I once taught a graduate tax class about choosing between an LLC and an S corporation.
Probably for this reason, people frequently ask me about which entity form they
should chose. "Is an S corporation better than an LLC?" they ask.
"What about a C corporation?" others query.
Options such as S corporations, C corporations and LLCs can be the right
choice in certain cases. But the lowly sole proprietorship-an entity you form
automatically merely by starting business-is often best for tax reasons. And
here's why:
The $500-to-$1000-A-Year Tax Benefit: Easy Returns
A sole proprietor reports his or her business profit to tax authorities on
simple one- or two-page form called Schedule C. For many sole proprietorships,
in fact, all the IRS requires is a crude listing of revenue and expenses. In
comparison, a corporation tax return is at least eight pages in length-and the
return (typically either an 1120 or 1120S form) can it can be much larger if
there's a bunch of complexity.
Corporate tax returns, by the way, practically force you to use full-blown accounting software
such as QuickBooks.
Now, admittedly, the "easy tax return" may seem like a small
point. But the extra work and complexity of a corporation return doesn't just
mean more hours. It probably means you'll need to pay someone like me to do
your return. That cost can be anywhere from a few hundred to a several thousand
dollars annually in extra costs-costs that are over and above what the return
would cost if your business operated as a sole proprietorship.
The $1500-to-$2,000-Per-Kid-Per-Year Tax Benefit: Hiring Junior
Here's another often-missed tax-saver unique to sole proprietorships. A sole
proprietor can hire his or her minor children and not pay any payroll taxes.
Other employees and employees of corporations would trigger payroll
taxes-typically of at least 7.65% of wages paid.
In addition, the earned income of minor children typically isn't subject to
federal income taxes if the child earns less than $5,000 a year because of the
child's standard deduction.
If your minor kids help out in your business and the business is operated as
a sole proprietorship, the family tax bill can drops by one to two thousand
dollars annually for each child employed.
Here's how the math works: If you just keep your last $5,000 of sole
proprietorship profit, you'll very likely pay roughly 15% in self-employment
taxes on the profits. So that's roughly $750 of tax. You'll probably also pay
at least another $750 in income taxes and quite possibly another $1250 in
income taxes on the profit you keep yourself.
If you pay your teenager that last $5,000 because they're actually doing
work for you-the payment needs to be reasonable-neither the teenager nor the
business nor the parent will pay any income or employment taxes. Total tax
savings? $1500 to $2000 annually.
The $5,000-a-year Tax Benefit: Healthcare Reimbursement Arrangements
One other uniquely powerful tax benefit for sole proprietorships exists:
Healthcare reimbursement arrangements, or HRAs. A healthcare reimbursement
arrangement (also known as a IRC Section 105(b) plan) is an employer plan to
reimburse employees for medical costs, including medical and dental insurance,
deductibles, co-pay amounts, and any other legitimate healthcare expense.
Sole proprietors, partners in partnerships, and S corporation
shareholder-employees can't participate in HRAs. But there's a loophole in the
law: A sole proprietor's spouse can be covered. And that coverage can include
both the employee and the employee's family. Even though the spouse-employee's
family includes the sole proprietor!
What this means is that if your proprietorship employs your spouse, the sole
proprietorship can establish an HRA that reimburses all or some huge portion of
employee's family medical costs. The reimbursement is a business deduction for
both income tax and self-employment tax purposes. That double deductibility
often saves big taxes.
Let's say that your family pays $9,000 a year for health insurance and
another $9,000 for uncovered medical expenses. Say a family member has an
expensive long-term illness. Or simply that you've got teenagers with big
orthodontia bills.
Because you're self-employed, you would get to use the $9,000 of health
insurance costs as a business income tax deduction in most cases anyway.
(Self-employed individuals can write off medical insurance if their business is
profitable.) However, with an HRA, you'll also be able to use the $9,000 of
health insurance costs as a self-employment tax deduction. That saves you
roughly $1350 annually.
In addition, you'll be able to fully deduct the other $9,000 of uncovered
healthcare costs as both an income tax deduction and as a self-employment tax
deduction. This deductibility could easily save you another $1350 in self-employment
taxes and then another $2250 in income taxes. Total savings: $4950 annually.
A quick caution: A HRA needs to be nondiscriminatory, so you would have to
provide it to all employees. Many sole proprietors, therefore, might want to
offer a full reimbursement plan only if family members were the only employees.
You should confer with a tax advisor, probably, if you want to set one of these
plans up.
New
York LLC formations expert and tax accountant Stephen L. Nelson CPA has
written more than 150 books. Formerly an adjunct tax professor at