If you own a small business as a sole proprietor (or are thinking about starting one), it may make sense to form a S corporation (S Crop).
When compared to a sole proprietorship, a S Corp will help protect your personal assets and can help you save on self-employment taxes.
In our Sole Proprietorship vs S Corp guide, we will explain the key differences between a sole proprietorship and a S corporation, as well as how to make the best decision for your business.
Sole Proprietorship vs S Corp: What’s the Difference?
A sole proprietorship is an unincorporated business in which the owner has no legal separation from the business.
An S Corp is a limited liability company or corporation that has elected to be taxed as a S corporation.
S Corporation vs. Sole Proprietorship The main difference between a sole proprietorship and a S corporation is that S corporations have limited liability protection and tax options, whereas sole proprietorships do not.
What is a Sole Proprietorship?
A sole proprietorship is an unincorporated business structure in which the owner is not legally separated from the business. Sole proprietorships do not provide limited liability or tax benefits.
Protection of Limited Liability A type of legal protection that protects a business owner’s personal assets from the company’s losses and debts.
Sole Proprietorship Taxes
The net profit of a sole proprietorship is subject to income tax and self-employment tax. The income generated by the business is reported on the owner’s personal tax return.
Pass-Through Taxation A taxation system in which the profits or losses of a business are not taxed at the business level. Instead, they “pass-through” to the owners’ personal tax returns and are taxed at the individual income tax rate of each owner.
When a sole proprietor has a large profit and few expenses, paying self-employment tax and income tax can result in a significant tax burden. An electrician or other skilled trades professional is an example.
What is an S Corporation?
An S corporation (S Corp) is a tax status available to incorporated businesses such as LLCs and corporations.
In fact, an LLC or corporation can only choose the S Corp tax status. This means that any business that operates as a S corporation, like any other LLC or corporation, provides limited liability protection.
Most small businesses should have liability insurance to protect the owner’s personal assets in the event of a business loss.
When forming an LLC, sole proprietorships have the option of electing S Corp status (or corporation).
S Corporation Taxes
S corporations are taxed in accordance with Subchapter S of the IRS Internal Code. The IRS treats the business owner as an employee under the S Corp tax election. The business owner does not have to pay self-employment tax on their portion of the company’s profit as an owner-employee.
In a S corporation, the owner-employee pays FICA taxes as well as income taxes on a reasonable salary. Only income taxes apply to distributions.
Under the right circumstances, this can result in significant tax savings. Tax savings must be balanced against increased payroll and accounting taxes.
The Difference Between Sole Proprietorship vs S Corp Taxes
Sole proprietors must pay self-employment taxes as well as income taxes on their business’s net profit.
The business owner in a S Corp pays FICA and income taxes on their “reasonable salary,” as well as income taxes on distributions.
Choosing a Business Structure: Sole Proprietorship vs S Corp
To be taxed as a S Corp, a sole proprietor must change their business structure to a corporation or LLC. We recommend using an LLC as your S Corp business structure because a corporation would almost never benefit from electing S Corp tax status.
When to Start an LLC Taxed as an S Corp
A company can form an LLC and then elect S Corp status. Under the right conditions, S corporation tax status allows business owners to pay less tax on their earnings.
If the following four conditions are met, you should elect to be taxed as a S corporation:
- You know you’ll want to take a significant portion of your company’s profits rather than reinvesting them to grow the company year after year.
- You are confident that your company will generate enough profit to pay the owner(s) a reasonable salary as well as at least $10,000 in annual distributions.
- Your company is a limited liability company (LLC) or a corporation.
- The company satisfies the S Corp requirements.
S Corp Requirements, Advantages, and Disadvantages
- Reasonable Salary
LLC owners who elect a S Corp become employees. The IRS requires owner-employees to be paid a reasonable salary. A reasonable salary is any salary that you would pay someone to do the same job.
The IRS has increased its scrutiny of LLCs taxed as S corporations. If the owner is not paid a reasonable salary, the IRS may deny S Corp status and levy fines and back taxes.
You can compare similar salaries on websites like Glassdoor or the US Bureau of Labor Statistics to determine a reasonable salary for your position.
- Profit and Distribution
The S Corp election allows a business owner to distribute the profits of an LLC to owner-employees in the form of salary and distributions. Only the salary is then subject to FICA and income taxes by the IRS. Only income tax is levied on distributions.
- Positive Return on Investment
It costs money to form and maintain a S corporation. The IRS filing fees are minimal, but the additional bookkeeping and payroll costs are not. This factor will be less important for LLCs that already have employees and payroll costs.
Business owners should weigh the cost of maintaining these services against the fiscal tax benefits of choosing the S Corp classification. In general, a reasonable salary plus $10,000 in annual distributions is often enough to make the S Corp financially viable.
- IRS S Corp Requirements
Businesses that choose S Corp status must have 100 shareholders or less and can only issue one class of stock, according to the IRS.
The owners of the company must be US citizens or permanent resident aliens. Owners must also be private individuals rather than corporate, LLC, or trust entities.
When to Operate as a Sole Proprietorship?
Sole proprietorships are ideal for businesses that have the following characteristics:
- They HAVE TO BE SAFE (low chance of liability or financial loss)
- They serve a smaller number of customers, who are frequently friends, family, and neighbors.
- They could be hobbies such as photography, blogging, or live video streaming.
Sole Proprietorship Advantages
There are numerous advantages to running a sole proprietorship. Here are some of the most important advantages of being a sole proprietor for new business owners.
- Affordable and simple
The benefits of forming a sole proprietorship are simplicity and affordability. However, there are a few things you must consider before registering as a sole proprietor.
- You have freedom and flexibility
This business structure includes the freedom and flexibility of operating as a sole proprietorship. The process of registering as a corporation is longer and more expensive, and business operations as an incorporated business are also more complicated.
As a sole proprietor, you are not bound by complicated and strict regulations. This is especially appealing to small business owners who lack the manpower to constantly ensure and carry out these stringent guidelines. Sole proprietors have complete decision-making authority.
- Less paperwork
Because no business owner wants additional paperwork, some choose to register as a sole proprietorship rather than incorporate their company. It is necessary to file yearly documentation after incorporation. Less paperwork means lower overhead costs for a bookkeeper who is familiar with incorporation and securities laws.
- Simpler income tax
Taxes as a sole proprietorship (also known as self-employment taxes) are significantly simpler. As a sole proprietor, you benefit from certain tax advantages associated with small business deductions.
A portion of housing costs, including utilities, internet, and so on, can be written off for a small business that uses their own home as a business base. When you file your personal tax return, this helps reduce your personal taxes and may even result in a tax refund. Corporations do not have this advantage.
- Lower business fees
The fees for registering as a sole proprietorship business structure are significantly lower than those for an incorporated business, which is one of the most appealing advantages.
As a sole proprietor, you and your business do not have separate legal identities, and in some cases, you do not need to register your sole proprietorship business. Registration is required, however, if you use a name other than your personal legal name for your proprietorship business.
Many sole proprietors choose to register their business name regardless of regional requirements in order to present the most professional image possible.
- Straightforward banking
Dealing with complicated banking is inconvenient, just like dealing with taxes. The beauty of this type of business is its banking simplicity. You can use your personal checking account as your business account, but you’ll kick yourself when it comes time to separate expenses at tax time. In this case, it’s best to open a separate business bank account. This is simple, inexpensive, and even possible online!
- Simplified ownership
In terms of business structure, a sole proprietorship is the most basic. A single owner makes all decisions, accepts responsibility, and controls all aspects of the business. This is ideal for many small business owners because there is no risk of discord between owners of corporations or partnerships. To put it simply, a sole proprietor is not at risk of losing control.
Disadvantages of sole proprietorship
- No liability protection
Personal liability is one of the disadvantages of this type of business entity. You are solely responsible for your company’s financial operations. This means that you are responsible for all debts and any litigation. As a result, your personal assets are exposed, putting your own money at risk. Having separate business insurance is a good idea in this case.
This is one of the most significant distinctions between sole proprietorship and incorporation. With incorporation, the business’s liability is limited to the business as a legal entity.
- Financing and business credit is harder to procure
You may have a more difficult time obtaining financing and business credit as a sole proprietorship than as a corporation. A incorporated business is eligible for government funding and can easily raise funds. In most cases, a sole proprietorship cannot. Part of the reason for this is that a corporation has a legal distinction that a sole proprietorship does not.
- Selling is a challenge
Sole proprietors may be unwilling to consider selling their business. Many business owners do not want to consider passing the baton, but it is necessary to do so.
A sole proprietorship is more difficult to sell than a corporation. If your company earns a lot of money, you’ll have to pay capital gains tax when you sell it. This is the tax on the gains made from the purchase or start-up of the business to the date of sale, and it can amount to up to 49% of the total gains. This can be difficult for a sole proprietor to accept.
The sale of a sole proprietorship entails the sale of debts as well. Newer businesses may have debt that outweighs profit, especially when they are first starting out. While this is normal, it can be difficult for potential buyers to forecast future profits.
Because many sole proprietorships are small businesses with a high level of personal connection, certain emotions may arise and potentially cloud your judgement.
- Unlimited liability
One of the most significant disadvantages of a sole proprietorship is unlimited liability. This liability extends not only to the business but also to the business owner’s personal assets. Debt collectors can seize your savings, property, cars, and other assets in order to collect on a debt. As a precaution, when you register your business, you should look into insurance.
- Raising capital can be challenging
While the costs of starting a sole proprietorship are low, difficulty raising capital can limit growth and even put you in the red for a while. Because you are personally liable for business debts, you must also pay for suppliers, overhead and labour costs, and so on. One of the major disadvantages of sole proprietorships is that the business owners’ personal assets are limited or tied up in the business.
