If you have not already read our article “What is a Pass Through Entity?“, do so now and then come back here!
This is one article in a multi part series we are doing on S Corporations. Before we dig too deep on S Corps we need to discuss the alternative options. Many people start their business as a Sole Proprietor or LLC. Lets discuss the tax piece of this setup.
1. Where do I report activity from a Sole Prop or LLC?
As discussed in our previous article a Sole Prop or LLC is considered a pass through entity. You file the activity from a Sole Prop on your personal tax return (Form 1040) via a Schedule C.
If you are a Single Member LLC you would do the same, report activity via the Schedule C.
If you are a Multi-Member LLC you would report the activity on a business tax return (Form 1065) which would include a K1 that you use to bring it to your personal return.
Again, these are considered pass through entities so if you haven’t read our first article, check that out first to understand this concept further.
2. How is a Sole Prop or LLC taxed?
As a Sole Prop or Single Member LLC (SMLLC) you pay your normal income tax rate on the income of your business as well as self employment taxes.
Regular Income Tax Rate: This would be your normal rate that you pay on all ordinary income including a W2 from an employer.
Self Employment Tax (15.3%): This is broken into two separate pieces, Social Security and Medicare. Social Security is 12.4% on your first $137,700 (2020) of business income. Medicare is 2.9% on your total business income. The total combined is 15.3%.
Again, with a Sole Prop or SMLLC self employment tax is over and above your normal income tax rate, so you pay both. There are no deductions or credits to offset self employment tax.
3. Let’s see an example!
Everything makes more sense when you put some numbers to it. So lets look at an example. In this example we are using business profit of $80,000.
In this example with $80k of business profit you will pay $11,304 in self employment taxes, again this is in addition to your normal income tax rate.
Note that it does not matter whether you are a Sole Prop OR a SMLLC, for tax purposes they would both be treated the same. Thus, by simply creating an LLC you are not creating any tax advantages.
This self employment tax is one of the biggest disadvantages to a Sole Prop/SM LLC setup.
4. So now what do I do?
Fortunetly there is a tax strategy we can utilize to help eliminate a portion of your self employment tax and that is by utilizing an S Corporation. In our next article we are going to dig deeper into what an S Corp is and how it can potentially bring tax savings to you!
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