S corp vs sole proprietorship tax is a consideration that must be made when starting a business. Business structure affects the tax liabilities of the business, and this will create an impact on your success and failure. You need to understand the concepts of an S corporation and sole proprietorship to properly design your business to maximize your profits.

What Is a Sole Proprietorship?

Sole proprietorship is a business entity owned and managed by you. It is the simplest form of business entity because you're just working for your own company. In terms of business name, you can nominate your own name or have a preferred business name given that no other business has already used. Most people in the business world are sole proprietors. Here are few advantages of having a business of this type:

  • Business owner owns all business assets and sole charge of the decision making.
  • Starting a business is cheap and simple.
  • No extra documents are needed, apart from the license, permit, and other regulatory requirements.

A risk of having your business registered under a sole proprietorship is that it doesn't provide personal liability protection. This makes you legally responsible for any damages caused by your negligence. With that, it is best to consider getting a liability insurance.

What Is an S Corporation?

A sole proprietorship business can still be organized into a corporation with the sole owner as the only shareholder, the president and director, and the executive who manages the business. After forming the corporation by filing IRS Form 2253, you can have your business taxed as an S corporation. An S corporation's status protects its shareholders with a limited liability.

Most of the time, the shareholders are not responsible for corporate debts, but limited liabilities have loopholes, especially when the corporation is small. The business owner needs to personally guarantee corporate debts. He or she is personally liable for negligence and other misconduct.

S Corp vs Sole Proprietorship Tax

When it comes to tax returns, sole proprietors are required to declare all their business income as self-employment income. Moreover, the more income generated, the fewer business deductions will be subjected to both ordinary tax rates and self-employment taxes. Self-employment tax comes with a 10.4 percent Social Security tax and 2.9 percent Medicare tax applied to all self-employment income. On the other hand, ordinary income taxes can reach up to 35 percent.

Owners of business entities with a sole proprietorship status file taxes as individuals using the following documents: 

  • Profit or Loss from Business
  • Schedule C
  • Form 1040

The sole proprietor is in charge of paying and withholding all the taxes. This includes estimated taxes and self-employment taxes. One of the biggest risks of having a sole proprietorship is that the business and the owner have no legal separation: You are not an employee of your business if you are in a sole proprietorship status. You will be addressed as the business owner and, in this context, self-employed. The business is not allowed to pay income or withhold income taxes from your pay, and the business is not required to file for employment tax returns or pay necessary unemployment taxes.

Meanwhile, an S corporation is a pass-through entity, which means that the income and losses of the company just pass through the business to the owner's personal tax return. All the taxes a business owner files will be a little different from that of a sole proprietor. Similar to sole proprietors, business owners of an S corporation are also eligible for the 20 percent pass-through deductions based on the Tax Cuts and Jobs Act for pass-through business owners.

Social Security and Medicare taxes are hefty amounts of money if you're in a sole proprietorship business. This is where S corporation saves the business owner some of the business income without paying these taxes. S corporations are not required to pay these taxes on distributive shares. S corporation is the only business form that allows business owners to save some of their income from Social Security and Medicare taxes. This is the main reason why S corporations remain popular for small business owners.

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