Sole proprietor or S corporation: when the switch makes sense for a small business

If you run a business in the Valley on your own, you probably started as a sole proprietor. Your profit goes on Schedule C, attached to your Form 1040, and that is the whole return. At some point someone tells you an S corporation would save you money. Sometimes that is true. Sometimes it is a more expensive way to do the same thing. Here is how to tell the difference.

What is the difference between Schedule C and an S corporation?

A sole proprietor and the business are the same taxpayer. All of the profit is yours, it goes on Schedule C, and you pay income tax on it plus the Social Security and Medicare tax that people pay on their own business profit. The IRS calls that self employment tax and it is figured on Schedule SE.

An S corporation is a separate entity. It files its own federal return, Form 1120-S, and in California a Form 100S. The corporation itself usually pays no federal income tax. Instead the profit passes through to you on a Schedule K-1 and lands on your personal return. The IRS describes it this way on its S corporation page: the corporation passes income, losses, deductions, and credits through to shareholders, who report them on their own returns. Under the rules on that page, the corporation must be domestic, have no more than 100 shareholders, and have one class of stock.

Why does an S corporation sometimes lower taxes?

The whole case rests on one idea. As a sole proprietor, every dollar of profit is subject to Schedule SE tax. As an S corporation owner who works in the business, you must pay yourself a reasonable salary through payroll. That salary is subject to Social Security and Medicare tax the way any paycheck is. The profit left over after salary is a distribution, and it is not subject to that tax.

So the savings come from the gap between total profit and the salary. The bigger the gap, the bigger the savings. The IRS watches this closely. A salary that is far below what you would pay someone else to do your job invites a notice, and the IRS can reclassify distributions as wages. Reasonable means what the work is worth, not the smallest number that fits.

What does an S corporation cost?

This is the part the advice on social media leaves out. An S corporation adds real cost and real chores every year:

• A separate corporate return (Form 1120-S and Form 100S) in addition to your personal return.
• Payroll. You need a payroll service or someone to run it, quarterly payroll filings, and W-2s at year end.
• California’s minimum franchise tax, which an S corporation owes every year it exists, including years with little or no profit. The amount, and the state’s rate on S corporation income above it, are published at ftb.ca.gov.
• A separate bank account and clean books. Mixing personal and corporate money undoes the protection and makes the return much harder.
• Secretary of State filings and a registered agent.

If the Schedule SE savings do not clearly exceed all of that, you are paying for a structure that does nothing for you.

When does the switch usually make sense?

For the businesses we work with around Reseda, the switch starts to pay for itself when all of these are true:

• Profit is consistently well above what a reasonable salary for your role would be, year after year, not just in one good year.
• The business has steady cash flow, so it can run payroll on time every month.
• You are already keeping books, or are ready to start, with our bookkeeping and accounting service or on your own.
• You plan to keep the business running for several more years.

A contractor, a trucker who owns the rig, a salon owner with staff, a consultant with steady clients: these are the profiles where we run the numbers. A side business with modest profit, or a first year where you do not know what you will earn, is usually better left on Schedule C.

When does it not make sense?

Skip it, or wait, if:

• Profit is modest or unpredictable.
• You have a day job with W-2 wages that already reach the Social Security wage limit for the year, which shrinks the savings.
• You cannot commit to payroll and separate books.
• You own real estate that you plan to hold inside the entity. Moving appreciated property out of an S corporation later can trigger tax.

How and when do you make the election?

You form a corporation (or an LLC that will be taxed as a corporation) and file Form 2553 with the IRS. The IRS instructions for Form 2553 say the election must be filed no more than 2 months and 15 days after the beginning of the tax year it is to take effect, or at any time during the preceding tax year. For a business that runs on the calendar year, that means acting early in the year, or deciding before December 31 for the following year. Late elections are sometimes allowed, but it is far easier to meet the date.

California generally follows the federal election. You will file Form 100S for the first year the election is in effect.

Our small business tax preparation service includes running this comparison with your real numbers, both ways, before you decide. The office is on Tampa Ave in Reseda and the comparison usually takes one sitting with last year’s return and a current profit estimate.

When to call

Call (818) 401-7468 before you form the corporation, not after. Once the entity exists it has filing duties whether or not it helps you. You can also reach us through the contact page and send last year’s Schedule C ahead of the appointment.