting and tax preparation costs factored in the calculation. You will need to prepare, or pay to prepare, state and federal payroll reports with an S Corp. You will need to pay to have one more set of federal and state tax returns prepared (Form 1120S).
Also, an additional cost that hasn’t been taken into account would be state fees that may exist with a payroll that won’t with a Schedule C. Since that varies from state to state it hasn’t been included in this calculation.
At this point, it may be pretty much a wash as to whether you are an S Corporation or a Sole Proprietorship. Once your taxable income is over the income threshold, the S Corporation is definitely the better choice. If your taxable income is planned to go up, then an S Corp may be better.
The one final item to consider is a MERP (medical expense reimbursement plan). You can’t put a MERP in place with an S Corp, or at least you can’t put one in place that will benefit you. However, if you’re married, filing jointly, you could employ your spouse and then have your spouse set up the MERP.
If you have a lot of medical expenses that you pay out of pocket, a MERP allows you to take a full deduction against your income for the expenses. Only the Schedule C or C Corp would allow you to do that.
What is the right answer? Should you have a Sole Proprietorship or an S Corporation? The answer is, like with most tax questions, “It depends.” Take a look at all of the factors in this blog and then talk to your tax professional. But don’t settle for a tried and true answer. The law changed everything and what worked before isn’t necessarily a slam dunk anymore. You have to make some assumptions and crunch the numbers.
If we can help, give Richard a call at 888-592-4769. He can talk to you about our coaching program or possibly set-up a personal consultation with me.