Tom Talks Taxes - February 3, 2023
When should a sole proprietorship switch to an S corporation?
Tax practitioners must regularly evaluate entity choice as part of ongoing advisory services provided to the client. A typical situation to consider is when a sole proprietorship should graduate to a more sophisticated structure, which could be the S corporation in many cases.
While the S corporation may provide tax savings (yes, it is not a certainty), some costs and obligations go along with the S corporation that must be weighed against any potential tax savings.
There are two reasons that now is the time to do this analysis for 2023:
If the sole proprietorship is operated in a limited liability company (LLC), the taxpayer has until March 15, 2023 to elect S corporation status retroactively to January 1, 2023.
If the sole proprietorship is not conducted in a business entity, it can form one and shift operations to make a prospective election during 2023. The sooner this is done in 2023, the more potential tax savings the taxpayer can get from the structure this tax year on a short-year tax return.
To make this determination, a tax professional should compare total income tax, self-employment tax, and payroll tax paid over the next three to five years. Projections used to make this determination must consider the following factors:
Reasonable compensation. The most common reason to consider a corporation is to reduce self-employment and payroll taxes. These savings are primarily driven by the difference between the net income of the business (all of which is subject to self-employment tax for the sole proprietor) and the reasonable wage compensation amount for the owner (which is the only amount subject to payroll tax for the S corporation). The larger the difference, the larger the self-employment and payroll tax savings and the more the decision leans toward the S corporation. A solid reasonable compensation figure is essential to this determination, and I recommend using RCReports to generate the analysis.
§199A deduction. The move to an S corporation can either increase or decrease the §199A deduction. Since the reasonable compensation amount is not qualified business income (QBI), QBI is reduced in the S corporation; however, in the sole proprietorship, if there are no other employees, the lack of wages may reduce or eliminate the §199A deduction amount for owners whose taxable income is over the §199A threshold ($364,200 for married filing jointly; $182,100 for all other filing statuses). The §199A deduction is temporary; it exists through tax year 2025.
Sole proprietorship tax benefits. Certain tax benefits unique to a sole proprietorship are unavailable to S corporations. Two examples include:
A typical tax reduction strategy is to hire a child in the business, pay them a reasonable wage for services performed, and deduct the salary as a business expense. This shifts the wage amount to the child, who likely pays no income tax due to the standard deduction. In the sole proprietorship, the wages are not subject to payroll taxes if the proprietor’s child is under age 18; this exclusion is not available for S corporations.
In a sole proprietorship, the owner can hire their spouse and provide them a tax-free §105 medical expense reimbursement plan as compensation for their services, provided the spouse is the only employee. The plan can cover the employee’s family, which includes the sole proprietor and their children. This would allow the insurance premiums and other §213 medical expenses as a deduction for income tax and self-employment tax purposes.
State income tax deductions. For individuals, the state and local tax deduction on Schedule A is capped at $10,000 through 2025 ($5,000 married filing separately). For sole proprietors, the state income tax paid on their business income may be partially or fully nondeductible. The state income tax is also not deducted if an individual does not itemize deductions. In the S corporation, a taxpayer likely can take advantage of a state-level pass-through entity tax to shift the state tax paid from nondeductible to fully deductible as a business expense. To take advantage of this, the S corporation must be doing business in a state with a pass-through entity elective tax, and over 30 states have now enacted one of these taxes. The IRS blessed these arrangements in Notice 2020-75; please take a look at my article here to learn more.
Federal and state employment taxes. This is an additional cost to the S corporation. The S corporation will have to pay federal and state employment taxes on the wages paid to the owner/employee. In some states, this could be significant; for example, in California, the state disability tax is 0.9% of the employee’s wages up to $153,154 in 2023 (in 2024, there will be no limit).
Payroll, bookkeeping, and tax preparation costs. This is an additional cost to the S corporation. The S corporation will require payroll services for the owner/employee and an additional tax return to be prepared. A set of double-entry books should be required for an S corporation (and the balance sheet should be completed for all S corporations, regardless of size). A sole proprietor should also have double-entry books for return accuracy; however, some smaller proprietorships may not need them to present accurate financial data.
While this article looked at the sole proprietorship versus S corporation decision, it is essential to note that a C corporation may instead be optimal if:
The effective rate on income on Form 1040 will exceed 21%,
The business does not qualify for the §199A deduction,
The business qualifies for specific tax provisions only applicable to C corporations (e.g., §1202 exclusion), or
Earnings within the corporation can be either retained or withdrawn tax-free.
This is sophisticated tax planning and not a free “tax tip” to be given during tax preparation. How are you providing and charging for this service?
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Regarding the 105 plan, I've done a lot of reading and am just confusing myself where marketplace insurance subsidies are involved. I have read on some websites that you can have the 105 plan for out of pocket expenses but not for the actual marketplace health insurance premiums, but other websites/references seem to indicate you can not have any type of HRA with the marketplace insurance subsidies. Do you know of a good reliable reference source that could possibly shed some light on this?
Great article. I think in the hurried world of taxes and clients using QBooks and converting
the equity section in Q books from sole prop. to SCorp etc to the tax return is not setup or mapped properly. Is there a good resource to ensure consistency. You would think it is simple but not as clients or staff use the wrong form of business inside QBooks all the time.