You’re thinking a set of setting up a new business. But you’re not sure how it should be structured for tax purposes?
You’ve heard people speak of S corporations and also sole proprietorships. But really what you need is an S-Corp vs sole proprietorship tax calculator.
In this post, we’re going to review and discuss how to calculate the difference between an S corporation and a sole proprietorship. There are some key differences that you need to consider and pros and cons of each plan structure. Let’s get started.
How is an s-corp taxed?
An S-Corporation (S-Corp) is taxed differently than a Sole Proprietorship, because it is a separate legal entity for tax purposes. Here are some key points to consider about how an S-Corp is taxed:
- Pass-Through Entity: Like a Sole Proprietorship, an S-Corp is a pass-through business for income tax purposes. This means that any profits or losses of the business “pass through” the business to the individual shareholders, who report the income on their personal income tax returns.
- S-Corp Tax Return: An S-Corp files its own tax return (Form 1120-S) with the IRS, but the purpose of this return is to report the business income, deductions, and credits. The S-Corp itself does not pay federal income tax.
- Shareholder Income: Each shareholder reports their share of the business income on their personal income tax return, which is Form 1040 for U.S. federal taxes. The share of income is determined based on the ownership percentage of each shareholder.
- Salary and Distributions: S-Corp owners who work for the business must pay themselves a reasonable salary, which is subject to payroll taxes, including Social Security and Medicare taxes. Any additional profits can be distributed to the owners as draws, which are not subject to payroll taxes. The total amount of W2 compensation paid to the owners, including salary and distributions, should be reasonable for the work performed by each owner.
- Self-Employment Tax: S-Corp owners who work for the business may be able to reduce their self-employment tax liability by taking a reasonable salary and receiving additional profits as distributions, as opposed to taking all profits as self-employment income. However, S-Corp owners who provide services to the business may still be subject to self-employment tax on their salary.
It is important for S-Corp owners to keep accurate records of their business income and expenses, and to ensure that they are complying with all applicable tax laws and regulations. It is recommended to consult with a tax professional to ensure that they are meeting all of their tax obligations and minimizing their tax liability.
How is a sole proprietor taxed?
A sole proprietor is taxed on the profits of their business on their personal income tax return, which is Form 1040 for U.S. federal taxes. The business itself is not taxed separately as a separate entity.
This is because a sole proprietorship is considered a “pass-through” entity for income tax purposes, meaning that the business income, deductions, and credits “pass through” the business to the owner’s personal tax return. This is why an S-Corp vs sole proprietorship tax calculator is so important.
Here are some critical points to keep in mind about how a sole proprietor is taxed:
- Reporting Business Income: A sole proprietor reports their business income on Schedule C of their personal income tax return. The income is calculated by subtracting the business expenses from the business revenue.
- Self-Employment Tax: A sole proprietor is responsible for paying self-employment tax, which includes both the employer and also employee portion of Social Security and Medicare taxes. Any self-employment tax will be calculated on Schedule SE and is based on the net income from the business.
- Estimated Taxes: A sole proprietor must make estimated tax payments to the IRS throughout the year if they expect to owe $1,000 or more in taxes. Estimated taxes are calculated based on the expected income for the year and the applicable tax rates.
- Deductions and Credits: A sole proprietor can deduct ordinary and necessary business expenses, such as car mileage, office supplies, rent, and advertising, from their business income to reduce their taxable income. Additionally, a sole proprietor may be eligible for certain tax credits, such as the Earned Income Tax Credit or the Child and Dependent Care Credit.
It is important for a sole proprietor to keep accurate records of their business income and expenses to ensure that they are reporting their income correctly and taking advantage of all applicable deductions and credits. It is also recommended to consult with a tax professional to ensure that they are meeting all of their tax obligations and minimizing their tax liability.
S-Corp vs sole proprietorship tax calculator
The essential thing in the tax calculator to consider is the fact that an S Corp. and a sole proprietorship are both fully subject to federal and state income tax. There is no change in federal or state tax due to the structure.
But the critical difference is the self-employment tax that is paid. A sole proprietor’s entire business profit is subject to self-employment tax. But for an S corporation, only the W-2 wage to the business owner is subject to employment taxes.
The business will deduct the wage with an S corporation as a business expense. However, the owner must pick up that W-2 on their tax return. So, this is a wash.
But to consider how the calculation would work, you must first consider the Social Security maximum, currently $160,000. So let’s assume you have an S Corp. and a sole proprietor with the same net profit of $160,000. For an S corporation, this is before a W-2 is paid to the entity. Let’s look and see what the employment taxes would be for both entities below:
W2 wage of $100,000 = employment tax of $15,300.
Business profit of $160,000 = employment tax of $24,480.
How do I calculate the tax difference between an S-Corp and a Sole Proprietorship
Calculating the tax difference between an S-Corp and a Sole Proprietorship can be complicated as various factors affect each business entity’s tax liabilities. Here are some key points to consider:
- Tax Structure: A Sole Proprietorship is a pass-through entity, meaning that all of the business profits and losses will be reported on the owner’s personal tax return. In contrast, an S-Corp is a separate tax entity and files its own tax return.
- Self-Employment Taxes: As a Sole Proprietor, you are responsible for paying both the employer and employee portion of Social Security and Medicare taxes (also known as self-employment taxes). On the other hand, as an S-Corp owner, you are only responsible for paying Social Security and Medicare taxes on your salary, not on the business profits.
- Salary vs. Distributions: As an S-Corp owner, you must pay yourself a “reasonable” compensation for the work you do for the company. This salary is subject to payroll taxes, including Social Security and Medicare taxes. Any additional profits can be distributed to the owners as distributions, which are not subject to self-employment taxes. In contrast, a Sole Proprietorship owner is not required to pay themselves a salary and can take all business profits as income, subject to self-employment taxes.
- Other Tax Considerations: Both types of businesses may be subject to add’l taxes, such as state and local taxes, sales taxes, and excise taxes, depending on the company’s nature.
To calculate the tax difference between an S-Corp and a Sole Proprietorship, you will need to consider the factors listed above and any other relevant tax considerations for your specific business. It is recommended to consult with a tax professional to determine the best tax structure for your business and to help you navigate complex tax laws.