Sole Proprietorship. S Corporation. Which entity choice is best for your taxpayer??
Let’s Get Ready To Rumble! Does a Sole Proprietorship ‘trump’ an S Corporation during the TCJA years?
In this corner, weighing in at 27 lbs., we have the hero of the self-employed…the Don of deductions…the superman of simplistic set up – let’s give it up for Washington’s own Sole Proprietorship!
And in this corner, the contender, weighing in at 38 lbs., the savior of shareholders…the baron of balance sheets…the prophet of profit and loss – let’s hear it for the S Corporation!
Ok boys—-let’s have a good clean fight out there…
Round 1: Ease of Establishment
In this round, the Sole Prop lands a blow to the jaw of the S Corp…no paperwork to file, no minutes to keep, no additional returns to file…
Round 1 goes to the Sole Prop!
Round 2: Deduction of Reasonable and Necessary Business Expenses
The S Corp makes a nice recovery. We find basically the same deductions available to both the Sole Prop and the S Corp.
Judges? This round is voted a draw!
Round 3: Reasonable Compensation
The Sole Prop scores nearly a TKO here. Ever have any discussion about reasonable comp with a Sole Prop? Nope, you haven’t because it’s not an issue. The net profit of the Sole Prop is the ‘compensation’ of the owner. Conversely, the S Corp must pay reasonable compensation to the officer/shareholder or risk having distributions recharacterized as wages. Also S Corp wages are subject to FUTA and SUTA….not so with taxable profit for a Sole Prop.
Round 4: Self-Employment Tax on Net Profit
The S Corp comes roaring back with nearly a TKO of its own! S Corp profit, under current law, is not subject to self-employment tax, which saves 15.3%. Now, we still have the issue of reasonable compensation as we talked about in Round 3, but aside from that fact, the advantage here is clearly to the S Corp. The Sole Prop net profit is subject to self-employment tax, pure and simple. Round 4 goes to the S Corp.
Round 5: The QBID
The Sole Prop lands another convincing blow in this round. The qualified business income deduction for a Sole Prop is the net profit of the Schedule C minus adjustments to income effectively connected with the trade or business. Examples include the self-employed health insurance deduction, contributions to pension plans for the owner and the adjustment for one-half of self-employment tax. There’s no reduction for the amount of profit going to the owner. For the S Corp, the net profit must be reduced by all wages including reasonable compensation for the officer/shareholder. For example, all things being equal, a Sole Prop with a net profit of $100,000 has a tentative QBID of approximately $18,470 ($100,000 net profit – the one-half of self-employment tax adjustment to income of $7,650 x 20%). The S Corp, on the other hand, with $100,000 of net profit still needs to take a deduction for officer’s compensation. For simplicity let’s make that $25,000. The final net profit is then $75,000, which gives us a tentative QBID of $15,000 ($100,000 – $25,000 officer’s compensation x 20%).
Another round to Sole Prop.
Round 6: Accelerated Depreciation Decisions (Bonus and/or §179)
Once again Sole Prop comes out swinging! S Corp takes the blows but doesn’t retaliate. Is S Corp holding back for later rounds? TCJA increased §179 expensing to $1,000,000 ($1,020,000 in 2019) and introduced 100% bonus. Bonus is now available for used property and interior improvements to commercial property.
The issue here revolves around how much accelerated depreciation is allowed in a given year. For §179 expense electing, we are limited to the net profit of the entity. For the S Corp, that’s net profit + officer’s compensation. For the Sole Prop, it’s net profit on the Schedule C plus other earned income reported on Form 1040. That other earned income could be wages (including those of a spouse if filing jointly), 4797 gains, or other net profit reported such a partnership or another business activity. So here a Schedule C could actually show a loss for expensing under §179…..clear advantage to the Sole Prop. Both the S Corp and Sole Prop treat bonus depreciation the same way, in that there is no income limit so bonus could create a loss in either circumstance. However, we must consider basis issues especially in light of the need to track S Corp stock basis. It could be argued the same is true for a Sole Prop, but we seldom discuss basis in a Sole Prop activity.
Judges? This round goes to the Sole Prop!
Round 7: Liability Issues
The bell rings…the S Corp comes flying out of his corner…he lands a right…a left…another right…another left…he’s pummeling poor Sole Prop! Down goes Sole Prop! Down goes Sole Prop!…The referee starts to count to 10…. 1-2-3-4-5-6-7…wait… the Sole Prop is back on his feet! He staggers to his corner but the fight isn’t stopped.
Sole Props have unlimited liability in their activity. S Corp shareholders should have at least some degree of liability protection. Even in the LLC environment, attorneys have told this writer that single-member LLCs who go with the default treatment of filing a Schedule C have less liability protection than a single-member LLC who makes a corporate election for tax treatment. Discuss this in more detail with an attorney and be careful not to practice law if you don’t have a law license.
Round 8: Audit Risk
It’s a melee! S Corp lands a right, Sole Prop counters with a punch to the gut…Oh the humanity! The bell rings and they each stumble off to their respective corners. This round must be close to a draw!
The IRS Data Book (Pub 55B) for the period October 1 2017 through September 30 2018 indicated that 0.6% of individual taxpayers without a business return were audited vs. 2.4% for individuals with a business return (Schedule C). Only 0.2% of S Corps for the reported period were audited.
Advantage here would appear to be with the S Corp. Judges—you decide.
Round 9: The Fight is Stopped
Exhausted, the S Corp and Sole Prop can’t answer the bell and ask the judges to declare a winner. Here’s their verdict—it’s a split decision!
Facts and circumstances with each taxpayer helps determine the best entity decision and every taxpayer’s situation is different. Ultimately, it’s up to the taxpayer to decide. But, we could always change later on—-right?
So hit the showers and be prepared to come out swinging next time!
by Tom O’Saben, EA