Is S Corp Same as Sole Proprietorship?

Sole Proprietorship

Sole proprietors make up the majority of businesses. Most are unaware of this legal status. By default, if you own a business by yourself without incorporating or forming a limited liability company, you are a sole proprietor.

Contrary to a corporation, LLC, general partnership, or LLP, a sole proprietorship is not considered a separate legal entity. The owner of a business (proprietor) personally owns all its assets and is an integral part of its management.

A major reason why sole proprietorships are so popular is that they are the simplest and cheapest way to incorporate a business with a single owner. A sole proprietorship is a simple business to set up, other than having to obtain a license, permit, and comply with other regulatory requirements your state and locality require.

S Corporation

An S corporation (S corp) is a tax status available to incorporated businesses, including corporations and limited liability companies. The S corp tax status can only be elected by an LLC or corporation. Therefore, any company that operates as an S corporation also offers limited liability protection, just like any other LLC or corporation.

Small businesses should have liability coverage to protect the owner’s personal assets in the event of a loss.

Concerns About Liability

Unlike S Corporations, sole proprietorships do not offer limited liability protection to the business owner. Unlike a sole proprietor, in the same scenario, an S Corporation would be held liable for business debts, instead of the owner.

In small businesses, however, owners may still have to guarantee business debts personally. In either case, you’ll need personal liability insurance to protect yourself from any damages caused by your negligence. Due to this, S Corporations provide limited liability protection.

Tax Concerns

As a sole proprietor, you are not an employee of your business. You are a business owner, also known as self-employed. There is no payroll tax on your income and there is no tax withheld from your pay. There is no requirement to file state or federal employment tax returns. You do not need workers’ compensation insurance. This can save you hundreds of dollars a year.

You do, however, have to pay self-employment taxes on your business income. The IRS calls this self-employment income. Taxes on self-employment include a 12.4% Social Security tax and a 2.9% Medicare tax, regardless of earnings level.

As pass-through entities, S Corporations are taxed on the owner’s individual tax return for business income and losses. Thus, you will pay the same taxes on your business income and deduct the same business expenses as a sole proprietor. An S corporation may be eligible for a 20% tax deduction for pass-through entities.

In S corporations, tax benefits come from savings in self-employment taxes. Profits can be paid out to shareholders as distributions, not as income. These distributions are not subject to Social Security or Medicare taxes.

Nonetheless, shareholders who perform significant services for a corporation must be treated as employees and paid a reasonable salary. Suppose you take half of your profits as a distribution, half as a salary. On the salary half of your profits, you’ve got to pay Social Security and Medicare taxes. However, on the distribution portion of your profits, you’ve saved the taxes.

Sole Proprietorship Taxes vs. S Corporation Taxes

Generally, sole proprietors pay self-employment taxes and income taxes on the net profit of their business.

S-corporations have owners who pay FICA and income taxes on their “reasonable salary.” They also owe income taxes on distributions.

When to Operate as a Sole Proprietorship?

Businesses with these characteristics should form sole proprietorships:

• LOW RISK (low chance of liability or financial loss)
• There is a smaller customer base; they often serve friends, family, and neighbors
• Among them may be hobbies like photography, blogging, or streaming video

Advantages of a Sole Proprietorship

Here are five advantages of being a sole proprietor

• There is less paperwork to complete.
• Processes are easier and business taxes are fewer.
• Registration fees are lower.
• Banking is more straightforward.
• Ownership of a business simplified.

Disadvantages of a sole proprietorship

• No protection for personal liability. There is no personal liability protection for sole proprietorships. If your business goes bankrupt or if it is sued, your personal assets are at risk.
• Tax benefits are zero. In addition to self-employment taxes, sole proprietors pay income taxes as well. As an informal business structure, taxing a profitable company will be very costly.
• Growth potential is limited. A high tax burden and a lack of liability protection can prevent a business from being successful.
• Credibility and branding are reduced. As a sole proprietor or partnership, you must invoice, receive payment, open a bank account, and market under your surname(s) unless your state allows you to register and use a business name.

Useful Resources: Free invoice templates