s corporation vs sole proprietorship
The answer depends on particular business, as each business type has its own pros and cons, tax benefits is biggest factor when choosing a business structure.3 min read
2. Taxes and Other Considerations
Which is better: an S corporation vs. sole proprietorship? The answer depends on your particular business, as each business type has its own pros and cons. Tax benefits tend to be the biggest factor when choosing a business structure, but they shouldn't be the only factor. Because S corporations are corporations, they are subject to formalities that sole proprietorships aren't. There are also some strict guidelines that a business must meet in order to be eligible for S corporation tax status.
S Corporation vs. Sole Proprietorships
S corporations are similar to LLCs in that they're not taxed as separate business entities. Instead, business profits and losses pass through to company shareholders.
Individuals who run their own business are automatically considered sole proprietors. No formal filing is required in order to form a sole proprietorship. Sole proprietorships are not considered legal entities separate from their owners in the way that LLCs, partnerships, LLPs, and corporations are. As a result sole proprietorships don't offer limited liability protection. Other business structures offer this protection, which is why many business owners prefer them.
Sole proprietorships don't file business tax returns or pay business taxes. Instead, you file a personal tax return on Form 1040, where you report your income and losses.
The following apply to you as a sole proprietor:
- You're not an employee of your business. You're a business owner, or self-employed.
- Your business doesn't have to withhold income tax or pay payroll taxes on your income.
- Your business doesn't have to pay unemployment taxes or file employment tax returns.
- You don't have to be covered by workers' compensation insurance.
Taxes and Other Considerations
As a sole proprietor, you're responsible for paying self-employment taxes on your business income, or self-employment income. This includes Medicare taxes and Social Security. Companies cover a portion of these taxes for their employees, which are equivalent to self-employment taxes.
Even if you run a business by yourself, you can still legally organize it as a corporation. You would be the sole shareholder, president, and director. Once you incorporate your business, you may choose to be taxed as an S corporation by filing Form 2553 with the IRS. S corporations offer limited liability protection to its owners and shareholders.
In fact, tax benefits are the main reason many small business owners elect S corporation status. S corporation owners, like sole proprietors, are eligible for the 20% pass-through tax deduction, which was established under the Tax Cuts and Jobs Act. Unlike sole proprietorships, corporations automatically deduct Medicare and Social Security taxes from the employee's paycheck. As a result, these employees are not responsible for paying these taxes separately on their personal tax return.
Employees can also own stock in the S corporation they work for. Shareholders who work for the S corporation are subject to the same taxes that a sole proprietor pays regarding Medicare and Social Security. As an employee or an owner, you must receive a reasonable salary. The IRS tends to place extra scrutiny on a shareholder's taxes when he or she also works for the S corporation, which is why emphasis is placed on "reasonable wages."
Because shareholders don't have to pay employment taxes on the dividends they receive, some owners try to receive more dividends than they do wages, thereby lowering their payroll taxes. The IRS specifically looks for instances where S corporation owners are receiving a lower wage than they should based on their employee duties and training.
Personal asset protection and tax benefits also make S corporations an attractive business type for small business owners. However, it does take some time and effort to form a corporation. While S corporations offer some advantages over sole proprietorships, some business owners are satisfied running a one-person operation without a lot of additional paperwork and hassle.
If you're unsure which business type is best for you, consider the goals you have for your company. Think about growth and investment opportunities. If you're perfectly content remaining a small business owner who doesn't venture out of your local area or you're happy being a one-person company, either of these business types are suitable.
If you need more information on sole proprietorships, S-Corporations, or other business types, 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.