Self-Employed & Taxes: Schedule C vs S Corporation

Are you self-employed and want to save on self-employment taxes? Then becoming an S Corporation might be a great option for you! Below we will go over the basic taxation you will see as a Schedule C versus an S Corporation, outline when it makes sense to become an S Corporation, and discuss how to become an S Corporation.

Note: Income taxes are the same under either scenario, so we will only be comparing PAYROLL taxes.

To see the blog on comparing taxation as a W-2 employee and self-employed on Sch C, click here.

PAYROLL TAXES USING SCHEDULE C

Whenever you are self-employed reporting your earnings on Schedule C, you pay 15.3% of self-employment (SE) taxes on your net income. Why? Because you aren’t on payroll (like a traditional W-2 employee) but are still required contribute towards the Social Security and Medicare systems. (Note that the Social Security part of the SE tax is 12.4% maxed at $137,700 [for 2020].)

EXAMPLE FOR SCHEDULE C

Let’s say that you have net income (revenue minus expenses) of $100,000. At 15.3%, that equates to $15,300 of self-employment taxes. This tax is reported on your Form 1040, individual income tax return.

PAYROLL TAXES AS AN S CORP

As an S Corporation, you are now an employee of your business. Your business will issue you a Form W-2 at year-end for the wages paid to you during the year. Anything not paid out as wages you can take out as a shareholder distribution with no negative tax impact (assuming you have adequate basis…we won’t get into those details here).

There is no direct calculation or specific guidance to determine what a “reasonable wage” would be (the amount that goes on your W-2) – it is subjective. However, the IRS mentions three major sources of gross receipts to help determine a reasonable wage: 1) services of shareholder 2) services of non-shareholder employees and/or 3) capital and equipment.

In addition, the factors the IRS mentions as part of determining reasonable compensation include:

• training and experience
• duties and responsibilities
• time and efforts devoted to the business
• dividend history
• payments to non-shareholder employees
• timing and manner of paying bonuses to key people
• what comparable businesses pay for similar services
• compensation agreements
• the use of a formula to determine compensation

Obviously there is some incentive to keep wages lower to pay less in payroll taxes. Therefore, we encourage you to keep documentation of the methodology you used to support your reasonable wage amount, should the IRS ever request it in an audit.

EXAMPLE FOR S CORP

The same as our Schedule C example, let’s say you have net income of $100,000. You determine that a reasonable wage would be $35,000. Instead of paying 15.3% on the $100,000 of net income, you are now only paying that 15.3% (plus a tiny bit more for state unemployment taxes and federal unemployment taxes) on the $35,000 of wages. That means $5,355 of FICA taxes (the W-2 equivalent of self-employment taxes). The remaining ~$65,000 of profit could be distributed payroll tax free!

SIDE-BY-SIDE COMPARISON

WHEN DOES IT MAKE SENSE TO BECOME AN S CORPORATION?

Well…it depends. 😊 While the potential payroll tax savings are apparent, there are some other considerations as well. There are additional costs (as compared to being a Schedule C) such as: 

• an additional tax return – an S Corp files Form 1120S with a due date of March 15 (can be extended 6 months to September 15)
• payroll processing fees – there will be monthly/quarterly/annual payroll form requirements so we recommend hiring a payroll processor to file these and remit the payroll taxes
• accounting fees – an S Corp return is more sophisticated [than a Schedule C], as it has Balance Sheet accounting; thus, we highly recommend (and require for our clients) hiring an accounting professional to either completely maintain your financials or at a minimum, do an annual tie out/review of the financials (note: we use QuickBooks for all of our clients)
• state fees – some states, such as California, charge a minimum amount for an S Corp in their state ($800 minimum for California); you will need to look at your specific state to see its rules and regulations

Therefore, it would be advantageous to estimate your payroll tax savings vs your additional costs.

The below calculation shows an estimate of the total net savings, using our S Corp payroll tax savings we computed in the earlier example. (Obviously these exact costs may vary.)

Another potential motivation in becoming an S Corporation beyond just the net savings: a Form 1120S is approximately 5 times LESS LIKELY to be audited as compared with Schedule C on your Form 1040.

HOW TO BECOME AN S CORPORATION

There are two ways to become an S Corporation. The first, and most common way we deal with, is to elect to have your LLC (Limited Liability Company) taxed as an S Corporation. The second, less common way is to set up a true-blue Corporation. In either case, you will file Form 2553 with the IRS which tells them you are choosing to be taxed as an S Corporation.

IMPORTANT NOTE: The earliest date you can elect to be treated as an S Corp is the date your LLC was formed. If you were operating as a sole proprietorship (without an LLC) before, then you first need to create an LLC as the potential start-date of your S Corporation election. Technically you have 3 months from the date the LLC was formed or the first day of the tax year (if not your 1^st year of operation) to elect S Corp status with the IRS, though we have been very successfully in filing late elections.

As always, feel free to reach out to us at Arndt & Company with any questions!

Thank you!

Kayla Weaver, CPA

Disclaimer: This article is not intended to be tax advice, and it does not cover all possible scenarios and/or rules within the tax code. Please contact Arndt & Company or your CPA for further information or clarification.