The Great Divide

Pre 1958 there was a great economic divide between sole proprietors and corporations that created a heated political situation. It was the haves vs the have nots, rich vs poor, big vs small. Small businesses were at a great disadvantage because corporations were complicated and expensive to set up.  Corporations were also subject to “Double taxation” meaning the corporation paid taxes and then the owner paid taxes on any dividends paid to them by the corporation. An expensive proposition for sole proprietors. In order to bridge the gap S-Corps were created. It eliminated double taxation for shareholders making it affordable for sole proprietors.

Today there are over 30,000,000 US-based businesses and 25,000,000 are still classified as sole proprietors for tax purposes. A single-member LLC is classified as a sole proprietor for tax purposes unless there is an election made to be taxed as a S-Corp. 

 

With 25,000,000 businesses still being taxed as sole proprietors It’s obvious that the S-Corp never caught on and there are reasons, it didn’t. It was never promoted as a solution to the tax problem sole proprietors face and in fact, almost all of the information on the SBA, IRS and any other government website touts the simplicity of sole proprietorship. The government leveled the playing field and didn’t really bother to let anyone know.

 

Why is it so bad to be a sole proprietor? 

Sole proprietors are overtaxed, over audited, have no legal protection (unless they are an LLC) and get zero respect from the business community at large. Sole proprietors do not get to choose how they get paid, and have to pay fica tax on all of their profits, even if they don’t take them out of the business! Sole proprietors get audited much, much, much more than corporations for a number of reasons. 

• They usually don’t have a knowledgeable professional advising them and don’t keep good books and records.
• Alot of them prepare their own returns. 
• For every $10,000 in adjustments the IRS adds $1,500 in social security taxes plus the increase in taxes. That’s at least 27% (15% in self employment taxes plus 12%-the lowest income tax rate for 2021) in taxes plus interest and penalties for every $1. 
• Corporations usually have a tax professional, keep good books and the return is not nearly as great as with sole proprietors.

 

The IRS

It’s important to understand the IRS Structure and mission to fully grasp what lies ahead for sole proprietors.

• The IRS is comprised of 4 main divisions- 
  • Large Business & International
  • Tax exempt & Government Entities
  • Small Business & Self Employed
  • Wage & Investments

The mission of the Small Business & Self Employed division is threefold which are to address:

• The underreporting gap. These are businesses that underreport income or overstate expenses.
• The underpayment gap. These are businesses that have filed returns but did not pay.
• The non-filing gap-businesses that simply don’t file.

It’s important to note that sole proprietors are the most likely to fit those three categories and in my opinion the main reason is the lack of good information put out by government agencies such as the “Small Business Administration”. For example, the SBA claims that a “small business” has fewer than 1,500 employees and less than $41,500,000 in revenue. This makes no sense when over 25,000,000 sole proprietors represent the bulk of USA based businesses. In fact a very small percentage make it to 5 employees. It’s no coincidence that a business with 1,500 employees qualifies for the same SBA programs as a sole proprietor. That is not a level playing field because a business with even 25 employees can usually afford to hire professionals to wade through all of the compliance and financial hoops to qualify while a sole proprietor usually can not. This results in the smallest businesses not being able to compete for programs that have caps on spending. That’s exactly what happened recently with the PPP and EIDL programs where larger firms went to the head of the line draining the available funds. The Biden administration tried to correct that with the 2nd round of PPP loans basing it on form 1040 schedule C info, the form used by sole proprietors. Unfortunately the damage was already done shutting the smallest businesses out of a program that was supposed to help them.

 

The current IRS workforce

After the 2008 financial crisis the IRS bulked up it’s workforce by 25,000 to reach 95,000. In 2010 congress started to gut the IRS by regularly reducing their budget. By 2018 they had less than 10,000 revenue officers and agents, the lowest level since 1953. Today they have 75,000 employees with less than 8,500  revenue agents and  3,000 revenue officers. The difference between an IRS Revenue Agent and an IRS Revenue Officer is that an agent conducts audits while revenue agents collect outstanding taxes.

 

The Family Cares Act and Tax Audits

The new law includes investing over $80,000,000 dollars and hiring an additional 87,000 employees (more than doubling their workforce) which they believe will produce over $7,000,000,000,000 (Trillion) dollars in unpaid taxes. Unfortunately, as in the past they will be targeting sole proprietors.

When I started in accounting tax audits were conducted face to face. You had a chance to look the auditor in the eye and present your case. Today they are doing audits by fax. They are faceless agents making major decisions based on static information. The problem with this is they are making poor decisions that negatively affect people’s lives and ability to operate their business without a chance to plead their case unless it goes all the way to tax court. I recently had 2 cases where the revenue agents made an erroneous decision that the taxpayers expenses were not “business related” and disallowed all of the deductions. One was a trucking company that had gone out of business and lost over $30,000. The auditor disallowed all of the expenses claiming there was no business purpose even though there was over $250,000 in payroll, $80,000 in fuel, $60,000 in insurance and $50,000 in repairs, all documented and submitted. Who would spend that kind of money on a hobby? The taxpayer hired me and I proposed to file a petition with the tax court to the new agent in charge. They wisley allowed all of the expenses and sent my client an apology letter. Before that she was facing a $250,000 tax bill. What the auditor did should have been criminal. This is an IRS that is out of control!

 

The Concentration of Wealth

In my humble opinion the system is set up to keep the concentration of wealth exactly where it is. The politicians that make the laws get a lot of funding from large corporations that are owned by the wealthiest individuals in the country. 

In a recent article by www.propublica.org they showed the 25 wealthiest individuals gains in net worth compared to the taxes they paid.

“In 2007and 2011, Jeff Bezos, then a multibillionaire did not pay a penny in federal income taxes. In 2018, Tesla founder Elon Musk, also paid no federal income taxes. Michael Bloomberg managed to do the same in recent years. Billionaire investor Carl Icahn did it twice. George Soros paid no federal income tax three years in a row.”

It seems very unfair to me and instead of attacking the smallest of small businesses maybe they should figure out a way to get billionaires and corporations that pay little or no taxes to start paying their fair share.

 

The Future For Sole Proprietors

It is troubling! With a new army of auditors and collection agents targeting them they must start taking steps to protect themselves starting with selecting a corporate business structure, retaining a professional and start keeping good books and records.

 

The Solution

Be as stealth as possible by doing business as a S-Corp. A single owner corporation is not nearly as complicated as they would like you to think. The truth is that the IRS has less control over corporations and owners of corporations have much more leeway over paying themselves and what they pay in taxes. Net profits of a sole proprietor are subject to fica tax while dividend distributions from a S-Corp are not. If only 40% of existing sole proprietors became S-Corps there would be a major drain on the social security system. A system that is already broken. That’s not a sole proprietor’s problem though, staying in business is.

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