Two consultants earn $200,000. One pays $28,200 in self-employment tax. The other structured as an S corp, paid herself $120,000 salary, and saved roughly $9,900 in payroll taxes. Same work. Different entity. Different tax bill.
Default structure. No legal separation from the owner. Unlimited personal liability. Income on Schedule C flows to Form 1040. Subject to income tax and SE tax.
Because a sole proprietor is both employer and employee, she pays both halves of Federal Insurance Contributions Act (FICA) through SE tax, hence 15.3%, not 7.65%. There is no payroll office to split the bill with.
SE tax = 15.3% (12.4% Social Security up to $184,500 + 2.9% Medicare, no cap). Additional 0.9% Medicare above $200,000 single / $250,000 MFJ.
Before applying 15.3%, multiply net SE income by 92.35%. This approximates the employer-equivalent deduction. Half of SE tax is an above-the-line deduction.
EXAMPLE: Sole proprietor with $200,000 net income. $200,000 x 92.35% = $184,700. SS tax: $184,500 x 12.4% = $22,878. Medicare: $184,700 x 2.9% = $5,356. Total SE tax: $28,234. Above-the-line deduction: $14,117.
Common mistakes
- Treating S corp distributions as free from all tax. Distributions escape FICA/SE tax. They are still subject to income tax as K-1 pass-through income. Trap: $0 tax on distributions.
- Forgetting QBI does not reduce SE tax. A sole proprietor's QBI deduction helps on income tax only. The SE tax bill is unchanged. Trap: subtracting QBI from both income and SE tax.
- Confusing partnership and S corp basis rules. Partnership: share of liabilities increases basis. S corp: only direct shareholder loans count. Guarantees of corporate debt do not create S corp basis. Trap: S corp shareholder claiming full loss based on a guaranteed loan.
Bottom line
- S corp advantage: salary is subject to FICA, distributions are not; the salary must be "reasonable".
- Sole proprietors pay SE tax on every dollar of net profit, with no salary/distribution split available.
- C corps face double taxation: 21% corporate plus the qualified dividend rate (~36.8% combined).
- QBI deduction (20%) phases out entirely for SSTBs above $276,750 (single) / $553,500 (MFJ).
Exam shortcut
When comparing entities, run the full computation: income tax (including QBI) plus payroll/SE tax. The exam's favorite trap is getting income tax right but ignoring the payroll difference between sole prop and S corp. Remember: "SCALP" for SSTBs. Financial Services, Consulting, Accounting, Law, Performing arts. If the business is SCALP, check the income threshold before claiming any QBI deduction.
The full lesson (about 2,342 words, 16 min read) adds 2 worked examples, all 5 common mistakes, a self-check, free in the app.
Learning objectives
- E.38
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