S Corp or Sole Proprietorship: Everything You Need to Know
S corp or sole proprietorship refers to the different forms a business entity can take for tax purposes.3 min read
S corp or sole proprietorship refers to the different forms a business entity can take for tax purposes. A sole proprietorship is the way the business entity is owned. An S-corp refers to the federal tax election that the business entity has filed with the IRS.
What is a Sole Proprietorship?
When a proprietor (or owner) has legal ownership of all assets and makes all decisions in regard to the business, then it is considered a sole proprietorship.
This is an extremely popular choice for a new business due to its elegant simplicity and its low cost.
In fact, there are no filings required to begin a sole proprietorship (although some local licenses, regulatory requirements and permits may apply). The drawback of a sole proprietorship is that it offers the owner no personal asset protection. Limited liability companies, limited liability partnerships and corporations all offer limited liability to their owners or shareholders.
Sole Proprietorships and the IRS
One area of concern for a sole proprietorship is taxes. As far as the Internal Revenue Service (IRS) is concerned, the owner of the business and the business itself are one and the same. The income that the business earns or the losses incurred are the responsibility of the owner. If the business earns a profit, that amount is added to the owner’s income for a tax year. Then all of the income is taxed at your personal income rate.
The Internal Revenue Service considers a sole proprietorship a “disregarded entity”. An owner files no tax return for the business. The recent Tax Cuts and Jobs Act passed by Congress may make sole proprietorships eligible for a 20% income tax deduction. An owner of a sole proprietorship should have a professional tax preparer or a tax attorney advise them on whether they are eligible. As a sole proprietor, you don’t have to pay payroll taxes or withhold income tax from your pay because you are not an employee.
What is a S-Corporation?
Even if a business entity has one owner, it can still be organized as a corporation. An S-corp is also a popular way to organize a business. They are extremely common in some states. The owner of a corporation can then elect to have the business taxed as an S-corp. The requirement for this business election is simply filing a form with the Internal Revenue Service.
Of course, the S-corp is a little more complicated to run than a sole proprietorship. For example, one requirement for an S-corp is regularly scheduled shareholder meetings which must be memorialized in minutes (or notes). Another requirement includes having shareholders, officers and directors who conduct themselves in the same way as their C-corp counterparts.
S-corps and the IRS
The S-corps offer owners attractive tax benefits. They include:
- Pass through entity status
- No requirement for owners to pay taxes on entire net income of the business
- Same essential business deductions as a sole proprietorship
- Eligible for the 20% pass-through tax deduction
- The profit earned from an S-corp is not subject to Social Security or Medicare taxes
Not all of the news is good for S-corps. Most states required that employees are provided both unemployment insurance and workers’ compensation coverage. There are also states that have a minimum annual tax. This tax applies no matter how much the company actually earns. Finally, the complexity of the tax return to file is daunting. In addition, an S-corp may face higher scrutiny by the tax man. The IRS looks closely at payments to shareholders to make sure the way they characterized them are accurate.
Seeking Professional Help
When forming a business, you should consult an experienced corporate attorney or accountant. These professionals can help you navigate the pros and cons of each type of business entity and others. Your tolerance for complexity, your desire to shield income from taxes and the profitability of your organization are all considerations when making this decision. A professional can make all of these decisions clearer for you.
If you need help with forming a business as an S Corp or any other legal need, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5-percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with, or on behalf of companies like Google, Menlo Ventures, and Airbnb.