As a freelancer or contractor, at some point, you may wish to incorporate as an S corporation. Here’s a closer look at the process of becoming an S corp and when switching might be a good option for a sole proprietor.

The main benefits of S corporations

• Self-employment tax savings. As a sole proprietor, you must pay a 15.3% self-employment tax (which includes Social Security and Medicare) on your entire income. However, with an S corporation, you can split your income into two parts: a reasonable salary and distributions. A reasonable salary is subject to self-employment taxes, while distributions are subject to income taxes but not self-employment taxes.
• Pass-through taxation. Similar to sole proprietorships, S corporations are considered pass-through entities. This means that the business itself doesn’t pay income taxes. Instead, profits and losses pass through the business to the owner’s personal tax return. Profits of a C corporation, on the other hand, are taxed twice. This occurs once at the entity level and again on the owner’s tax return.
• Legal protection. If there is a risk of possible legal action, an S corporation can potentially help protect your personal assets from your business assets. For example, this can be especially helpful if you are in the contractor trade and the customer makes a claim against the fulfillment of your contract.

Trade-offs to consider

While transitioning from a sole proprietor to an S corporation can undoubtedly result in significant tax savings, there are a few trade-offs to consider. Most of the trade-offs are regarding administrative requirements and potential costs, including:

• Running payroll. Even if you’re the only employee, you’ll need to set up payroll and withhold taxes. Many business owners utilize a payroll service to manage this process.
• Separate tax filing. Your business will now need to file a Form 1120-S tax return with a March 15th due date in addition to your personal tax return.
• Accountants or bookkeepers are typically used. Most S corporation owners work with professionals to handle bookkeeping and tax filings.
• Reasonable salary requirement. The IRS expects owners to pay themselves a fair market wage. Underpaying yourself to avoid taxes can lead to penalties.
• State-level requirements. Some states impose minimum franchise taxes or annual fees on corporations and LLCs, regardless of their income.

When to switch from sole proprietor to an s-corp

Switching to an S corp generally becomes worth considering when your net income (after expenses) is in the range of $75,000 to $100,000 or more per year. For example, assume you earn $120,000 in net income as a consultant. As a sole proprietor, you’d pay self-employment tax on the full amount, about $18,000. As an S corp, if you pay yourself a reasonable salary of $60,000, you’d only pay payroll taxes on that amount, roughly $9,200. The remaining $60,000 in profit would be subject to income taxes but not payroll taxes. That’s a potential tax savings of nearly $9,000 per year.

Switching from a sole proprietor to an S corp can offer real tax advantages, but it’s not a one-size-fits-all solution. It’s generally best practice to review your situation annually to ensure proper organization of your business. Contact our RRBB advisors for more information, if you have any questions, or are ready to take the next step.