Sole Proprietorship vs. S Corp

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 Corps 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.

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. 

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.

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 fictitious name or a separate business name.

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.

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 costs only $50. However, 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.

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 vs their businesses.

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 creates 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.
• Investors tend to see corporations as safer investments because of the separation of assets.
• Managers can hire workers immediately.

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 if they are approaching retirement, this is not the time to take on risk. Not only should they consider S Corps, 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

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 Corps. If they have multiple related ideas that work well, they may complete DBAs for each one and operate them together under one incorporated business.

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.

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.