For many entrepreneurs, the business formation option comes down to Sole Proprietorship vs S Corp.

Sole Proprietorships offer an easy way to get a business started, but provide no protection for personal assets. In contrast, choosing an S Corp can protect business owners’ personal finances and lead to significant tax savings in the future.

So, how exactly does this work, is the Sole Proprietorship the same as S Corp, and how do entrepreneurs choose the right option?

Let’s find out.

What Is a Sole Proprietorship?

Sole Proprietorships make up the bulk of businesses in America. Freelancers, independent contractors, and sole practitioners generally fall into this category. This unincorporated business structure provides no separation of the business from the individual owner.

While this facilitates a much easier way to get a business started, it exposes owners to greater levels of risk. If the business goes under, the owner could lose personal assets to cover the cost of defaulted loans, lawsuits, or other expenses. Sole proprietors may also lose their business assets to personal debts.

When to Start a Sole Proprietorship

A Sole Proprietorship is the ideal structure for businesses with the following characteristics:

  • It has low risk–the chances of financial loss or liability are low
  • It has a small customer base; usually friends, family members, and neighbors
  • It involves a personal hobby such as photography, baking, or blogging

Advantages of a Sole Proprietorship

The biggest advantage of starting a business as a Sole Proprietor is its simplicity. It couldn’t be any cheaper or easier to start and run a business.

Other advantages of a Sole Proprietorship include:

  • There’s no double taxation. Sole proprietors don’t pay corporate tax for their business’s profits
  • Easy to change the business structure later when circumstances change
  • Easy to maintain since it doesn’t involve a lot of legal documents

Disadvantages of a Sole Proprietorship

While they are easy to set up and manage, Sole Proprietorships face many operational challenges. These include:

  • A sole proprietorship doesn’t provide liability protection to the owner. In case of a lawsuit, the owner’s personal assets can be seized to settle a business debt or claims.
  • As a sole proprietor, you are required to pay self-employment tax and income tax on your net profit. And since a Sole Proprietorship is an informal business structure, its taxes become expensive when the business becomes profitable.
  • Limited liability protection and a high tax burden can prevent a Sole Proprietorship from growing fast.
  • Sole Proprietorships struggle to raise capital because most lenders treat the business and the business owner as the same entity.

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What is an S Corp?

Owners of LLCs and corporations can elect for a taxation status known as S Corp. Because only incorporated businesses can elect for S Corp treatment, business owners enjoy the separation of personal and business assets and debts.

When business owners choose to form an S Corp, it treats the owner as an owner-employee, which may reduce tax liabilities by avoiding double taxation. For many business owners, working closely with financial professionals can help determine the best compensation structure for reducing taxable incomes.

When to Start an S Corp

You should elect to set up your business as an S Corp if the following things are true:

  • You know that you’ll be taking a substantial amount of money out of the business instead of reinvesting all the profits
  • You are sure the business will make enough money to pay the owners a reasonable salary in annual distributions
  • Your business is currently set up as a Limited Liability Company or Corporation
  • Your business meets all the requirements to become an S Corporation

Advantages of an S Corporation

Organizations that are set up as an S Corp enjoy the following benefits:

  • Under S Corp classification, the owners of an LLC become employees. This means they are entitled to a reasonable salary that would be paid to someone to do the job. It helps them save on self-employment taxes.
  • The election of an S Corporation allows the entrepreneur to distribute the profits of the business to the owner-employees in the form of salaries and distributions. As such, it’s only the salary that’s subjected to FICA taxes. Distributions are only subjected to income tax.
  • S Corps pay minimal filing fees with the Internal Revenue Service. Bookkeeping and payroll fees are also minimal, thus resulting in a positive return on investment.

Disadvantages of an S Corp

The following are the challenges entrepreneurs face when they elect to form an S Corp:

  • S Corporations are required to file Articles of Incorporation, which requires a filing fee. Some states also require the business to incur expenses, such as annual reporting fees and franchise tax
  • The Internal Revenue Service (IRS) inspects payments made by the business to ensure the distribution of resources conforms to the laid-out requirements

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What Are the Differences Between a Sole Proprietorship and an S Corp?

It’s easy to determine key differences in the definitions of Sole Proprietorship vs S Corp. Still, let’s take a closer look.

Protection

The first difference between Sole Proprietorship vs S Corp involves liability protection.

When creating their businesses, owners have the option to make them separate legal entities. When business owners opt for a sole proprietorship, the business is not a separate entity. Instead, government agencies, creditors, and other key parties treat the business and its owner as one and the same. This results in no liability protection.

S Corporations maintain their status as separate legal entities. Consequently, they can own property, owe debts, and execute transactions in their own names. Should the business fail, only its assets would face risk.

Taxes

The other difference between Sole Proprietorship vs S Corp is about how the entities are taxed.

Sole proprietors enjoy pass-through taxation. In this arrangement, they pay self-employment tax and income tax on net profits. Put simply, the business profit passes through to the individual owner’s tax return as income.

Additionally, a sole proprietor is not treated as an employee of the business. This means they don’t pay payroll taxes on business income or withhold income taxes from their pay.

They also don’t need to file employment tax returns or pay unemployment taxes. And if that’s not enough, sole proprietors don’t need workers’ compensation insurance to cover their day-to-day operations.

All these measures can save the business thousands of dollars every year, thus making it easy to manage a Sole Proprietorship.

However, sole proprietors must pay self-employment taxes on the business income as already mentioned earlier. The self-employment tax rate currently stands at 15.3% of business income, which consists of 12.4% for social security and 2.9% for Medicare.

When owners elect for S Corp tax status, owner-employees enjoy some degree of pass-through taxation. They pay income taxes and FICA taxes on their reasonable salaries. However, they only pay income tax on distributions from earnings.

For example, let’s say Rose is a business consultant and decides to form an S Corporation in which she is the sole owner/shareholder. After one year, the business makes $100,000 in profits.

The business pays Rose a “reasonable salary” of $50,000 as an owner-employee of the business. It also pays her a corporate distribution of $50,000. In this case, her $50,000 salary will be subjected to FICA taxes but the corporate distribution will not.

As a result, Rose pays less taxes than she’d have to if she was a sole proprietor since the entire $100,000 business income would be subjected to these taxes in that case.

However, an S Corp still has additional taxes that can affect your entity choice between sole proprietorship vs S Corp. For example, some states require the S Corps to provide each employee with workers’ compensation, which can be hundreds of dollars per employee.

Some states also require S Corps to pay minimum annual taxes, regardless of how much they make in a year. For example, the minimum annual tax in California is $800.

FTB State of California

Image via FTB State of California

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Names

You should also consider how you’ll name your entity when choosing between Sole Proprietorship vs S Corp.

Most sole proprietors do business under their existing names. This is especially likely for freelancers, independent contractors, and micro-business owners. However, some states might require filing a DBA for the use of a separate legal business name.

Do you need help filing your DBA? Our trusted partner My Company Works offers quick and easy DBA registration.

The naming conventions for LLCs and corporations differ across state lines and professions. Some of the most highly regulated industries include law, medicine, and finance. For the most part, business owners can name their businesses after themselves, but may also need to include the LLC designation or a profession-specific equivalent, as per state law.

Cost

Did you know how much it costs to start and manage a Sole Proprietorship vs S Corp?

One of the main reasons people first gravitate toward sole proprietorships is the low barrier to entry. It costs virtually nothing in time and money and they can get started almost immediately. Of course, some industries might require licenses, but so do S Corps, and the initial cost amounts to much less.

LLCs and corporations do require upfront fees for creation. The specific fees vary across state lines and industries. For example, registering a business corporation in Georgia can cost you nothing other than only $50 in state filing fees. Additionally, the IRS charges companies nothing for EIN applications. From a long-term perspective, the initial investment can save owners thousands to even millions down the line.

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Complexity

You also have to consider the complexity of the business entity when choosing between Sole Proprietorship vs S Corp.

Sole proprietors could go from working for someone else to operating their own business on the same day. It would take very little, if anything at all, to transition from employee to sole proprietor. They can even use their personal accounts for business transactions.

When business owners create LLCs or corporations, it introduces some new complexities to preserve separation. Generally speaking, they will need to open a business account. They will also need to determine the assets owned by them and not the corporation.

Need help to create a Limited Liability Company? Register your LLC for free with Inc Authority.

Scalability

Your decision of the best entity among Sole Proprietorship vs S Corp will also be affected by the scalability it offers.

Sole proprietors have one owner who often does the majority of the work for the business. If sole proprietors choose to hire employees, this is the point when getting an EIN becomes necessary. While they certainly can expand operations, each new person intensifies risk significantly. Accepting investments also create general partnerships, which have a 70% failure rate.

LLCs and corporations are much easier to scale up and down. Consider these factors:

  • It is often easier to attract investors without transitioning into a partnership
  • Corporations can go public at any time
  • Corporations enjoy separation of assets, which makes them a preferred business structure by investors who see them as safer avenues for investing
  • Managers can hire workers immediately

Management

Lastly, consider the management of the two business entities when choosing between Sole Proprietorship vs S Corp.

Sole proprietors have full control over their businesses. They make all the decisions and have no legal obligation to discuss anything with anyone. There are no formal documents governing business or operations unless they choose to create one.

LLC owners might enjoy a similar level of freedom for single-member LLCs. However, they still generally need to file articles of incorporation, they may need to identify an organizer, and some states require operating agreements.

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In What Ways Is a Sole Proprietorship the Same as S Corp?

Ironically, the taxes serve as common ground where Sole Proprietorship vs S Corp is concerned. As established earlier, both enjoy pass-through taxation. Another similarity between Sole Proprietorship vs S Corp comes around during the tax-filing season.

Because the IRS treats them as one entity, sole proprietors only need to file one tax return for themselves and their businesses. Single-member LLCs can also file one tax return. To report business activity in this manner, small business owners fill out Schedule C and attach it to their tax documentation.

Excellent bookkeeping is also crucial for both types of business structures. Both business types need this for tax purposes and to determine profitability.

Transitioning from Sole Proprietorship to S Corp

As a business grows, many small business owners start to reevaluate the suitability of their existing structure.

Transitioning from a Sole Proprietorship to an S Corp is often considered when a business owner seeks liability protection, tax benefits, or a more formal business structure.

Reasons for Transitioning from a Sole Proprietorship to an S Corp

  • As profits grow, the self-employment tax burden in a Sole Proprietorship can become less favorable, prompting a need for a more tax-efficient structure
  • S Corps provide an opportunity to optimize tax liabilities by allowing business owners to pay themselves a reasonable salary and take remaining profits as distributions, which are not subject to self-employment taxes
  • The tax advantages of an S Corp can lead to significant savings, especially as the business scales and generates more revenue
  • Incorporating as an S Corp helps establish a separate legal entity, which can protect personal assets from being targeted in business-related liabilities
  • The legal separation provided by an S Corp can be crucial for reducing personal risk, as the owner’s liability is limited to their investment in the company, unlike in a Sole Proprietorship where personal assets are exposed
  • Transitioning to an S Corp can also enhance the business’s credibility and may offer better access to funding and investment opportunities

Steps Involved in the Transition Process

  1. Form a Legal Entity: Start by forming either an LLC or C Corporation, as Sole Proprietorships cannot directly elect S Corp status.
  2. File IRS Form 2553: Submit Form 2553 to the IRS to elect S Corp status. This must be done within 75 days of forming the entity or starting the new tax year.
  3. Apply for a New EIN: Obtain a new Employer Identification Number (EIN) from the IRS — it’s necessary, plus it has many benefits for the new business entity.
  4. Update Licenses and Permits: Revise any existing business licenses, permits, and registrations to reflect the new business structure.
  5. Set Up Accounting and Payroll Systems: Implement accounting and payroll systems to manage the dual roles of salary and distributions typical of an S Corp.
  6. Maintain Compliance: Ensure ongoing compliance by filing annual reports, paying necessary state and federal fees, and adhering to S Corp regulations.

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Sole Proprietorship vs S Corp: Implications for Long-Term Planning and Exit Strategies

When it comes to long-term planning and exit strategies, the choice between a Sole Proprietorship vs S Corp can have significant implications.

Both structures offer different advantages and challenges in terms of retirement planning, business transfer or sale, and succession planning. Here’s how they compare.

  • Retirement Planning:
    • Sole Proprietorship: Typically limited to individual retirement accounts (IRAs) and SEP IRAs, offering flexible contribution levels.
    • S Corp: Provides access to 401(k) plans with both employer and employee contributions, along with other corporate retirement plans.
  • Tax Benefits:
    • Sole Proprietorship: All profits are subject to personal income taxes and self-employment taxes.
    • S Corp: Utilizes a salary plus distributions model, which can reduce self-employment taxes.
  • Business Transfer:
    • Sole Proprietorship: The business is inseparable from the owner, making it complex to transfer.
    • S Corp: Allows for the sale or transfer of shares, enabling smoother business transitions.
  • Valuation Complexity:
    • Sole Proprietorship: The business is tied to the owner, making it harder to value.
    • S Corp: Easier to value as it is recognized as an independent, separate entity.
  • Succession Planning:
    • Sole Proprietorship: Succession planning is challenging, with a risk of business dissolution upon the owner’s exit.
    • S Corp: Ownership can be transferred through shares, leading to a more orderly succession process.
  • Estate Planning:
    • Sole Proprietorship: Business assets are part of the personal estate, which can increase tax liability.
    • S Corp: Shares can be distributed to heirs, providing better management of estate taxes.

Sole Proprietorship vs S Corp: How Do Entrepreneurs Choose the Right Option?

Most finance gurus and business consultants agree that all business owners should seek to incorporate their businesses. However, preferences and unique situations might inform which business entity you opt for between Sole Proprietorship vs S Corp.

Risk

How much risk are entrepreneurs willing to shoulder for their businesses? If they are young and have very few assets, they have little to lose and a lot of time to recover. In this instance, a sole proprietorship might not seem like a bad idea.

However, if they have accumulated assets or are approaching retirement, this is not the time to take on risk. Not only should they consider S Corporations, but they should also look into insurance after setting up the business. Smart business owners in high-risk fields also choose incorporation. Here are some examples:

  • Health care
  • Construction
  • Real estate
  • Law
  • Food
  • Sports

Commitment

Some entrepreneurs try their hands at various business ideas before finding the one that works for them. If they intend to bounce around various ideas, just getting started and going for it might be a good idea.

However, once they have established business operations, they should consider transitioning to S Corporations. If they have multiple related ideas that work well, they may complete DBAs for each one and operate them together under one incorporated business, especially since registering multiple DBAs under a Sole Proprietorship is state-dependent.

Business Credit

Ease of access to business credit will also affect the business structure you choose between Sole Proprietorship vs S Corp.

Most businesses could use a little extra money to cover working capital or to expand. There are far fewer opportunities for sole proprietors. Banks also often set much lower limits or might charge higher interest rates to reflect higher risk caused by a lack of asset separation.

In contrast, LLCs have a much easier time building business credit and attracting loans for expansion and operations. Business credit cards, business lines of credit, and business loans are just some of the many opportunities that become easier to secure.

Authority

When it comes to establishing professional reputations, the type of business structure can make a difference. Because sole proprietorships are usually associated with newcomers and a lack of commitment, this might attract less credibility.

Even though virtually anyone can form an LLC, consumers and the general public tend to view them as more permanent. Consequently, creating an LLC can significantly boost the credibility of a business. This is especially important for services, such as consultancy.

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FAQs

Q1. Which is better between Sole Proprietorship vs S Corp?

A. Both these business entities have their advantages that can appeal to you as an entrepreneur. If you are looking for a quick and easy setup process, a Sole Proprietorship may be ideal for you.

But if you are looking for liability protection and to save on certain taxes, create an LLC and apply to have it treated as an S corporation.

Q2. Is it better to be self-employed or form an S Corporation?

A. Self-employed people operate their businesses as a Sole Proprietorship. They make all the decisions about the business and enjoy all the profits. However, they don’t have liability protection and their assets can be seized to clear business debts.

On the other hand, an S Corporation enjoys liability protection and the owner’s assets cannot be claimed to settle the business debt. An S Corp also enjoys more tax advantages since some portion of the business income is not subjected to FICA taxes.

Q3. When should a Sole Proprietorship become an S Corp?

A. A Sole Proprietorship should become an S Corporation when the business can make enough money to pay the owners a reasonable salary in annual distributions.

Q4. Can a Sole Proprietorship become an S Corp?

A. Yes, it can but it first needs to be registered as an LLC by filing Articles of Incorporation with the Secretary of State. It then has to elect to be taxed as an S Corp by the IRS.

Q5. Why is an S Corp better than a Sole Proprietorship?

A. An S Corporation is better than a Sole Proprietorship because it is an incorporated business. This means its owners enjoy liability protection and cannot lose their personal assets in case of a lawsuit.

An S Corporation also pays less taxes than a Sole Proprietorship because not all of its income is subject to FICA taxes.

How Do Entrepreneurs Complete the Related Paperwork?

Some entrepreneurs have the knowledge and experience to tackle business formation on their own. Maybe they have opened other businesses before or maybe they are business law attorneys. Unless they have a legal background, though, going it alone can lead to poor strategic decisions that resurface down the road.

Hiring an attorney is arguably the best solution, but attorneys are expensive to work with. According to one Forbes article, startups often spend as much as $800 per hour on legal fees. When entrepreneurs have a tight budget, fees like this could eat right through it in no time.

Consequently, companies all across the internet provide business formation packages at more reasonable prices. Then, there are companies like ours that provide these services at no cost. Instead, we make money from paid partnerships with other businesses, while offering this free service. Consequently, entrepreneurs pay only for fees mandated by local, state, and federal governments.

Comparing Sole Proprietorship vs S Corp leaves you with several options. Whether you plan to formalize your sole proprietorship, create an LLC, form a corporation, or elect S Corp tax status, we can help. Are you ready to get started?