S Corp vs. Sole Proprietorship: A Simple Guide

In this article we will discuss the main differences of two popular types of business entities: the S Corporation (S Corp) and the Sole Proprietorship.

s corp vs sole prop chart

S Corp vs. Sole Proprietorship: Key Differences

1) Separation of Personal Assets

The main difference between an S corp and a sole proprietorship is the separation of the individual from the business.

Sole proprietorships do not provide any separation of personal and business assets and therefore can leave you exposed to more personal risk if anything were to happen to your business.

On the other hand, forming an S corporation (S corp) creates a whole new legal entity for your business, creating separation between your personal assets and business assets.

Due to the separation of personal and business assets, S corporations allow for much more protection if something were to go wrong within the business.

2) Ease of Setup

Sole proprietorships do not require any paperwork to set up and most business owners do not even realize when they are classified as a sole proprietor because the title is automatically earned once a person decides to go into business by themselves without forming a corporation or creating a limited liability company.

While achieving S corp status is not overly complicated, it is definitely more involved then simply doing nothing (as is true with sole proprietorships).

In order to gain S corp status your must first form a corporation within your desired state and then you need to file Form 2253 with the IRS in order to be taxed as an S corp.

3) Tax Benefits

Sole proprietorships and S corporations are both considered "pass-through" entities, meaning that you would report the income you earned or losses you incurred on your personal tax return.

However, these entities differ in that S corporations are not subject to self-employment taxes on all income.

Sole proprietorships must pay self-employment taxes, which consists of Social Security and Medicare, on all reported income.

S corporations, however, allow profits to be dispersed through dividends (or distributions) rather than income, but there's a catch: you can't designate all of your income as "distributions".

If you are also the sole employee of your S corp you must legally treat yourself as an employee and pay yourself a reasonable salary for the work you completed and this salary is still subject to self-employment taxes.

What is an S Corp?

An S Corp (S Corporation) is a type of business entity that allows the owner to separate his or her personal assets from the assets of the business.

In other words, an S corp acts as a completely separate legal entity from the owner and is able to pay out dividends to its shareholders.

S corporations are created by forming either a corporation or an LLC and electing for taxation status as an S corp by filing Form 2253 with the IRS.

These business entities are highly regulated and require you to keep extensive records of stuff like corporate bylaws and shareholder meetings.

Advantages of an S Corp:

  • Creating an S corporation will separate your business assets and debts from your personal assets and debts
  • When you choose to be taxed as an S corp, you are lowering your personal risk if something were to go wrong with your business
  • S corporations provide favorable tax situations compared to other types of business entities

Disadvantages of an S Corp:

  • S corporations are highly regulated compared to other types of business entities
  • S corporations require greater amounts of record keeping in order to stay in compliance

Should I Create (Set Up) an S Corp For My Business?

You should create an S Corp for your business if:

  • your business has large inherent risks
  • you plan to distribute most of the income rather than reinvest

What is a Sole Proprietorship?

A sole proprietorship is a type of business entity that includes anyone running a business that has not incorporated or formed an LLC.

Advantages of a Sole Proprietorship:

  • there is no paperwork required to form a sole proprietorship
  • there is no double taxation
  • it is simple to change your business structure at a later time

Disadvantages of a Sole Proprietorship:

  • there is no personal protection for the owner (ex: in the case of a lawsuit, the owner's personal assets can be taken to settle a business debt)
  • sole proprietors are required to pay self-employment tax on all net profits
  • it is more difficult to raise capital as a sole proprietorship due to the lack of legal separation between the business entity and the owner

Should I Create (Set Up) a Sole Proprietorship For My Business?

You should structure your business as a sole proprietor if:

  • your business has a low chance of financial loss
  • you have a small customer base
  • note: technically your business is automatically classified as a sole proprietorship if you did not fill out any other paperwork with your state

S Corp vs. Sole Proprietorship: FAQ's

Which is better: S Corp or Sole Proprietorship?

This question is completely subjective and can only be answered on a per-business basis as there are many advantages and disadvantages to each type of business entity.

When should a sole proprietorship become an S corp?

In general, a sole proprietorship should become an S corp once your business begins growing and taking on more risk.

Can a sole proprietorship file as an S corp?

A sole proprietor is not eligable to file as an S corp. You are required to incorporate your business before electing to be taxed as an S corp.

S Corp vs. Sole Proprietorship: Which is Best?

There are many advantages and disadvantages to both types of business entities and depending on your current situation you may benefit more from choosing one over the other.

Unfortunately, there can be no definitive answer as to which business structure is best due to each situation having its own unique challenges.

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