Tax Savings for the Solopreneur

Quick point: This post is for educational purposes only. For tax advice related to your specific business, be sure to consult a reputable tax professional.

Schedule C

As a single member LLC, you report your business income and expenses on Schedule C of your individual Form 1040. (You also report your LLC income to the appropriate state tax agency.)

Let’s say you net $100,000 after expenses. As an LLC, you need to pay ordinary income tax AND self-employment (SE) tax on this amount.

Self-Employment Tax

What is self-employment tax? The self-employment tax is the Social Security and Medicare tax paid by self-employed individuals. In 2018, the self-employment tax rate is 15.3%. 12.4% for Social Security and 2.9% for Medicare.

Your self-employment tax on $100,000 will be $14,130.

$100,000 (15.3%) = $15,300

$15,300 / 2 = $7,650

$100,000 - $7,650 = $92,350

$92,350 (15.3%) = $14,130

Now, how does that compare to an S-Corporation?

Let’s first see how an S-Corporation works. When you organize your business as an S-Corporation, you classify some of your income as salary and some as a distribution. You become an employee of the S-corporation and must receive reasonable compensation for your services.

Example: Let’s say your salary is $52,000. This will then reduce your net income from $100,000 to $48,000. Your new net income of $48,000 is NOT subject to self-employment tax. You only pay Social Security and Medicare tax on $52,000. Doing the math: 15.3% of $52,000 is $7,956.

Technically, the S-Corporation pays 7.65% and the employee pays the other 7.65% of the $52,000. Since you are both the sole shareholder and sole employee of this S-Corporation, you are essentially paying the entire 15.3% which comes out to $7,956.

As you can see, $7,956 is less than the $14,130 you pay as an LLC. This is a tax savings of $6,174.

Keep in mind you will still pay ordinary income tax on the $100,000 just like with the LLC. The tax savings come strictly from the self-employment taxes.

Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) added a new tax deduction for owners of pass-through entities – a 20% deduction of qualified business income (QBI) from a qualified trade or business.

With a net income of $100,000 you will qualify for this deduction whether you’re a single member LLC or a single member S-Corporation.

Let’s first look at a single member LLC

The QBI deduction for a $100,000 net income will be the lesser of 20% of your net income or 20% of your taxable income. What is your taxable income? Let’s assume you’re single. Your standard deduction for 2018 is $12,000. You also receive a $7,065 deduction for half of the self-employment tax you pay.

$100,000 - $12,000 - $7,065 = $80,935

$80,935 (20%) = $16,187

Since 20% of your taxable income ($16,187) is less than 20% of your net income ($20,000), your QBI deduction is $16,187.

The $16,187 reduces your taxable income from $80,935 to $64,748.

Your federal income tax on $64,748 is 22% = $14,245

Now let’s look at a single member S-Corporation

The QBI deduction for a $48,000 net income will be the lesser of 20% of your net income or 20% of your taxable income. Your taxable income includes the $48,000 net income you receive on a Form K-1 and the $52,000 wages you receive on a Form W-2.

$48,000 + $52,000 = $100,000

$100,000 - $12,000 = $88,000

Your QBI Deduction is the lesser of:

20% of your taxable income: $88,000 (20%) = $17,600

20% of your qualifying business income: $48,000 (20%) = $9,600

Since 20% of your qualifying business income ($9,600) is less than 20% of your taxable income ($17,600), your QBI deduction is $9,600.

The $9,600 reduces your taxable income from $88,000 to $78,400.

Your federal income tax on $78,400 is 22% = $17,248

Your federal income tax from the S-Corporation ($17,248) is $3,003 more than your federal income tax from the LLC ($14,245).

In Summary

The Tax Cuts & Jobs Act has made it a bit more difficult to choose the right entity. While the S-Corporation gives you a higher self-employment tax savings, your QBI deduction is smaller since you cannot include reasonable owner compensation as qualified business income. A lower QBI deduction leads to a higher taxable income which leads to a higher federal income tax.

In the example above, the S-Corporation has a $6,174 self-employment tax savings over the LLC. The LLC has a $3,003 federal income tax savings over the S-Corporation. If you net these amounts out, we get a $3,171 total tax savings by choosing the S-Corporation. At $100,000 net business income, the self-employment tax savings you receive by choosing the S-corporation outweighs the federal income tax savings you receive by choosing the LLC. These tax savings may vary as your net business income changes.

Good luck!