Most people starting a small business default to filing a sole proprietorship. Why not, it is generally quite easy to do. But, other entity structures may work better to accomplish your financial goals as you grow a business. Before deciding, learn the pros and cons of structuring a small business as a sole proprietorship versus an S corp.
What is a sole proprietorship?
Most small business owners operate as sole proprietorships. If you start a business without choosing a business entity, the IRS will automatically consider you a sole proprietor. A sole proprietorship is not a separate legal entity from its owners. The proprietor owns all business assets and is responsible for operations, debts and commitments.
Sole proprietorships are popular because they are simple to start and cost-effective for most small business owners just getting started. They are pass-through companies, so owners file one individual return, which also accounts for the business income.
What is an S corp?
LLCs and S corporations (S-corps) are not an either-or choice. A limited liability company (LLC) is a legal business structure. An S corp is a tax classification.
S corporations have an official tax status under IRS rules that apply to two business structures: a limited liability company (LLC) or C corporation. A sole proprietorship must incorporate as an LLC or C corp before obtaining S corp tax status.
Sole proprietorship vs. S corp
Before deciding to operate as a sole proprietorship or S corp, it’s important to note the differences so you can make an informed decision about how your small business.
Sole proprietorships generate income in a very simple, streamlined manner. The proprietor sells a product or service for enough money to cover expenses. They pay taxes on profits that exceed the expenses. S corps, on the other hand, can distribute income to owners in two ways: dividends or reasonable salary for an owner-employee. Owner-employee salaries and sole proprietorship revenues are subject to the same Social Security and Medicare taxes.
S corps are either an LLC or a C corporation. The legal distinction lies between the business and ownership, providing owners with liability protection. Members of an LLC or shareholders in a corporation that elect S corp status will not be personally liable for most of the corporation’s debts or any damages awarded in the event of litigation. Sole proprietorships do not have the same liability protection as there is no legal separation between the proprietor and the business.
S corp gets its name from Subchapter S of the IRS code. They enjoy certain tax benefits since the IRS considers the business owner an owner-employee. The IRS, doesn’t subject the owner to self-employment tax. Sole proprietorships, however, pay both self-employment tax and income tax on the business profits. S corp owner-employees pay Federal Insurance Contribution Act (FICA) tax, or Social Security and Medicare taxes, and income tax on any salary they receive from the business. S corps may pay payroll taxes and unemployment insurance for employees, but they avoid self-employment tax which can equate to substantial tax savings.
How to choose
Choosing between a sole proprietorship and an S corp ultimately comes down to liability and cost. If you want to limit personal liability and taxes on profits from your business, you choose to incorporate and then elect S corp status. This process is complex and often subject to certain startup costs. State business registration fees, attorney fees and CPA fees add up initially, but the entity structure can save money with time. If you favor simplicity and cost-effectiveness, operating your small business as a sole proprietorship is the right move.
When should sole proprietorships become an S corp?
Sole proprietorships should be incorporated as LLCs or C corps before electing S corp status. Typically LLCs and C corps are formed by registering in the state where they intend to be based and do business (though sometimes, for tax purposes, they may incorporate elsewhere). After incorporating as an eligible entity, the business may elect S corp status by filing a Form 2553 with the IRS.