by Eric Murphy
For many entrepreneurs, the biggest question they should ask themselves after deciding what kind of business they want to have is what kind of entity should the business be established as? This is very important since the choice they make can have a long-term impact on their profitability and security. This article will address some of the benefits of Incorporating a Sole Proprietorship into a subchapter S-Corporation. While there are many rules and conditions that have to be considered, this general overview should explain why it is a beneficial choice for the solo entrepreneur.
When a person first begins a business without incorporating, they would report their income and expenses on Schedule C of their Individual tax return (Form 1040). This form is used for Sole Proprietorships and reflects the business as an entity, inseparable from the individual. Because of this lack of separation, any liability or risk to the business becomes a direct risk to the individual. This means if the business incurs debt and defaults or is the defendant in a lawsuit, the individual’s personal assets can be pursued for settlement and there is no limit to the potential liability.
If the individual chose to incorporate instead, their income and expenses would be reported on a separate tax return known as Form 1120S. This return reflects the business as an entity separate from the individual with the net profit or loss flowing to the individual who is a shareholder in the entity on Form K-1. As a separate entity, the individual has the benefit of limited liability in the event of a lawsuit or in case of default on debt. This liability is limited to the extent of their initial investment in the business and any appreciation on that investment.
Another big benefit of having an S-Corporation instead of a Sole Proprietorship is savings on taxes paid. A sole proprietor must pay ordinary income tax as well as self-employment tax on all net income generated by the business. The self-employment tax is assessed as a means of collecting what the individual would have had withheld for Social Security and Medicare taxes if they were working for someone else. While of a portion of this tax is deductible, it can be a costly burden to the entrepreneur when the time comes to file their personal tax return.
With an S-Corporation, the individual still pays ordinary income tax on all the net income of the business, but they only pay it once at the shareholder level when they file their Form 1040. There is no tax liability for the business itself. Individuals are also exempt from self-employment tax when they operate under an S-Corporation. The reason is, the entrepreneur should get paid a salary and be issued a W-2 from the business and that way they are paying Social Security and Medicare taxes from wages earned and those wages are deducted from the business’s net income. The salary paid doesn’t need to be excessive, and the entrepreneur and can also take money out of the business as non-taxable distributions – provided the distributions don’t reduce their basis in the business below zero. Otherwise, those excess distributions are subject to capital gains tax on the individual’s 1040.
If you’re a self-starter who plans to start their own business or has an existing business and wants to know all the details to determine if incorporation is the right path for you, contact Langdon & Company, LLP. Our tax professionals can provide you all the help you need to incorporate your business, file your required tax returns, and setup payroll for your business and file required payroll reports.
Eric ([email protected]) is a Tax Senior at Langdon & Company, LLP. He works on various types of returns ranging from non-profit corporations, to individuals, and partnerships.