What Is an IRS Schedule C, And How to Reduce Taxes As a Sole Proprietor
If you are self-employed or receive 1099-NEC Forms, you'll likely need to use Schedule C to report income and expenses for your trade or business. However, if you file Schedule C, you may be paying more income and self-employment taxes than other business owners. Are there ways to reduce this tax burden? Here's what you need to know.
What is a Schedule C (1040)?
Schedule C (1040) is an IRS tax form for reporting business-related income and expenses. Its official name is Profit or Loss From Business (Sole Proprietorship), and it is attached to Form 1040, U.S. Individual Income Tax Return; 1040-SR, U.S. Tax Return for Seniors; 1040-NR, U.S. Nonresident Alien Income Tax Return; or 1041, U.S. Income Tax Return for Estates and Trusts.
What types of businesses use Schedule C?
Per the IRS website, business owners should use Schedule C (Form 1040) to report income or loss from either a business they operated or a profession they practiced as a sole proprietor. An activity qualifies as a business if:
- The primary purpose for engaging in the activity is for income or profit
- Business owners are involved in the activity with continuity and regularity
Sole proprietorships and single-member LLCs taxed as sole proprietors use Schedule C (1040).
Do Schedule C filers pay more income and self-employment taxes than other business owners?
Business owners required to file Schedule C may find they personally pay more in taxes than individuals who own S Corporations or C Corporations. That’s because owners of sole proprietorships and single-member LLCs (which are by default disregarded entities for tax purposes) pay income tax and self-employment taxes (Social Security and Medicare tax) on all of their business profits.
Their business income is taxed whether or not they take money out of their company to pay themselves or leave it in their business bank accounts. Taxes pass through to the individual's tax returns; the business does not file tax returns of its own.
Self-employment taxes can particularly sting owners of sole proprietorships and single-member LLCs. The business owner does not receive a paycheck (they get paid through owner's draws) from which 50% of their Social Security and Medicare taxes are withheld, nor does the business pay the other 50% as would happen with employees on the payroll. Instead, a sole proprietor or LLC owner must pay the entire 12.4% Social Security tax and 2.9% Medicare tax, usually through quarterly estimated payments to the IRS.
A Schedule C filer can claim a 50% deduction of the self-employment tax paid for individual income tax purposes, and an S Corp or C Corp can claim an income tax deduction for the employer portion of Social Security and Medicare taxes.
Can forming an LLC taxed as an S Corp or a C Corp reduce my tax burden?
Possibly. However, various factors can influence whether that will be the case. It’s important that you talk with an attorney and tax professional for guidance.
Generally speaking, most LLC owners can minimize their self-employment tax burden by choosing to be taxed as an S Corporation or a C Corporation. So, too, can sole proprietors, but first, you must either:
a. Convert from a sole proprietorship to an LLC before electing S Corp or C Corp tax treatment, or
b. Convert from a sole proprietorship directly to a C Corp before either remaining with C Corp tax treatment or electing S Corp tax treatment.
LLC taxed as an S Corporation
When a single-member LLC is taxed as an S Corporation, profits and losses continue to pass through to the owner’s personal income tax return. However, there’s a difference that may reduce the LLC owner’s personal tax liability. The owner of an S Corp gets paid through the company's payroll for their work in the business. Therefore, only their wages or salary is subject to FICA tax (Social Security and Medicare taxes). The remaining profit, taken by the individual as a distribution, is subject to income tax but not Social Security and Medicare taxes.
In addition, when an LLC is taxed as a S Corporation, the business owner’s wages and salaries, plus the employer portion of FICA taxes, are tax deductions that pass through to the owner’s personal income tax return.
LLC taxed as a C Corporation
When a single-member LLC is taxed as a C Corporation, profits and losses get reported on a business tax return, and income taxes are paid by the business. Meanwhile, the business owner reports their wages, salaries, and profit distributions from the company on their individual tax return. Owner’s wages or salary are subject to FICA tax (Social Security and Medicare taxes), while profits taken as distributions are subject to income tax but not Social Security and Medicare taxes.
In addition to potentially lowering the business owner’s tax burden, there is the potential to save on income taxes, too. When taxed as a C Corporation, the business owner’s wages and salaries plus the employer portion of FICA taxes are tax deductions for the company (which is not the case with owner's draws in LLCs and sole proprietorships). Also, if the corporate tax rate is lower than the business owner’s individual tax bracket, that might lower the overall income tax burden.
However, some C Corp income gets taxed twice, which might negate any of the potential tax advantages I just mentioned. Profits distributed to the business owner (made on an after-tax basis) are not tax-deductible for the company. The company pays tax on that income at the corporate rate, and then that money is taxed again at the individual level when the business owner receives the distribution.
What about partnerships and multi-member LLCs?
While owners of partnerships and multi-member LLCs do not use Schedule C (1040), their companies are pass-through entities. Therefore, as with sole proprietorships and single-member LLCs, they may face a lofty self-employment tax burden. Thus, the potential advantages of tax election as an S Corporation or C Corporation also apply to them.
Steps to becoming an LLC taxed as an S Corp or C Corp
An existing LLC files IRS Form 2553 (election by a Small Business Corporation) to become an S Corporation or IRS Form 8832 (Entity Classification Election) to become a C Corporation for tax purposes. These forms change an LLC’s tax status without changing its underlying business entity type.
Sole proprietorships must first form an LLC before filing for S Corp or C Corp tax treatment. Besides gaining tax flexibility, business owners also gain personal liability protection when they form an LLC because an LLC is a separate legal entity from its owners. The steps to establish a limited liability company vary by state.
Generally, here's what's involved:
- Designate a registered agent to accept service of process and other official legal and government paperwork on the LLC’s behalf.
- File Articles of Organization with the state.
- Obtain an EIN from the IRS.
- Create an LLC operating agreement.
- Open a business bank account for the LLC.
- Apply for any required licenses and permits.
- Comply with ongoing business compliance responsibilities (e.g., maintain a registered agent, file annual reports, keep business finances separate from owners’ accounts, and be aware of any other federal, state, or local requirements).
Should I change my business's legal structure?
Changing a business’s legal structure or tax election requires careful thought and thorough exploration of the implications. Many factors influence how a change will impact a company and its owners.
If you’re considering switching your business entity type, or applying for S Corporation or C Corporation tax treatment, I encourage you to speak with trusted legal and tax professionals for guidance so you can make an informed decision.
