Tax Savings for the Solopreneur
As a solopreneur, every minute and every dollar matter. The last thing you need is to pay more tax than you have to. No matter the size of your business, consider incorporating to protect your personal assets. Don’t risk losing your home over a business mishap.
As a solopreneur, you can choose to organize as a single member LLC or a single member S-Corporation. Which one saves the most tax? Well it depends how much money you make.
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.
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.
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).
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.