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Why be a Sole
Proprietor
when There are Better Options?
Compare the advantages of sole proprietorships (and disadvantages) to other corporate structures and
you'll realize that S corporations offer
owners more protection against liabilities generated by their businesses.
Specifically, S corps can take advantage of pass-through taxation,
meaning there generally is no corporate-level federal income taxes
to worry about. Instead, all the company’s income, deductions
and tax credit items are "passed through" to the shareholders,
which they then report on their Form 1040 and pay the taxes.
Need Bank Lines of Credit? If so, Never Start Your Business as a Sole Proprietorship!
In contrast, running your business as a C corporation
can result in double taxation, meaning your business income gets
taxed once at the corporate level and again when liquidated or
where dividends are distributed. Keep in mind this is a simplistic
answer. There are many advantages to a C corporation also and
the effects of double taxation can be minimized, as you will soon
see.
Maxing Out Your Personal Revolving Debt to Finance Your Sole Proprietorship is NOT the Way to Start Your Business!
S corporations have strict qualification rules:
- Only citizens or residents of the US can be
shareholders
- The corporation can only have one class of
stock
- The corporation may have as shareholders only
individuals, estates or certain trusts. Partnerships and corporations
can not be shareholders.
- There must not be more than 100 shareholders.
You must also consider these major disadvantages
to an S corporation:
- The stock of an S corporation is very difficult
to protect from a personal lawsuit, whereas the stock of a C
corporation can be held by a family limited partnership or an
LLC taxed as a partnership.
- In some states, S corporations are taxed and
must file a state level tax return.
- If the S corporation owns appreciated assets,
they cannot be distributed to you without triggering an income
tax bill. There is no such problem with a sole proprietorship.
Let’s
look at the tax benefits of an S corporation over the sole proprietorship.
As the shareholder-employee of a solely owned
S corporation, you receive a salary, subject to a 15.3 percent
federal payroll tax (for Social Security and Medicare) on
the first $106,800 and 2.9 percent on the excess (for 2010). The corporation, as your employer pays half, and the other
half gets withheld from your paychecks. The corporation deducts
your salary as a business expense on its tax return (Form
1120S).
Under current law, that pass-through income
is not subject to SE tax. In contrast, all income from a sole
proprietorship is subject to SE tax. Also, an LLC taxed as
a partnership (if the member is deemed actively involved)
most likely is subject to SE taxes.
Strategy: Pay yourself a reasonable salary
to avoid federal payroll taxes. Just make sure it’s not
too low. Have industry comparisons on hand to show you’re
in the ballpark.
Example: The taxable income generated by your
S corporation business is estimated to be $100,000 for 2010
before you pay yourself. You take a $40,000 salary. Only that
amount is hit with the 15.3 percent federal social security
tax and Medicare tax, which amounts to $6,120. You can withdraw
the remaining corporate cash flow in the form of distributions
to yourself that will not be subject to SE taxes (this will
be added to your personal income on which you will pay tax
at your current tax bracket).
If you operate the same business as a sole
proprietorships all the profits are subject to SE taxes, you
owe SE tax on your entire $100,000 profit, for a total
of $15,300 (15.3 percent up to $106,800). Operating as an S corporation
could save you thousands ($15,300-$6,120= $9,180).
In addition, a sole proprietorship that files a schedule C is 300% percent more likely to get audited. Last year, the IRS did their own audit and determined they were $300 billion short in taxes. Thirty percent of that shortfall was from small business owners of which 1/3 were schedule C filers.
Remember: You must be able to show that a
$40,000 salary is reasonable. If the IRS thinks it’s
too low, it may try to reclassify all or part of your purported
cash distributions as disguised wages.
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