Single-Member LLC Tax Classification: Sole Proprietorship vs S Corp

Jovan Johnson, MBA, CFP®, CPA/PFS

Did you know that your business tax classification can have a significant impact on your business operations and the amount of taxes you pay? When comparing a sole proprietorship vs S Corp, it is crucial to consider your business goals and the level of complexity you are willing to manage. For single-member businesses, sole proprietorship is the default tax classification, making it simpler and less expensive to establish than an S Corporation.

Before committing to an S Corp for potential tax savings, consider key differences such as tax forms, how to pay yourself, the QBI deduction, and additional costs. Additionally, you can check out this S Corp checklist to understand the requirements and responsibilities if you choose to become an S Corp.

In this article, we will focus on the sole proprietorship vs S Corp tax classifications for a single-member LLC.

Single-Member LLC Tax Classification: Sole Proprietorship vs S Corp

Tax Return Forms

Sole Proprietorship

Under the sole proprietorship tax classification, you must report business activity on Schedule C of Form 1040. There is no separate business tax return needed to be filed. Your business income and expenses are reported on Schedule C, which then flows to your personal income tax return (Form 1040).

S Corp

Under the S Corp tax classification, you have additional tax return filing requirements. First, you must file a separate business income tax return, Form 1120S. This return will report all business income and expenses, including payroll. After filing this return (deadline March 15th), you will be issued a Schedule K-1, which you will use to input the information into your personal income tax return.

There are two areas where S Corp income will flow through to your personal income tax return. First, your salary is reported on page 1 of Form 1040 as W-2 income. Second, your share of the S Corp’s profits (distribution portion) is reported on Schedule E, using the information provided on Schedule K-1.

Paying Yourself and Self-Employment Taxes

Sole Proprietorship

If your business is taxed as a sole proprietorship, you will incur both income and self-employment taxes on all your profits. As a sole proprietor, you can distribute all profits after taxes to yourself. Paying taxes as a sole proprietor is often simple as you only have to worry about paying quarterly estimated taxes (no payroll). 

S Corp

As an S Corp, you will pay yourself through both salary and distributions. You will incur income taxes on both types of income. However, self-employment taxes are withheld only from your payroll salary, while distributions avoid the self-employment tax.

It is important to note that you must pay yourself a reasonable salary. The IRS does not clearly define what constitutes a reasonable salary, so it is crucial to work with a tax professional to determine the appropriate amount. Consider factors such as your role in the business, years of experience, location, hours worked, and the company’s profitability. If a reasonable salary is significantly less than your total business profits, electing S Corp status could provide tax advantages.

QBI Deduction (May Sunset in 2025) 

This deduction is set to end after 2025 unless extended. Therefore, the last tax year to claim the QBI deduction, as of now, is 2025.

Sole Proprietorship

As a sole proprietor, you may be eligible to claim a QBI deduction of up to 20% of your business profits or your taxable income, whichever is lesser. This is because you do not have to run payroll when taxed as a sole proprietor.

S Corp

Things differ if you are taxed as an S Corp. Since you must pay yourself a reasonable salary, you can only claim a QBI deduction of up to 20% of your business profits after deducting that salary, or 20% of your taxable income, whichever is less. For example, if your business makes $100,000 and you pay yourself a salary of $50,000, you can only get the QBI deduction on the remaining $50,000.

Some additional requirements and complexities impact your ability to claim the QBI deduction. For instance, there are taxable income thresholds that may limit this deduction. Additionally, the nature of your business is crucial in determining if you qualify for the QBI deduction. It is advisable to consult with a tax professional to navigate these complexities and maximize your deduction.

Additional Things to Consider Before Electing S Corp Status

Before electing S Corp status, consider the following additional items: 

• Federal Unemployment Insurance (FUTA): S Corps are required to pay FUTA for their employees (yourself).
• State Unemployment Insurance (SUTA): Similar to FUTA, S Corps must also pay state unemployment insurance.
• Potential State Franchise Taxes: Some states, like California, impose franchise taxes on S Corps.
• Additional Tax Return Filings: You will need to file Form 1120S, the S Corporation income tax return.
• Payroll Provider: A payroll service is often necessary to ensure reasonable salary payments and compliance with payroll taxes.
• Hiring an Accountant: The complexities of S Corp tax status often necessitate professional accounting assistance.
• Hiring Children: There are additional complexities when hiring children to avoid self-employment and income taxes on their income.
• Board of Directors: S Corps are required to have a board of directors and must hold at least one annual meeting.
• States Recognition: Not all states recognize S Corp status, so you must verify your state’s regulations.

Final Thoughts

While minimizing taxes is an important part of every business owner’s strategy, it should not be the only consideration. Choosing the right tax classification for your single-member LLC is a crucial decision that can significantly impact your business’s financial goals. Both the Sole Proprietorship and S Corporation classifications offer distinct advantages and challenges. Consider whether the benefits of potential tax savings outweigh the complexities and costs associated with S Corp status.

Ultimately, the best choice depends on your unique circumstances and long-term goals. Consulting with a tax professional can provide personalized guidance tailored to your specific business situation.

Would you like to learn more about choosing the right tax classification for your single-member LLC? If so, please feel free to book a free consultation with us.

Disclosures

None of the information provided is intended as investment, tax, accounting, or legal advice, as an offer or solicitation of an offer to buy or sell, or as an endorsement, of any company, security, fund, or other securities or non-securities offering. The information should not be relied upon for purposes of transacting securities or other investments. Your use of the information is at your sole risk. The content is provided ‘as is’ and without warranties, either expressed or implied. Piece of Wealth Planning LLC does not promise or guarantee any income or particular result from your use of the information contained herein.