Sole Proprietorship vs S Corp: Everything You Need to Know
Learning about a sole proprietorship vs. S Corp is very important when you're choosing a business entity type. 3 min read
Learning about a sole proprietorship vs. S Corp is very important when you're choosing a business entity type. Both options have their strengths and weaknesses, which is why it's important to examine each entity type very closely.
Most people who own and operate their business themselves are running a sole proprietorship. In fact, many people have the legal status of a sole proprietorship without knowing this is the case. As long as you run your business by yourself and have not incorporated, you are a sole proprietor. While you usually won't need to fill out any legal paperwork to form your sole proprietorship, you may need to apply for permits or licenses, depending on where your business is located. You can either name your business after yourself or choose a completely original name. The only requirement is that the name you choose can't already be in use by another business.
When you file taxes as a sole proprietor, you will do so as an individual by using Form 1040 and a Schedule C form. Sole proprietors, as they are self-employed, are required to withhold and pay their own taxes. This includes estimated taxes and self-employment taxes.
When you form a sole proprietorship, you and your business will be considered the same legally, which can be very risky. For example, if your business incurs debt and you are unable to pay this debt using business assets, creditors can pursue your personal assets.
Businesses entities where the business and its owners are legally separate include:
- Limited liability partnerships
- Limited liability companies
A sole proprietor will own all business assets and is the only person responsible for operating the business. While there is liability in choosing a sole proprietorship, this entity type is popular because it is affordable and easy to set up. No special paperwork is necessary for a sole proprietorship, and there are generally very limited state regulations.
You will have no limited liability protection with a sole proprietorship. If you need to protect your personal assets, you should form a corporation or an LLC instead of a sole proprietorship. Unfortunately, even if you choose one of these other entity types, your protections will be limited if you are the only owner. For instance, if you are personally negligent and cause damages, you will be liable. To protect yourself more fully, you should consider purchasing liability insurance.
For tax purposes, you and your business are treated exactly the same. As a sole proprietor, you will not file tax returns or pay taxes. Instead of filing a business tax return, you will report the losses and profits of your business on your personal tax return. Should your business earn a profit, you will add this money to your other income, which can include your spouse's income or interest income. After adding your profits to your other income, the total amount will be taxed. It's possible to receive an income tax reduction for pass-through entities of 20% if you are a sole proprietor. This is outlined in the Tax Cuts and Jobs Act.
A sole proprietor is the owner and operator of a business but is not considered an employee. This means you don't have to withhold income taxes or pay payroll taxes. Sole proprietors also aren't required to have workers' compensation insurance coverage. However, your business income will be taxed for Medicare and Social Security.
If you are the only owner of your business and want to form a corporation, you can choose an S Corporation. This is a very common entity type for single business owners. Once your corporation is formed, you can elect S Corp status for tax purposes by filing a form with the IRS. The form you will need is IRS Form 2253.
As an S Corp is a corporation, you will have limited liability protection with this entity type. Theoretically, this will protect your personal assets from being taken to cover business debts. In reality, there are certain circumstances where these protections will fail, particularly if you are a small company. For instance, you may need to guarantee company debts personally, which can cause you to be held liable when these debts aren't paid for. You will also be liable for your own wrongdoing.
If you need help forming a sole proprietorship or S Corp, you can post your legal needs 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.