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S Corporation vs. sole proprietorship: Which is right for your business?

As a business owner, you want the best legal entity and tax classification for your business. Here's the low-down on S Corporations vs. sole proprietorships and their tax implications.

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S Corporation vs. sole proprietorship

A sole proprietorship is an unincorporated business entity that is owned by one individual. An S Corporation, on the other hand, is a tax classification that a Limited Liability Company (LLC) or a corporation can elect. A sole proprietorship is not eligible to elect S Corporation status for its taxes.

Sole proprietorships are subject to pass-through taxation, which means that instead of paying business taxes, profits are passed through and reported on the owner’s personal tax return. An LLC or corporation that has elected S Corporation status is subject to the same pass-through taxation, but with the added benefits of these business entities, most notably limited liability protection.

Nearside Tip
A sole proprietorship is a business entity. An S Corporation, on the other hand, is a tax classification that Limited Liability Companies (LLCs) and corporations can elect.

Differences between S Corporations and sole proprietorships

  • Sole proprietors pay self-employment tax and income taxes from the net profits incurred by their business. Personal assets such as bank accounts and houses are at risk due to a lack of personal liability protection.
  • An S Corp business owner pays the income taxes and FICA based on their reasonable salary and the income taxes on distributions. S Corp business owners enjoy tax advantages. 

What is an S Corporation?

An S Corp, also called an S Corporation, is a tax classification used by the Internal Revenue Service (IRS) that LLCs and corporations can elect. Business owners may choose to elect this tax classification if they want to be taxed like a sole proprietorship, while maintaining the benefits of their incorporated business structures. Both LLCs and corporations offer limited liability protection, meaning that the business owner(s) are not liable for legal action taken against their business. 

Since an S Corporation is a tax classification for an LLC or a corporation, let’s discuss the differences between these business entities and a sole proprietorship. Aside from limited liability protection, LLCs and corporations both offer a more formal business structure compared to a sole proprietorship. Most of the time, sole proprietorship owners change their business into an LLC when they want protection from the legal and financial responsibilities of their company. Single-member LLCs also offer more flexibility in terms of management structure and taxation than sole proprietorships. Corporations are similar to LLCs in that they offer limited liability protection, but they differ in terms of management structure. Corporations must be composed of shareholders, directors and officers. For this reason, small business owners typically do not choose this type of business entity.

How is an S Corp taxed?

An S Corporation is taxed under Subchapter S of the IRS internal code. The IRS treats the entrepreneur or the business owner as an employee. This allows the owner not to incur the self-employment tax since the owner is an owner-employee. They are not taxed on their portion of the profits incurred from the business activities. The owner-employee, however, pays the FICA and income taxes on their salary. The distributions are subjected to income taxes only. However, tax savings are weighed between the accounting taxes and the additional payroll. A business owner can save on the taxes under the right circumstances. One can start an S Corp by forming an LLC and electing the S Corp tax status from the IRS as the business owner requests the employee identification number (EIN). The election of an S Corp involves filing the IRS form. An S Corp has filing requirements, such as annual information statements.

Pros and cons of an S Corporation

Advantages of an S Corp

The advantages of an S Corp are that there is a reasonable salary. This is evident when a business entity has its LLC owners becoming employees. The IRS requires that the owner-employees be paid a reasonable salary which is any salary paid to any other person handling the same responsibilities. 

The other advantage includes the profits and distribution where an S Corp election allows the entrepreneur to hand the profits of the LLC to owner-employees in the form of salary and distributions. Therefore, the salary is only imposed on the FICA and income taxes, while the distributions are only subjected to the income tax. While doing the business taxes, the owner saves on the corporate taxes. 

There is also the positive return on investment where the S Corp has minimal filing fees with the IRS, and the bookkeeping and payroll costs are minimal. This makes the S Corp financially viable when electing. There is also a straightforward transfer of ownership without huge effects on the tax rates and tax cuts. The owner-employees pay taxes on their personal income. An S corporation tax treatment allows the business to make income without paying Social Security. 

Disadvantages of an S Corp

One of the disadvantages of the formation and ongoing expenses is that businesses operating as an S Corp are required to file the Articles of Incorporation that depend on the state of incorporation obtained from the Secretary of State where the business selects a registered agent from the company. The states also have different state laws. This requires filing of Articles of Organization. This requires fees, and other states require the business to incur costs such as franchise taxes and annual report fees. A sole proprietorship does not incur these costs. 

The business is also at the risk of scrutiny from the IRS due to the distribution of resources in the salary. The IRS inspects the payments to ensure that the business conforms to the requirements. The business is subject to employment tax liability if the salary is characterized as wages. 

There are also taxable fringe benefits, where any benefits provided by the corporation are taxable as compensations to the owner-employees that own two percent or more of the corporation. 

How an S Corp is taxed

It is essential to understand how a Sole proprietorship is taxed. According to scholars, a sole proprietor reports all business losses or income on their income tax return. Similarly, a sole proprietor is taxed using the owner's tax return as perform 1040. After that, the business profit is calculated, analyzed, and presented on IRS schedule C, Loss or profit from different businesses. Schedule C in the business income is calculated as all expenses and income together with expenses for a home business and the cost for products sold. Therefore, the outcome of the calculation excluding expenses is the amount of taxable business income or net income. The loss of the business or the net income is then filled on Line 31 of the respective dole proprietor Schedule C for income purposes. A sole proprietorship is a legal entity in the U.S for U.S citizens. 

Besides that, there are several taxes that sole proprietors are obliged to pay. For instance, a sole proprietor is recognized as a self-employed person; hence one is subject to self-employment taxes such as Medicare taxes and social security. However, if a business has a loss, the owner will not pay any self-employment tax and thus will not receive social security or Medicare benefits. Furthermore, the IRS demands that sole proprietors pay their net tax daily and not just once a year. If an owner has employees, it will be their role to pay unemployment and worker's compensation taxes, among others. Besides that, if a sole proprietor owns real property or building, one is subject to property taxes. The tax is based on taxed rates and appraised value for the city or town the resource is located. 

Pros and cons of a sole proprietorship

Pros of a sole proprietorship

The first advantage is that the sole proprietorship type of business is simple and cost-effective. This is because it is not a formal business structure; hence there is zero or minimal paperwork to be completed before getting started. Simply one will have to start operating without paying filing fees or incorporation. Its simplicity and low cost make sole proprietorship a seasonal business and low cottage industry; hence entrepreneurs seeking to start a new business are always encouraged to start with sole proprietorship until the business grows. A sole proprietorship is not a separate legal entity and therefore does not require Articles of Organization. 

Secondly, a sole proprietorship has no double or corporate business taxes, as a sole proprietor does not have to pay 21% in corporate taxes on organizational profits. Sole proprietors are also negligible for the tax deduction. However, one must file personal tax incomes and claim every income the business generates. This insinuates that all business income is taxed at an ordinary income rate. A sole proprietorship does not have payroll taxes.

Cons of a sole proprietorship

One is that the business lacks personal liability protection. This means that sole proprietors are not provided personal protection; hence personal assets like a bank account, cars, or houses are at a higher risk when a company defaults on paying debt or is sued. Secondly, it has zero tax benefits. Sole proprietors always claim that income and self-employment taxes are their net profits. Therefore, when the business becomes profitable, it would be costly to be taxed as an informal business structure. Thirdly, a sole proprietorship is always associated with potentially limited growth. This is because lack of liability protection and high tax burden undermines a company from achieving successful growth. Finally, funding can also be difficult in a single-member LLC. Financial institutions usually prefer to work with a business with a good track record. Therefore, a member trying to start with a small balance sheet can make it hard for banks to lend money. Also, getting equity to attract investors is demanding because most banks prefer already set business. A sole proprietorship is also viable to double taxation. 

When to operate as a sole proprietorship

Several characteristics must be met to operate a single-member LLC or Sole Proprietorship. Firstly, the business must be at a low risk to minimize financial loss and liability. This will reduce the chances of putting the business at risk of losing its personal and business assets. Additionally, single-member LLC should be operated when it is a person's hobby. Furthermore, a sole proprietorship is vital for a business with a small customer base often made up of neighbors, friends, and family. The business name depends on the business owner's selection and does not limit the entrepreneur from doing business. 

When to operate as an LLC taxed as an S Corp

A company can choose to establish an LLC and then implement an S Corp status. Filling the Corporate tax status enables business owners to pay a small amount of taxes. Moreover, there are several instances whereby a company is eligible to operate as an S corp. For instance, when a business owner recognizes that they want to take a substantial amount out of business rather than reinvest profits to grow the business over the years. Additionally, a company can operate as an LLC taxed as an S Corp when one understands that the business will generate significant profit that will cater to the owner's salary of at least $10000 in yearly distributions. Also, a company can be taxed when it meets the Corp requirements, and the business is an LLC or a business corporation.

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