From Sole Proprietor to S-Corp: Consider a Switch
As a freelancer or contractor, at some point you may wish to incorporate and be taxed as an S corporation. Here’s a closer look at the process of becoming an S corporation and when switching might make sense for you.
The main benefits of S corporations
- Self-employment tax savings. As a sole proprietor, you’re required to pay a 15.3% self-employment tax (which includes Social Security and Medicare) on your entire income. However, with an S corporation, you can split your income into two parts: a reasonable salary (which is subject to self-employment taxes) and distributions (which are subject to income taxes but not self-employment taxes).
- Pass-through taxation. Similar to sole proprietorships, S corporations are considered pass-through entities. This means that the business itself doesn’t pay income taxes. Instead, profits and losses pass through the business to the owner’s personal tax return. Profits of a C corporation, on the other hand, are taxed twice – once at the entity level, and again on the owner’s tax return.
- Legal protection. If there is a risk of possible legal action, an S corporation can potentially help protect your personal assets from your business assets. For example, this can be especially helpful if you are in the contractor trade and the customer makes a claim against the fulfillment of your contract.
While transitioning from a sole proprietor to an S corporation can certainly result in significant tax savings, there are a few trade-offs to consider.
Trade-offs to consider
Most of the trade-offs are centered around administrative requirements and potential costs. These include:
- Running payroll. Even if you’re the only employee, you’ll need to set up payroll and withhold taxes. Many business owners use a payroll service to handle this.
- Separate tax filing. Your business will now need to file a Form 1120-S tax return with a March 15th due date in addition to your personal tax return.
- Accountants or bookkeepers are typically used. Most S corporation owners work with professionals to handle bookkeeping and tax filings.
- Reasonable salary requirement. The IRS expects owners to pay themselves a fair market wage. Underpaying yourself to avoid taxes can lead to penalties.
- State-level requirements. Some states have minimum franchise taxes or annual fees for corporations and LLCs, regardless of income.
When it makes sense to switch
Switching to an S corp generally becomes worth considering when your net income (after expenses) is in the range of $75,000 to $100,000 or more per year.
Here’s an example:
Assume you earn $120,000 in net income as a consultant.
- As a sole proprietor, you’d pay self-employment tax on the full amount, about $18,000.
- As an S corp, if you pay yourself a reasonable salary of $60,000, you’d only pay payroll taxes on that amount, roughly $9,200. The remaining $60,000 in profit would be subject to income taxes but not payroll taxes.
That’s a potential tax savings of nearly $9,000 per year.
Switching from a sole proprietor to S corp can offer real tax advantages, but it’s not a one-size-fits-all solution. It's usually best practice to review your situation once per year to ensure your business is organized properly.
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