Comparison of the 3 Business Entities for Year 1
In Year 1 of her business, Mary suffers a business loss because her expenses exceeded her income. Mary had business income of $30,000 but expenses of $40,000.
Schedule C
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $0
Payroll Taxes: $0
Profit or Loss: -$10,000
Result: Filing on a Schedule C will reduce Mary's taxable income by $10,000. If Mary is in the 25% tax bracket, this could reduce her tax by $2,500.
Change in Total Taxes: -$2,500.
C-Corporation
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $10,000
Payroll Taxes: $765
Profit or Loss: -$20,765
Result: The loss is retained by the corporation and offsets next year's business income. The loss is increased by the wages that the Corporation should pay Mary for her services and by payroll taxes on those wages. Mary's income is increased by $10,000. If Mary is in the 25% tax bracket, Mary's tax is increased by $2,500. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $3,265.
S-Corporation
Business Income: $30,000
Business Expenses: $40,000
Salary Expenses: $10,000
Payroll Taxes: $765
Profit or Loss: -$20,765
Result: The loss reduces Mary's taxable income by $20,765. The loss is increased by the wages that the Corporation should pay Mary for her services and by payroll taxes on those wages. Mary's income is also increased by $10,000 in additional wages. Mary's income has a net decrease of $10,765, and a net tax savings of $2,691 at the 25% tax bracket. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: -$1,926.
Comparison of the 3 Business Entities for Year 2
Given her economic situation from year 1, Mary decides to control costs in year 2 and maintain her existing contracts. Mary succeeds in holding business expenses at $15,000, and holding her business income steady at $30,000, giving her a tentative profit of $15,000 for the year. The real power of choosing the right business entity becomes clear when an unprofitable business suddenly becomes profitable.
Schedule C
Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $0
Payroll Taxes: $0
Prior Year Loss Carried Forward: $0
Profit or Loss: $15,000
Result: Filing on a Schedule C will increase Mary's taxable income by $15,000. If Mary is in the 25% tax bracket, this would increase her tax by $3,750. Also, Mary will have two pay Self-Employment Tax (15.3%) on her business profit, an additional $2,295. In order to avoid owing an additional $6,045 on April 15th, Mary should make four estimated tax payments of $1,511 each quarter.
Change in Total Taxes: $6,045.
C-Corporation
Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $10,000
Payroll Taxes: $765
Prior Year Loss Carried Forward: -$20,765
Profit or Loss: -$16,530
Result: Filing as a C-Corporation will decrease the Corporation's tax in year 2, because the loss from year 1 is carried over into year 2. Unlike the Schedule C or S-Corp, the loss is not distributed to the owners, and so it offsets next year's income. Because the Corporation has a net loss, there is no federal income tax. Just like in year 1, Mary's income is increased by $10,000. If Mary is in the 25% tax bracket, Mary's tax is increased by $2,500. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $3,265
S-Corporation
Business Income: $30,000
Business Expenses: $15,000
Salary Expenses: $10,000
Payroll Taxes: $765
Prior Year Loss Carried Forward: $0
Profit or Loss: $4,235
Result: Business profits are reduced by the addition of salary and payroll taxes that must be paid to Mary. The profit increases Mary's taxable income by $4,235. Mary's income is also increased by $10,000 in additional wages. Mary's income has a net increase of $14,235, and a net tax increase of $3,559 at the 25% tax bracket. Mary also pays an additional $765 for her share of Social Security and Medicare taxes.
Change in Total Taxes: $4,324.
