S Corporation versus Sole Proprietorship - Maximize Your Tax Savings
The Tax Cuts and Jobs Act offers a 20 percent deduction on pass-through business income, with specific eligibility criteria, from 2018 to 2025. This deduction significantly impacts the choice of entity. For instance, should you operate as a sole proprietorship or an S corporation?
The Importance of Reasonable Compensation
When operating your business as an S corporation, you must pay yourself “reasonable compensation.” Failing to do so can result in penalties, increased taxes, and missed deductions.
Balancing Act for S Corporation Owners
Lowering Salary: While reducing your salary might seem attractive to increase pass-through income and the Section 199A deduction, it risks IRS penalties and reduced benefits.
Increasing Salary: Conversely, a higher salary increases payroll taxes and potentially reduces your Section 199A deduction.
Unique Situation: Zero Salary
In rare cases, you might not need the S corporation to pay you a salary (e.g., you do not actively provide services to your S corporation). This setup can maximize your pass-through income and Section 199A deduction, but it requires careful planning to ensure legality.
S Corporation versus Sole Proprietorship
Choosing between an S corporation and a sole proprietorship is a nuanced decision, impacted by the Section 199A deduction, payroll taxes, and reasonable compensation requirements.
S Corporations: Can offer Social Security and Medicare tax savings. However, you must pay yourself a reasonable salary, which can complicate tax planning and potentially reduce the Section 199A deduction.
Sole Proprietorships: Benefit from a more straightforward tax structure and potentially higher Section 199A deductions under certain conditions. However, they are subject to self-employment taxes on all business income.
Additional Considerations
Qualified Business Income (QBI) Limitations: The 20% deduction applies to Qualified Business Income (QBI), but there are limitations based on income levels and the type of business. Service-based businesses, for example, face additional restrictions once income exceeds certain thresholds.
Aggregation Rules: If you own multiple businesses, the aggregation rules may allow you to combine income from several pass-through entities, optimizing the Section 199A deduction. Proper planning and documentation are essential to comply with IRS guidelines.
State Taxes: Consider the impact of state taxes on your overall tax strategy. Some states do not conform to the federal QBI deduction, affecting the net benefit of the Section 199A deduction.
Conclusion
Choosing the right business structure and optimizing your tax deductions under the Tax Cuts and Jobs Act requires careful planning and consideration of multiple factors. Balancing reasonable compensation, payroll taxes, and the Section 199A deduction can be complex but rewarding. If you need assistance navigating these choices or have questions about your specific situation, please call me on my direct line at 425-243-2026. We are here to help you make informed decisions that maximize your tax benefits and ensure compliance with all regulations.