When should you file a separate tax return for your business?

When should you file a separate tax return for your business?

As you are probably aware, our government passed some new tax laws. And many people are wondering how it will affect them and if it would benefit them to file a separate tax return for there business. Hopefully today I can walk you through a couple of scenarios to give you an idea of the benefits and cost of keeping your business reported on your personal tax return and filing a separate return.

What Changed with the new tax law for businesses.

The new tax law implemented several changes, and you can look at a more in-depth list from another blog post here or a list from the Tax Foundation here

The major changes we will focus on are the reduction of the Corporate tax rate and the new 20% deduction for pass-through entities.

But before we get into that, I need to define a couple of terms.

  • First, when I'm talking about a Corporation,  S-Corp, Partnership, or Sole Proprietor, I am only referring to how the IRS views the organization not how the organization is legally organized. For more details on that read this blog post.
  • Second, according to the IRS, a pass-through entity is a Sole Proprietorship, Partnership, or S-Corp. Pass-through means that the business itself does not pay taxes instead all profits are pass-through to the individual owners and taxed on their returns.
  • Third, in our analysis, we are only looking at the cost related to filing tax returns with the IRS and don't take into consideration the cost related to state filings because those can differ widely from state to state.
  • Lastly, for our discussion, we are comparing the cost and benefits of a Sole Proprietorship, S-Corp, and Corporation.

Benefits and costs related to a sole proprietorship

Benefits

  • Low startup costs
  • Don't have to register with any governmental agency
  • Reported on your personal tax return
  • 20% of your net income isn't taxed (several conditions apply)

Cost

  • You pay about 30% in taxes for all profit you make.
  • Your personal tax rate plus Self-Employment tax of 15.3%

Benefits and costs related to an S-Corp

Benefits

  • Business finances are mostly separate from your personal finances
  • Profits are only taxed at your personal tax rate
  • Don't need to pay estimated tax payments (most of the time)
  • Distribution of income from the business to your personal account aren't taxed
  • 20% of your net income isn't taxed (several conditions apply)

Cost

  • Must register the business with the IRS and State
  • Must file a separate tax return
  • Income is still reported on your personal tax return
  • Must pay yourself a reasonable W2 wage

Benefits and cost related to a Corporation

Benefits

  • Business finances are completely separate from personal finances.
  • Your business profits are taxed at a max 21%
  • Won't need to make estimated tax payments for your personal return.

Cost

  • Must register the business with the IRS and State
  • Must file a separate tax return
  • Must pay yourself a reasonable W2 wage
  • Distributions from the Corporation are taxed as dividends

Meet John and Susanne

John runs a small business which services automobiles. John has three employees and pays himself a wage of $50,000 a year and the business makes between $20,000 to $50,000 a year in net income. John is single.

Susanne just started a business as a real estate agent. She plans on making between $20,000 and $30,000 the first year. Susanne works as a real estate agent part-time and the rest of her time is spent taking care of her three children.

Let's start with John and assume he made a total income of $100,000 ($50,000 wage, and $50,000 net income from his business).

  • As a sole proprietor, his effective tax rate would be 28% or $24,390
  • As an S-Corp, his effective tax rate would be 19% or $16,740
  • As a Corporation, if he were paid the $50,000 as a dividend, his effective tax rate would be 30% or $27,240 (Tax on the dividend of $50,000 plus wages on his personal return plus the tax on the $50,000 on the corporate return)
  • As a Corporation without the dividend, his effective tax rate would be 18% or $16,240.

Now let's look at Susanne. For this example, she will be paying herself a wage of $20,000 in regards to the S-Corp and Corporation but no wage as a Sole Proprietor. Her total income will be $30,000 for her business. Her husband will be assumed to make a wage of $80,000.

  • As a sole proprietor, her effective tax rate would be 14% or $11,675.
  • As an S-Corp, her effective tax rate would be 8% or $7,085
  • As a Corporation with a 10,000 dividend, her effective tax rate would be 10% or $9,185
  • As a Corporation without the dividend, her effective tax rate would be 4% or $2,739

As you can see from both of these examples, you get the best tax benefit from the corporation without paying a dividend but you get the best overall benefit from the S-Corp because you pay the lowest tax rate and get to take home more cash.

What is the break-even point for filing my business as an S-Corp?

First, let's look at what other cost are involved.

  • $500 one time setup fee to set up an LLC and filing the paperwork to be taxed as an S-Corp
  • $350 annually to file a separate tax return.
  • $50 a month for payroll plus an additional $10 per employee.

For John, his additional cost would be $750 the first year and $350 the following years. He doesn't have any additional cost related to employees because he is already paying himself and employees.

For Susanne, her additional cost would be $1,350 ($500 Setup, $350 Tax Return, $600 payroll fees) the first year and $950 the following years.

John's breakeven would be about $20,000 of total income where he paid himself a salary of $15,000 and took a distribution of $5,000. This would be a tax savings of $15 the first year and $415 for the following years.

Susanne's breakeven would be about $20,000 where she paid herself a salary of $10,000 and took a distribution of $10,000. This would be a savings of $180 the first year and $580 the following years.

As I close out this post I need to mention one thing. As an owner of an S-Corp who provides substantial services to the S-Corp you must pay yourself a reasonable salary. There are three main things the IRS looks at when considering if a salary is reasonable.

  • Performance of the Employee
  • Salary Comparisons
  • Company Conditions

For example, if your business nets $50,000 the first year in business, $100,000 the next, and $150,000 the next and you only pay yourself a salary of $30,000 the IRS is going to look at the performance of the business and state your wage should be higher in year 2 and 3.  This example only looks at performance of the employee. Since I don't have time to go into detail here for more information checkout this article from Tony Nitti at Forbes.

One more thing before I conclude you may have noticed that I didn't take into account the new 20% deduction for pass-through entities. That is because the two businesses above provid services as their primary source of revenue and thus are disqualified from the 20% deduction. For more details on that check out this article from Tony Nitti at Forbes and to see what your potential deduction check out this calculator I created.

In Conclusion

If your business is more then just a hobby and you expect to make more than $20,000 to $30,000 in revenue this coming year you may want to consider being taxed as an S-Corp. To give you an idea of what the tax savings might look like check out this break-even calculator I have created and if your business sales products and not just services take a look at this 20% deduction calculator to get an idea of what your deduction might be.


Click Below to See if you would benefit from filing a separate tax return.

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