One of the biggest decisions a business owner makes when starting out is what type of business entity will work best. For those who are the only owners of the business, that decision often comes down to registering as a sole proprietorship, or an S Corp (Small Business Corporation).
What’s a Sole Proprietorship?
A sole proprietorship is the most common form of business organization in the U.S. A sole proprietor business is the easiest business type to start and operate, because you don't need to formally register your business with your state, unlike corporations or LLCs. If you haven’t registered your business with your state by forming an LLC or other business entity, you’re already running a sole proprietorship.
One question that's often asked is the difference between a sole proprietor and an independent contractor. A small business can be both a sole proprietor for the purpose of paying income taxes and an independent contractor for the purpose of getting paid by companies for work.
What’s an S Corporation?
An S Corporation is a special type of corporation formed through filing a certificate of formation with the office of the Secretary of State where the company is headquartered, as well as the necessary tax documentation with the Internal Revenue Service.
What distinguishes this from other types of corporations is the fact that the taxation of the company is similar to a partnership or sole proprietor as opposed to paying taxes based on a corporate tax structure.
Income is sent directly to shareholders annually in the form of distributions, and it is the shareholders who are taxed, not the corporation. The corporation itself remains a distinct, separate entity from the shareholders.
One drawback of sole proprietorships is that they offer no limited liability protection for the business owner, while S Corporations provide such protection. So, whereas a sole proprietor would have unlimited liability for business debts, in the same scenario, the S Corporation would generally be liable, instead of the owner.
However, when the business is small, owners may still have to personally guarantee business debts. And in both scenarios, you’ll need to purchase personal liability insurance to protect against anything that might happen due to your own negligence. This is why the liability protection provided by S Corporations is limited in nature.
When you’re a sole proprietor, you and your business are one and the same for tax purposes. Sole proprietorships don’t pay taxes or file tax returns. Instead, you report your profits or losses on your own personal tax return (IRS Form 1040). Sole proprietors may also be eligible for a 20% income tax deduction for pass-through entities.
When you’re a sole proprietor you are not an employee of your business entity. Instead, you are a self-employed business owner. Your business doesn’t pay payroll taxes on your income or withhold income tax from your pay. It doesn’t file employment tax returns or pay state or federal unemployment taxes. You aren’t covered by workers’ compensation insurance. All this can save you hundreds of dollars each year.
However, sole proprietors have to pay self-employment taxes. Self-employment taxes consist of a 12.4% Social Security tax on income up to an annual income ceiling, and a 2.9% Medicare tax not subject to any ceiling.
Note: Self-employment taxes are equivalent to the total Social Security and Medicare tax paid by a corporation for an employee.
S Corporations are pass-through entities, meaning the business income and losses pass through to the owner’s individual tax return. This means that the taxes you pay on your business income, as well as your business deductions, are the same as for a sole proprietorship. An S Corporation might also be eligible for the 20% tax deduction for pass-through entities.
The tax benefits of an S Corporation come through savings on self-employment taxes. S Corporations allow for profits to be distributed to shareholders, not as income, but as distributions, and distributions are exempt from Social Security and Medicare tax. However, shareholders who perform significant services for the corporation must be treated as employees and must be paid a reasonable salary. In other words, not all of your compensation can be in the form of a distribution. Let’s say you take half of your profits as a distribution, half as a salary. You must pay Social Security and Medicare taxes on the salary half of your profits, but you’ve saved the amount of those taxes on the half of your profits you took as a distribution.
Time, Money, and Paperwork
Despite the tax savings, S Corporations have additional expenses. Most states require that each employee be provided with workers’ compensation and unemployment insurance coverage, and some states also require all corporations, including S corporations, to pay minimum annual state taxes, no matter how much money they earn.
There’s no paperwork involved in setting up a sole proprietorship, while S Corporations require you to file documents with governmental agencies. S-Corporations may also have other ongoing filing requirements depending on the state where they are formed, like annual information statements. The time, money, and paperwork involved in setting up and running an S Corporation needs to be weighed against the tax and liability benefits they provide.
Deciding on the best business structure for your situation is never easy. Each state's laws differ as well as each company's circumstances. Before making your decision, do your research and calculate the pros and cons. It's also advisable to seek tax and legal counsel to help determine the best choice for your business.