03/22/2022
SHOULD I FILE SCHEDULE C OR 1120-S?
For many sole proprietors and small business owners, the decision to file as a Schedule C or an S-Corporation is very close to a life-or-death decision. Does it have to be this complicated? And in tax world, yes. Yes, it does. Ultimately, Schedule C and S-Corporations are two different routes to the same destination, to collect payroll taxes.
Schedule C
The main pro to filing Schedule C is simplicity. Schedule C is a schedule found on Form 1040, the tax return most of us should be filing anyway. There aren’t any extra tax filings required. Schedule C does a great job at calculating self-employment tax (payroll taxes) for you. As a self-employed individual that files a Schedule C, you are responsible for both the employer and employee portion of these taxes, which can make it kind of expensive. The going rate for total payroll taxes are 6.2% for Social Security tax, 1.45% for Medicare tax. And, since you are responsible for both the employer and employee portions, these amounts double. So, the payroll tax rates are really 12.4% for Social security tax and 2.9% for Medicare tax, for a grand total of 15.3%. Keep in mind, these tax rates do not take into account the federal income tax rates. [See an easy-to-read 2021 tax table chart here at https://taxfoundation.org/2021-tax-brackets/.] This means, that even if your taxable income is zero, you could still be liable for self-employment tax.
If you’re a small business that is just starting out i.e., low income, high expenses, Schedule C is a great way to file tax returns. However, as you begin to make some ‘real’ money, Schedule C might not be the best way to continue filing. That’s when you might want to think about S-Corporations.
S-Corporation aka S-Corp
The main pro to filing as an S-Corporation is flexibility. Now with that being said, there are more hurdles to jump through. Flexibility, not simplicity. An S-Corporation is well…a corporation. Which means you have to register as a corporation in your state. Creating a corporation can give not only tax flexibility, but certain legal protections. Go ask your attorney about this. Many S-Corporations are setup as the NOTORIOUSLY known, LLC (Limited Liability Company). And many are just traditional corporations, i.e. businesses that are incorporated; you know, the one’s with ‘Inc.’ at the end of their names... Once you create the entity of your choice, LLC or Inc., you want to obtain an EIN (Employer Identification Number) from IRS. It literally takes two minutes to do. See link here… https://www.irs.gov/businesses/small-businesses-self-employed/apply-for-an-employer-identification-number-ein-online.
Sidebar: Even if you only ever report your business on Schedule C, creating an LLC, obtaining an EIN and opening a separate bank account is always a good idea.
Then, after all of these steps, you can ELECT to have your LLC or Inc. be taxed as an S-Corporation using Form 2553. Learn more about Form 2553 here: https://www.irs.gov/forms-pubs/about-form-2553. If you don’t make this election, there are default tax categories you will be placed in, such as C-Corporation or partnership.
Besides the additional annual tax return, Form 1120-S, there will be more, you guessed it, payroll tax filings. By law, the S-Corp is required to pay ‘reasonable compensation’ to the shareholder-employee, whatever that means. As an S-Corp shareholder-employee, you are both the employer and employee and therefore responsible for these wages and related payroll taxes. This includes filing (and paying) payroll reports such as Forms 940, 941, W-2/W-3, state unemployment etc. Some of these reports are supposed to be filed and paid quarterly. So, even if there is a quarter you don’t take any wages, you still have to file the dreaded ‘zero’ returns. Luckily, there are payroll companies that handle all of this stuff, for a fee of course.
Although this may seem like a complete headache, paying yourself ‘reasonable compensation’ is a good idea, because now you have real W-2s; which are great when you actually want to buy something important like a car, house, or get a loan etc. Also, if you don’t pay yourself ‘reasonable compensation’, Uncle Sam will come find you and make you pay yourself ‘reasonable compensation’.
See more about ‘reasonable compensation' here https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical-insurance-issues.
A signature feature of S-Corporations is that no income taxes are paid at the S-Corporation level. It avoids double taxation. (This was in comparison to C-Corporations, which used to have the double taxation issue, but now have a flat 21% income tax rate. Now it seems that Schedule Cs have the double taxation issue.)
S-Corporations do not pay income taxes. People do.
Generally, S-Corporations save you in taxes since your income is now split between wage income and pass-through income on Form 1120-S via the K-1. Pass-through income is taxed at the shareholder’s ordinary income tax rate (see tax tables above). The income is ‘passthroughed’ (yes, I created a new word) via the K-1, which is reported on the shareholder’s Form 1040, Schedule E. This is comparison with Schedule C income, in which income is taxed as self-employment income (15.3%), as well as the taxpayer’s ordinary income tax rate.
Remember, Schedule C and S-Corporations are two different routes to the same end: to collect payroll taxes…which ultimately determines how much your Social Security check will be when you retire…plus they have the same initials…
Of course, everyone's tax situation is different, so please consult with a tax professional before making any rash decisions.
Determine your eligibility and apply online for an employer identification number (EIN).
