File 1120S instead of Schedule C

Schedule C is part of Form 1040 and is used to report income or loss from a business. “Business” means any continuous activity engaged in for income or profit. Schedule C is also used to report statutory employee wages and expenses, income and deductions of certain qualified joint ventures, and certain income shown on Form 1099-K and Form 1099-MISC. There are two important reasons why reporting business income on Form 1120S is better than reporting business income on Schedule C.

First, is audit risk. The IRS continually tracks the “tax gap,” or the amount of tax liability faced by taxpayers that is not paid on time. A huge portion of the tax gap is attributable to Schedule C under-reporting; this is the reason why the IRS audit efforts focus so heavily on Schedule C. Additionally, claiming several years of losses in a row on Schedule C will increase audit risk with the IRS arguing that the “business” is really a “hobby” and that the losses should be disallowed.

Not only does filing Schedule C cause an audit risk, it also results in paying more self-employment taxes than necessary. On Schedule C, all of the net income from the business is subject to self-employment tax, which is normally around 15 percent. Self-employment tax is in addition to income tax.

By forming a business entity and electing to have that business entity taxed under Subchapter S of the Internal Revenue Code, self-employment tax liability can be reduced. A Subchapter S Corporation (S-Corp) is created when an eligible entity, such as a corporation or limited liability company, elects to be treated according to the rules of Subchapter S of the Code and its regulations.

S-Corp net income is reported on form 1120S and flows through to the personal tax return of its owners, avoiding Schedule C and self-employment tax all together. However, S-Corps must pay a reasonable salary to its owners. Salary is subject to payroll taxes, and payroll taxes are virtually identical in amount to self-employment taxes. However, S-Corps do not need to pay all net income as salary, and any net income not paid as salary avoids both self-employment tax and payroll tax.

In order to form an S-Corp and file Form 1120S, advance planning must be undertaken since a business entity should be formed and Form 2553 should be filed to make the S-Election near the beginning of the tax year. Doing so, however, is likely to result in a smaller overall tax liability at year end.

Posted in: Income Tax,IRS,Payroll Tax,S-Corp