When entrepreneurs begin their journey, one of the critical decisions they face is the type of business structure to adopt. While there are various business structures to consider, sole proprietorships and S-corporations (S-corps) are two of the most common. While both have their merits, an S-corp can offer significant tax advantages over a sole proprietorship.
1. Self-Employment Tax Savings
Sole Proprietorship: If you operate as a sole proprietor, you’re required to pay self-employment taxes, which covers both the employer and employee portions of Social Security and Medicare taxes. As of my last update in September 2021, this tax rate is 15.3%.
S-Corp: One of the main tax advantages of an S-corp is the ability to split your income into two categories: salary and dividends (or distributions). Only the salary is subject to self-employment taxes, which can mean significant savings. The distributions are not subject to these taxes, though they still might be subject to federal income tax.
2. Deductibility of Health Insurance Premiums
Sole Proprietorship: Sole proprietors can deduct health insurance premiums for themselves and their families, but the deduction is an adjustment to income.
S-Corp: For S-corp shareholder-employees, the company can pay for health insurance, and then the amount is included in the employee’s W-2 as wages. This method can result in a business deduction for the S-corp and a deduction on the shareholder-employee’s personal return.
3. Retirement Plan Contributions
Sole Proprietorship: While sole proprietors can set up retirement plans, their contributions are based on net earnings from self-employment, which reduces the base for the deduction.
S-Corp: S-corp owners can set up retirement plans, and their contributions are based on their W-2 wages, not net earnings from self-employment, potentially allowing for larger contributions.
4. Deduction for State Taxes
Sole Proprietorship: State taxes paid on income earned in a sole proprietorship are usually considered an itemized deduction on the owner’s personal tax return.
S-Corp: If an S-corp pays state taxes on the entity level, it might deduct these taxes as a business expense, offering an above-the-line deduction.
5. Potential Audit Protection
Some experts believe that sole proprietors might be at a higher risk for an IRS audit, especially those who file a Schedule C and report high expenses or significant losses. Operating as an S-corp and separating your business and personal expenses might reduce the risk of scrutiny.
Conclusion
While the S-corp structure offers several tax advantages over a sole proprietorship, it’s essential to remember that there are also additional requirements, like payroll reporting and state-specific rules. Before making a decision, consult with a tax professional or CPA to determine the best fit for your business circumstances and to stay updated with any changes in tax laws post-2021.