Overview: S Corp vs. Sole Proprietorship
Trying to compare a sole proprietorship and an S corporation can be tricky. Here’s why:
- A sole proprietorship is an informal, unincorporated business structure that’s 100% connected to its owner from a legal standpoint. Sole proprietors are entitled to all of their business's profits, but they’re also responsible for all of the business’s debt and liabilities.
- An S corp isn’t a business structure; it’s a tax designation that some corporations and limited liability companies (LLCs) may elect.
Let's first delve into the differences between a legal structure and a tax designation before we discuss the key distinctions between S corporations and sole proprietorships.
Legal Structure vs. Tax Designation
It can be difficult to compare LLCs to S corps because an LLC is a legal business entity that separates the company from its owners while an S corporation is a tax designation that a legal business entity may elect. This article will compare the default LLC tax structure to the S corp tax designation.
- Legal Structure: This is the legal framework under which you organize your business. An LLC is one of four primary types of legal structure, which include:
- Tax Designation: This dictates how a business pays its taxes. A company’s tax designation is closely related to — but separate from — its choice of legal structure. S corporation status is a business tax designation that both LLCs and C corporations may elect.
What Is a Sole Proprietorship?
A sole proprietorship is an informal, unincorporated business owned by a single individual (or a married couple) that’s not formally registered as a legal business entity. Because sole proprietorships are considered as one and the same with their owners, they aren’t legally separated entities.
Sole proprietors must report their business’s profit and losses on their personal tax return, and they’re personally liable for all business debt and risk. This means as a sole proprietor, your personal assets are vulnerable to lawsuits because your business’s actions are extensions of you.
Although many businesses begin as sole proprietorships, they’re really only suited for small, extremely low-risk businesses like hobbies or side businesses (e.g., streaming, blogging, or photography) given the assumed liability and risk.
We recommend you incorporate your sole proprietorship to keep your personal assets safe and build your business’s credibility and legitimacy. Check out our How to Choose a Business Structure guide to learn more about formal business structures.
What Is an S Corporation?
An S corp is a tax designation an LLC or a corporation may elect. Both LLCs and corporations are formal business structures that offer their owners liability protection to safeguard their personal assets. Thus, all S corps have liability protection.
With S corp status, a business entity’s profits and losses pass through to its shareholders. This means LLCs and corporations that elect S corp status are exempt from paying corporate income tax. S corp owners instead have their business’s income taxed at the individual level — split between a reasonable salary and the remainder of the profits as distributions from the company.
S Corp Tax Advantages
S corp status can provide significant tax advantages when a business makes enough to pay its owners large sums in distributions. In general, we estimate your business needs to make $60,000 in net earnings with $20,000 in annual distributions to benefit from the tax advantages offered by S corp status.
Use our S corp tax calculator to determine if S corp status will benefit your business.
Qualifying as an S Corp
LLCs and corporations must meet several requirements in order to qualify to elect — and maintain — S corp status. These include:
- Shareholder Restrictions: S corps may have no more than 100 shareholders and may only issue one class of stock. In addition, all S corp shareholders must be US citizens or resident aliens or certain types of domestic estates, trusts, and tax-exempt organizations. As a result, non-US citizens and nonresident aliens — or any other non-U.S. entity — may not own an S corp in whole or in part. US corporations and partnerships also aren’t permitted to own shares in an S corp.
- Reasonable Salary: The Internal Revenue Service (IRS) considers S corp owners who simultaneously act as a director or a manager — or who perform any work within the organization — as employees who must pay themselves a reasonable salary.
- Additional Restrictions: The IRS bars various types of US institutions from owning an S corp, such as financial institutions, insurance companies, and domestic and international sales corporations. Additionally, companies that accumulate earnings and profits at the end of three straight years and earn more than 25% of their income from passive sources don’t qualify to elect — or maintain — S corp status.
If you’re ready to form your S corp, avoid the hassle and consider using an S corp formation service to get your business set up quickly.
Sole Proprietorship Taxes vs. S Corp Taxes
Although both sole proprietorships and S corporations are pass-through entities, the IRS treats them very differently for tax purposes.
For tax purposes, the IRS views a sole proprietorship as inseparable from its business owner. In contrast, an S corp is a hybrid form of pass-through entity that allows its owners to pass through some of the business’s profits as distributions.
Sole Proprietorship Taxes
The IRS taxes sole proprietorships as disregarded entities. That means the IRS disregards the “entity” and treats the business and its owner as one and the same.
Because a sole proprietorship lacks the legal separation of a formal business entity, the owner must report the business’s income on their personal tax return. Sole proprietors are, technically, self-employed and so must pay both income tax and self-employment tax on all of their business profits.
How to File Sole Proprietor Taxes
Sole proprietors don’t file a business tax return. Instead, they report the income, expenses, and credits from their business as self-employment activity (Schedule C) on their personal tax return (Form 1040). They must then pay self-employment taxes (Schedule SE) and personal income taxes on all of their business’s profits.
S Corp Taxes
The IRS treats S corps as hybrid pass-through tax entities. This means the company’s earnings pass through to its owners (or shareholders), and its profits aren’t taxed at the company level.
S corporations differ from other pass-through entities, however, in that their business profits and losses pass through to their owners in two ways. First, S corp owners must pay themselves a reasonable salary for the work they perform within the company. Second, S corps may then treat their remaining profits as distributions.
S corp shareholders who serve as a director or a manager — or who perform any work within the organization — must receive a reasonable salary. According to the IRS, reasonable compensation equates to “the value that would ordinarily be paid for like services by like enterprises under like circumstances.”
S corps must calculate, report, withhold, and pay employment and withholding taxes on all employee salaries and wages. They’re also responsible for calculating, reporting, and paying federal unemployment insurance as well as any other taxes or insurance required by their state.
The remainder of an S corporation’s profits pass through to its shareholders in the form of dividends or distributions. Each individual shareholder is then responsible for paying personal income tax on their individual salaries and share of the profits.
How to File S Corp Taxes
S corps must take several steps to fulfill their tax-filing obligations, including:
- Filing Form 1120S, US Income Tax Return for an S Corporation, along with all corresponding forms and schedules with the IRS. This form reports on an S corp’s income, deductions, shareholders, and profits and losses.
- Filing Schedule K-1 (Form 1120S) for each shareholder to report how the company allocated its profits and losses.
Because S corp owners must receive a reasonable salary for any work they do within the company, S corps will technically have employees. That means they’ll need to file and pay annual federal unemployment tax (FUTA) as well as employers' quarterly tax returns with the IRS.
- S corps must report all employee salaries and wages paid during the year to the IRS, using the corresponding copies of Form W-2, Wage and Tax Statement.
- S corps also must file Form 940, Employer’s Annual Federal Unemployment Tax (FUTA) Return.
- S corps also need to file Form 941, Employer’s Quarterly Federal Tax Return to report and pay the income taxes, Social Security taxes, and Medicare taxes they withheld from employees’ paychecks. They also use this form to pay their employer’s share of Social Security and Medicare taxes.
S Corp Shareholder Taxes
S corp owners must then report their wages or salaries — along with any taxes withheld (as reported on their Form W-2) — on their personal tax return (Form 1040). They also need to report any dividends or capital gains distributions as indicated on their Schedule K-1 on Schedule E.
Which Is Best, a Sole Proprietorship or an S Corp?
When it comes to your company's tax and business structure, there’s no one-size-fits-all answer. Whether it’s better to operate your business as a sole proprietorship or form an LLC and elect S corp tax status will depend on the size of your business, its goals, and several other factors.
Sole proprietors assume their business's liabilities, including its debts. This puts their personal assets at risk. Only very low-risk businesses, such as hobbies, should be sole proprietorships.
Let’s review the advantages and disadvantages of LLCs and S corporations to help you determine when it might be best to form an LLC and/or elect S corp status.
Recommended: Many businesses turn to formation services to form their formal business structure and apply for an S corp tax designation.
When Is It Best to Operate a Sole Proprietorship?
Many businesses begin as sole proprietorships because this informal business entity is simple to start. However, sole proprietors assume all of the liability of the business, thereby putting their personal assets at risk. For all but the smallest, low-risk businesses like hobbies, sole proprietorships should only serve as a stepping stone to creating a formal legal entity.
Sole Proprietorship Advantages
Beginning as a sole proprietorship does have several advantages. For example, it allows you to start working on your business, ensure it’s viable, and gain some traction before committing the time and resources to establishing a formal business entity.
Specifically, sole proprietorships provide these key benefits:
- They’re simple and easy to start.
- They give owners complete control and decision-making authority.
- They have fewer legal, accounting, and tax requirements and restrictions.
- They still enable owners to protect their business name, file a trademark, or apply for a patent.
Sole Proprietorship Disadvantages
Despite the ease of setting up a sole proprietorship, they have several potentially huge disadvantages:
- There’s no separation between the owner and the business.
- They come with unlimited personal liability.
- They may find it difficult to secure business credit, loans, and investments.
- They’re often difficult businesses to sell.
When Is a Sole Proprietorship the Best Option?
Many businesses start out as sole proprietorships, spending their earliest days as informal, unincorporated ventures. Sole proprietors operate their businesses, enter into contracts, and take on loans as individuals. This makes them personally liable for their company's actions and commitments. Therefore, most businesses don’t — and shouldn’t — remain sole proprietorships for long.
In most cases, you should seek to register your company as an LLC or incorporate your business as early as possible. This’ll require some time and resources as well as an ongoing commitment to maintaining your company. But, you’ll want to consider forming a formal company to gain the personal liability protection and other benefits of a corporation or LLC as you move from a startup or small business idea into a viable business.
When Is It Best to Elect S Corp Status?
For some businesses, electing the S corporation tax designation can prove very advantageous. Let's take a look at the key advantages and disadvantages of S corp status before discussing when it makes the best option.
S Corp Advantages
The S corporation tax designation combines the advantages of an LLC or corporation with a hybrid pass-through tax treatment. The main benefits of electing S corp status include:
- Personal liability protection (In order to elect S corp status, you must first have a formal business structure.)
- Profits aren’t taxed at the company level
- Losses pass through to shareholders
- Owners only pay employment taxes on their salary, not all their profits
- Profits are distributed and taxed as distributions
S Corp Disadvantages
S corps can be complex to operate and come with several disadvantages. For example:
- They have more complex tax reporting.
- They must distribute their profits and losses according to shareholder equity.
- They face additional bookkeeping, accounting, and tax-filing requirements.
- They may only issue one class of shares.
- They’re limited to 100 shareholders.
- Their shareholders must be US citizens or resident aliens.
- They’ll face taxation as a corporation in some states.
When Is Electing S Corp Status the Best Option?
If a business already makes a substantial amount in net earnings and its owners plan to take money out of the company, it may be best for those LLCs and corporations to elect S corp status. Because S corp distributions aren’t subject to self-employment taxes, many business owners may save money in taxes by electing an S corp taxation designation.
However, S corps face restrictions on the type of shares they can issue as well as the number and type of shareholders they can have. When compared to a default LLC tax structure, S corp status results in more complicated legal requirements and tax reporting. This tax designation often means businesses will incur additional expenses related to accounting, legal services, and payroll. Furthermore, your business will face increased IRS scrutiny to ensure you don’t abuse the system because S corp owners have the incentive to take less money in salaries and more in distributions.
As a result, it’s often best to elect S corp status only when the level of your LLC’s profits will allow the tax savings to justify the additional costs associated with this tax designation. While only you and your specific situation can determine that profit threshold, it generally becomes advantageous to elect S corp status when you anticipate your annual profits will reach a minimum of $60,000 to $100,000.
Still unsure if it makes sense to elect S corp status? Consult with an accountant and/or tax professional about how this tax designation will impact you and your business.
Frequently Asked Questions
Is it better to be a sole proprietor or form a formal business?
Formal business structures, such as LLCs and corporations, have a number of advantages over informal business arrangements like sole proprietorships and partnerships. For example, LLCs and corporations provide liability protection for a business’s owners and their personal assets. Formal business structures also give a company increased credibility and legitimacy along with tax treatment alternatives.
In contrast, a sole proprietor assumes all of the risk of their business and is 100% responsible for its debts and liabilities.
Should I form an LLC or a corporation?
Deciding whether to keep your business as an informal business structure, such as a sole proprietorship or partnership, or to form a corporation or an LLC depends on your business’s specific situation. Your company’s size, structure, goals, and more will help determine the right legal structure for your business.
To learn more about what business structure is best for you, read our How to Choose a Business Structure guide.
How are sole proprietorships taxed?
The IRS treats sole proprietorships as disregarded entities for tax purposes. This means it disregards their status as a business entity and treats their business income as the owner’s personal income. Sole proprietors are responsible for reporting their business income to the IRS (on Schedule C of their personal tax returns) and paying personal income tax and self-employment tax (Schedule SE) on all of their business’s profits.
Do sole proprietors pay self-employment tax?
Yes, sole proprietorships are responsible for paying self-employment taxes — Federal Insurance Contributions Act (FICA) and Medicare — on all of their business’s profits.
Do S corp owners pay self-employment tax?
No, not exactly. S corp owners don’t pay self-employment taxes, but the IRS considers them employees of the business. That means the S corp must pay them a reasonable salary if they perform any work for the business.
If you own a company that chooses the S corp tax designation, your wages or salary is subject to employment taxes (i.e., Social Security and Medicare taxes) — half of which is withheld from your salary as an employee and half of which is paid by the S corp.
The company may then treat any excess profits as capital gains distributions, which aren’t subject to self-employment taxes.