Is an S Corp a Sole Proprietorship: Everything You Need to Know
Is an S-corp a sole proprietorship? To answer this, we must first understand what an S-corp is. An S-corporation is a corporation that does not pay federal income taxes and protects the personal assets of its shareholders. 3 min read
2. What Is a Sole Proprietorship?
3. What Is an LLC?
4. Which Option Is Right for Me?
Is an S-corp a sole proprietorship? To answer this, we must first understand what an S-corp is. An S-corporation is a corporation that does not pay federal income taxes and protects the personal assets of its shareholders. It is formed by filing Articles of Incorporation with the proper authorities, usually the Secretary of State of the state in which it is incorporated.
Advantages and Disadvantages of an S-Corp
An S-corp has the following advantages:
- It protects the assets of its shareholders. Their personal assets cannot be seized to pay a business debt.
- It does not pay federal corporate income taxes.
- There is no "double taxation" at the corporate level and shareholder level.
- Shareholders are allowed to write off losses on their taxes.
- Shareholders can be employed by and paid as employees of the corporation while receiving dividends.
- Stock can be freely transferred with no tax consequences.
- An S-corp has simple rules for transfer of ownership, unlike some states where the transfer of ownership of an LLC means dissolving the LLC.
- It establishes credibility with potential customers and investors.
An S-corp has the following disadvantages:
- In order to become an S-corp, the owner(s) must file Articles of Incorporation, acquire a registered agent, and pay the necessary fees.
- Paperwork mistakes can lead to termination of S-corp status.
- An S-corp must choose a calendar year as its tax year unless it can establish a business purpose for a fiscal year.
- An S-corp can only have one type of stock and no more than 100 shareholders.
- Shareholder-employee wages can be characterized as dividends, which cannot be claimed as a business expense.
- It is difficult to allocate loss and income to specific shareholders.
- Fringe benefits to employee-shareholders can be taxed as compensation.
What Is a Sole Proprietorship?
Sole proprietorships are businesses owned and operated by one person. While no legal paperwork is required, depending on the location, licenses and permits may be necessary. Business taxes are filed on the individual's personal income tax by using a Schedule C, Profit or Loss from a Business, and a 1040. The owner is subject to the self-employment tax and is responsible for all withholding. The biggest risk of a sole proprietorship is personal liability for the business. If your business loses a lawsuit, you are personally responsible.
What Is an LLC?
A limited liability company, or LLC, legally separates business assets and personal assets because it is considered independent of its owner(s). It must be registered in the state it does business in. Profits and losses are shared among its members. The biggest drawback of an LLC is that every owner is considered self-employed, meaning they are responsible for the self-employment tax.
Which Option Is Right for Me?
There are three things you should consider to decide which option is right for you: simplicity, legal protection, and taxes.
A sole proprietorship is the simplest option, but it leaves you legally and financially vulnerable. The owner personally owns the business and all its assets and is personally responsible for its operation. There is no limited liability protection.
Forming a C-corporation is a tedious process and terrible from a tax standpoint, but it offers excellent legal protection.
Forming an LLC with S-corp status is simple, offers excellent legal protection, and protects some of your income from the self-employment tax. When you are an S-corp, the IRS views you as both owner and employee, which means that your salary can be taxed under the self-employment tax, but dividends cannot be.
If you ask the IRS to grant your LLC S-corp status, you have limited liability protection and are treated as an S-corp for tax purposes. However, this requires special paperwork, and it must be filed at the beginning of the tax year.
When you run a one-person business, the protection you get from incorporation or forming an LLC is limited. An S-corp does shield you from some liability and helps you avoid paying both personal and business taxes, but part of your income may be considered self-employment income. However, an S-corp owner, unlike a sole proprietor or LLC owner, can pay his/her own salary and dividends.
If you need help choosing between an S-corp and a sole proprietorship, post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers, who come from law schools such as Harvard and Yale and average 14 years of legal experience working with or for companies such as Google, Menlo Ventures, and Twillo.