S-Corp vs Sole Proprietorship: Which One Is Right for You?
Starting a business means that you need to make important decisions about your legal structure. So you might be thinking about starting an S-Corp vs sole proprietorship and which scenario makes the most sense for you.
By default, doing any kind of business activity automatically makes you a sole proprietor - whether you're freelancing online or running a physical business.
This can work for many new businesses, but there comes a point where switching to an S-corporation (S-corp) makes more sense - especially as your income grows.
Here's what to know about running your business as a sole proprietorship vs S-Corp and when to make the switch.
What Is a Sole Proprietorship?
A sole proprietorship is the most basic business structure. When you start doing business without registering as any other type of entity, you're automatically considered a sole proprietor.
In this case, you and your business are legally the same entity - there's no separation between your personal and business assets or liabilities.
As a sole proprietor, you report your business income and expenses on your personal tax return using Schedule C. You'll pay self-employment tax (which covers Social Security and Medicare) on your entire business profit, along with regular income taxes.
The main benefits of sole proprietorships are simplicity and low cost. There's minimal paperwork, no state filing fees, and straightforward tax reporting. So, many small business owners continue to use a sole proprietorship by default just because it's easy.
But there is a BIG downside. As a sole proprietor, you're personally responsible for all business debts and legal issues, which means your personal assets - like your car or bank account - could be at risk.
For example, if someone slips and falls in your store, they could sue both your business and you personally. No bueno, right?
What Is an S-Corp?
Contrary to popular belief, an S-Corporation isn't actually a business structure - it's a tax classification you can elect with the IRS. First, you'll need to form either a corporation or an LLC at the state level, and then file a special Form 2553 to be taxed as an S-Corp.
This special tax status gives you the legal protection of a corporation but with better tax benefits.
In an S-Corp, you're both an owner and an employee. You must pay yourself a reasonable salary for the work you do, and you'll pay employment taxes on this salary.
But the revenue outside of your salary can be taken out as distributions which aren't subject to the self-employment tax. This can potentially save you a lot of money come tax season.
Learn more about the pros and cons of an S-Corp tax status.
Sole Proprietorship vs S-Corp:
A sole proprietorship typically works best for new businesses who're just testing the waters. If you're freelancing to earn some extra money on the side, starting as a sole proprietor typically makes sense.
But once your business starts to earn more profit and becomes more established, you should think about registering a structured business entity, and the S-Corp tax status provides some of the best benefits to small business owners.
Pros of a Sole Proprietorship
Over 10% of businesses in the US are sole proprietorships, so it's a quite popular way to operate. The main advantage of being a sole proprietor is that it's easy.
You can start immediately without filing formation documents or paying state fees. Tax filing is straightforward, too - simply attach Schedule C to your personal income tax return, and you're good to go.
You have complete control over your business decisions and can freely mix personal and business funds as you wish (but we always recommend maintaining separate bank accounts).
That said, beyond ease, a sole proprietorship doesn't have many benefits to offer to business owners.
Cons of a Sole Proprietorship
As your business grows, there are more and more downsides to running a sole proprietorship. Here are the main ones:
No Legal Protection: Your personal assets (house, car, savings) are at risk if your business gets sued or can't pay its debts. There's no separation between you and your business, and you're personally liable for absolutely everything.
Higher Tax Burden: You'll pay self-employment tax on every dollar your business earns. With an S-Corp, you could potentially pay less in taxes.
Limited Growth: You can't sell parts of your business, and it can be complicated to hire employees.
Professional Image: Doing business as a sole proprietorship doesn't always look legitimate, especially as you become more established in your field.
If you're currently running a sole proprietorship and need help transitioning to an S-Corp tax status or an LLC, book a call with Desi Tax!
Pros of an S-Corp
Becoming an S-Corp can offer nice advantages to small business owners. This step requires more setup and maintenance than running a sole proprietorship, but the benefits are worth it for many people. Here's what makes S-Corps so attractive:
No Personal Liability: Your home, savings, and other personal assets are protected if your business faces lawsuits or debts. Only your business assets are at risk.
Tax Savings: You can split your income between salary and distributions. You'll pay employment tax only on your salary, not on the distributions. This often means you'll pay less in taxes.
Better Credibility and Business Continuity: Many people see S-Corps as more established and trustworthy than sole proprietorships. Also, your business can continue even if you leave or sell your shares.
Learn more about the tax advantages of an S-Corp in this S-Corp Taxes for Dummies Guide!
Cons of an S-Corp
Naturally, an S-Corp tax classification isn't the right choice for everyone. Here are a couple of important cons to consider:
S-Corp Set Up: You'll need to file state incorporation documents, apply for an EIN, and file Form 2553 for S-Corp status. This takes time and money.
Payroll Requirements: You'll have to run payroll, pay payroll taxes, and file quarterly reports for both yourself (since you're technically an employee) and any future employees.
Salary Requirements: The IRS requires you to pay yourself a "reasonable salary" before taking distributions. This can help you save on employment taxes, but setting it up incorrectly can trigger an audit.
Learn about these 7 sneaky tax loopholes for small business owners.
Which Is Better, S-Corp or Sole Proprietorship?
For many business owners, an S-Corp is the better option because of the limited liability protection and potential tax savings. But the right choice ultimately depends on your goals and income level.
For a freelance graphic designer making $30,000 annually, a sole proprietorship makes sense - the tax savings wouldn't offset an S-Corp's costs. But for a graphic designer earning $150,000, an S-Corp could likely save thousands in self-employment taxes.
You should also consider your business risks. A wedding photographer with expensive equipment and potential liability from large events might need an S-Corp's legal protection one day. At the same time, a virtual assistant with minimal liability risk and startup costs might be fine as a sole proprietor.
Also, if you're planning on hiring employees or bringing in investors, the S-Corp election is also typically a much better option than a sole proprietorship.
What Are the Benefits of Going from Sole Proprietor to S-Corp?
Converting to an S-Corp can bring immediate advantages once your business reaches a certain size.
For example, a real estate agent whose income jumps from $45,000 to $85,000 could switch to an S-Corp, set a reasonable salary of $50,000, and avoid paying employment taxes on the remaining $35,000. This could save the real estate agent a hefty amount in taxes.
Beyond tax savings, becoming an S-Corp often leads to better business practices (because you now have to comply with regulations) and provides you with immediate liability protection.
FAQs
Can I File as an S-Corp If I'm a Sole Proprietor?
You can't get the S-Corp tax election as a sole proprietor. But you can switch to an S-Corp by following a few important steps. You'll have to create either a C-corporation or an LLC with your state, get an EIN number from the IRS (Internal Revenue Service), then file Form 2553 to become an S-Corp. If you need help getting your S-Corp up and running, get in touch with Desi Tax!
Can an S-Corp Have One Owner?
Yes, you can run an S-Corp by yourself. S-Corps can have up to 100 owners, but there's no minimum requirement. Many small business owners run S-Corps solo. That said, you'll still need to comply with important S-Corp regulations, such as holding yearly meetings. It can feel silly to do when it's just you, but it's a requirement that comes with running an S-Corp.
Do S-Corps Pay Self-Employment Tax?
Yes, but S-corps handle employment taxes differently than sole proprietors. You only pay employment taxes (Social Security and Medicare) on your salary, not on all business profits. For example, if your business makes $100,000 and your salary is $60,000, you only pay these taxes on the $60,000.
The IRS requires your salary to be fair for your industry, so while you can't pay yourself an abnormally small amount just to avoid taxes, you can still save a considerable amount of money every year.
When Should a Sole Proprietor Become an S-Corp?
There's no black and white answer, but you should typically switch when you start making enough revenue to pay yourself a reasonable salary (whatever that is for your industry) and still have enough money left over to save on self-employment taxes. For example, if a fair salary for your work is $60,000 and your business makes $80,000, you might save enough on taxes to make it worth the extra paperwork.
Is It Better to Be Taxed as an S-Corp or Sole Proprietor?
It depends on how much money you make. Once you reach a certain level of income - enough to pay yourself a reasonable salary and have money left over - being taxed as an S-Corp is typically better because it can help you save on employment taxes. Below that, the costs of running an S-Corp might be more than what you'd save during tax season. Stick with sole proprietorship when you're starting out or running a side business.
Should My LLC Be an S-Corp?
If you own an LLC, you can elect for it to be taxed as an S-Corp. Your LLC already protects your personal assets, so the S-Corp status just changes how you pay taxes. If you make enough money to pay yourself a reasonable salary and take out the rest in distributions, you can save on employment taxes. In this case, the S-Corp tax election is worth it.
Learn more about how an LLC can also own an S-Corp and when it might make sense for you to do.
Find Clarity in Tax Season and Start Saving Money You Didn't Know You Had!
Choosing between an S-Corp vs sole proprietorship can feel overwhelming at first, but these are two very different structures with clear pros and cons.
Sole proprietorships work great for new businesses in industries with low risks. But even business owners in low-risk industries should eventually consider switching to a more formal legal structure - such as an S-Corp.
An S-Corp protects your personal assets and might help you keep more money as your income grows, but it's harder to set up and run than a sole proprietorship.
Talk to a tax expert to figure out the best option for your situation!
