Sole Proprietor vs S-Corporation in 2019
New tax law, new tax year, and every business owner needs to be asking themselves a question…. How should I be taxed? And more directly, what is the best tax structure for 2019? Sole proprietorship or S-corporation?
We are going to cover all of the options, and specifically the options as they relate to the new tax law and 2019. So much has changed. We have new tax rates, new and reduced deductions, exemptions are gone, and much more.
Also, this is written for business owners and not accountants. We skip over some of the calculation considerations that we do for our clients at Halon Tax already. This article is detailing what business owners need to know in order to choose a tax structure, not what accountants need to know to do a tax return.
First things first, let’s talk quickly about tax structure vs business entity. A business entity is a legal term. It is an LLC or corporation or LLP or PA or whatever. It is entity managed by the state in which you operate.
You set up an LLC or Corporation to have all of the tax benefits of a separate business, but the liability protection that will protect your personal assets. If you have not setup an LLC, you may be interested in an ebook of ours “Dangers of Sole Proprietorships”.
It has nothing to do with taxes, but each one has a default tax structure when you start them. Tax structures can be changed when you want..
As an example, if I start an LLC and I am the only owner, by default the tax structure is a sole proprietorship. However I can change that tax structure to a C-corporation if I want. My business is still and LLC but it IS TAXED as a C-corporation.
Get it? Good.
We are going to be covering tax structures. And what kind of tax structure you should have depending on your business.
Now that we know our businesses, what tax structures are available to them? Because we have both corporations (Harvey Consulting Inc.) and LLC’s (Sweet Cakes and Dave’s Delivery), there are several tax structure options:
Sole proprietorship: The easiest type of tax structure, but usually the most expensive from a tax point of view. Files on Schedule C of the personal return and pays self-employment tax as well as ordinary income tax.
Partnership: Partnerships are really sole proprietorships with multiple members. Same tax attributes for the most part. Files on Form 1065 and pays self-employment tax and ordinary income tax.
S-corporation: S-corps usually have tax advantages over sole props and partnerships. The reason is that the distributions from an S-corporation are not subject to self employment tax. It also allows you to run payroll on yourself, which if you are a large operation is very important to still getting the passthrough deduction.
C-corporation: The C-corp does not enjoy flow-through taxation which means it pays tax at the corporation level and at the personal level (distributions or dividends get taxed on your personal income tax return).
The sole prop, partnership, and S-corporation are all pass through entities. This means that the income flows through the business to the owners and is not taxed at the business level. It also means they are allowed the new Sec 199A deduction.
The C-corp is not a pass through and it pays tax at the corporate level.
Default Tax Structures
As I talked about earlier, each business entity has a default tax structure. This means when you start your business, you are automatically assigned a tax structure.
Limited Liability Company (one owner): Sole proprietorship (Schedule C)
Limited Liability Company (multiple owners): Partnership (Form 1065)
Corporation (1 or multiple owners): Corporation (Form 1120)
And in case you are wondering… is anything ever a S-corporation by default? The answer is no, there is never a case where a business entity has a default tax structure as an S-corporation.
Self Employment Tax
For decades, one of the major planning opportunities as it relates to tax structures has been the avoidance of self employment tax (or SE tax). SE tax is an additional tax that is paid alongside normal income tax. It is the equivalent of what employees pay called FICA. It's a payroll tax.
The SE tax rate is 15.3% and you don’t get any personal deductions against it. The tax is simply 15.3% x Business Income.
It is a huge tax liability for small businesses and usually accounts for 70% of the taxes they owe. This is because there are no deductions for it. So kids, charity, house interest, none of that stuff helps you like it does on your regular income tax, it is a very nasty surprise.
The planning technique involves the S-corporation, because it allows you to avoid paying SE tax on some of your income. I say some, because S-corporations are required to run payroll on the owner/officers and you end up paying a bit of SE tax via payroll taxes. But as i will show you in a moment, it is well worth considering, even in 2019 with all of these new tax laws.
Tax Structures Side by Side
Below we have a side by side comparison of different structures. Think of this as a foundation and will be a starting point in understanding how to compare tax structures. Then, as we go through our example businesses, we will apply some of what we learned here.
Sole Proprietor/Partnership vs S-corporation vs C-corporation
The example above assumes that you would form an llc, then for tax purposes utilize these different structures. So this is all apples to apples. As you can see at the bottom, the S-corporation is better.
I can tell you that 95% of the time, that is the case and most small businesses should be s-corporations.
If you are not sure what tax structure is right for you, why not chat with one of our advisors? We will ask you a few questions about your business, learn how you are set up, then give you a recommendation on what is best. A consultation with Halon Tax is easy and it's free!