Sole Proprietorship vs. S Corp

What is a sole proprietorship? 

When you’re the sole owner of a business and don’t file any paperwork with your state to create a formal business entity, you own a sole proprietorship. A sole proprietorship is the default business structure for entrepreneurs who don’t have partners or shareholders. Some business owners choose to keep this structure, and some seek a structure for their entity that’s a little more formal and provides liability protection. Let’s take a look at the reasons for and against maintaining a sole proprietorship. 

Advantages

If you’re new to the business world, a sole proprietorship is often an attractive option because it’s so easy to set up. You don’t have to register your sole proprietorship with your state to form it. You don’t have to write governing documents for your business operations. And you don’t have to file periodic reports with your state to keep your business legally compliant. If you choose to sell your sole proprietorship, you have virtually unlimited options regarding how to conduct the sale and how to choose the buyer.

Sole proprietors don’t even have to file separate tax returns for their businesses. If you own a sole proprietorship, you can avoid the dreaded double taxation associated with traditional corporations. Instead, a sole proprietor benefits from pass-through taxation, which means the business itself doesn’t pay federal income taxes on its revenue. Only the owner pays taxes on the income they generate from the business. 

While you might need to apply for permits or licenses to engage in certain commercial activities as a sole proprietor, the upkeep for many commercial licenses and permits is less complicated than conducting business as an LLC, corporation, or limited partnership. You basically form a sole proprietorship as soon as you start conducting business. However, the ease of forming and operating as a sole proprietor vs an s corp owner comes at a price not all entrepreneurs are willing to pay. 

Disadvantages

What you gain in ease of formation and ownership with a sole proprietorship, you lose in liability protection. Many people seek to keep their business and personal lives separate, but that isn’t possible when you are a sole proprietor. If you own a sole proprietorship and your business incurs debt or a legal obligation, you are also personally responsible for those obligations.  

Owning a sole proprietorship also means you have fewer options for raising business capital. More formal business entities can generate capital by selling shares or acquiring partners. However, sole proprietors depend mainly on their own savings and loans from financial institutions to cover startup, business, and expansion costs. 

What is an S corporation? 

An S corporation could be called a “small business corporation,” but it’s actually not a business entity. Although the word “corporation” is in its name, an S corporation is actually a tax designation that can be applied to LLCs and corporations. Usually, once you start whichever business entity you choose in your state, you can select S corporation tax status with the IRS. 

Advantages

The main advantages that many business owners seek when electing to be an S corporation owner vs a sole proprietor are the tax benefits. For business people who want to run a corporation in their state but don’t want to be taxed twice, an S corporation can be a great choice. S corporations enjoy the same pass-through taxation as sole proprietorships and LLCs while allowing business owners to bring in more capital through corporate shareholders. LLCs operating as S corporations can also save money when it comes to self-employment taxes (more on that below). 

Disadvantages

Unlike running a sole proprietorship, running an S corporation does have some additional restrictions you need to satisfy. If you want to be eligible for S corporation status, your business must fulfill the following requirements: 

• Your business must be a domestic entity
• Your business must have only U.S. shareholders (for a corporation) or members (owners of an LLC), which can be individuals, certain trusts, and estates
• Your business can’t have shareholders/members that are partnerships, corporations, or non-resident aliens
• Your business can’t have more than 100 shareholders/members
• Your business can have only one class of stock

• Your business can’t be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

These requirements can also make selling your S corporation more difficult than selling your sole proprietorship because the number of eligible or willing buyers might be smaller.   

Differences Between an S Corp and a Sole Proprietor

So, what is the difference between owning an S corp and being a sole proprietor? A lot of the differences boil down to paperwork, taxes, and eligibility for ownership. 

Paperwork

While you can form a sole proprietorship with little to no effort, you must file additional paperwork with the IRS to make your business an S corporation. In addition to your personal tax return, you have to file a separate income tax return for your S corporation. 

S Corp vs Sole Proprietorship Taxes

You own a pass-through entity whether you own an S corp or are a sole proprietor. However, S corporations can offer more tax-saving opportunities to owners. You can save more on taxes as an S corporation owner because you have more options for reducing your self-employment tax liabilities.

In general, entrepreneurs must spend 15.3% of their business income on self-employment taxes. These taxes include 2.9% of a business person’s income to pay for Medicare and 12.4% to pay for Social Security.

If you’re a sole proprietor, you have to pay self-employment taxes on whatever you earn from your business. But if you’re running an S corporation, you only have to pay self-employment taxes on the “reasonable salary” you set for yourself as an owner/operator. The remainder of your S corporation business income can be classified as distributions that aren’t subject to self-employment tax. (The distributions will still be subject to income and other applicable taxes, of course.) It’s best to speak to a tax professional about your options to see whether filing as an S corp would benefit you in your particular circumstances. 

Eligibility for Ownership

As we stated above, the IRS places strict limitations on who can own an S corporation. If you don’t fit the IRS’s criteria for ownership, an S corporation is not for you. And if you’re seeking a variety of options for selling your business, an S corporation might be the wrong tax status for your goals. 

Is a sole proprietor or S corp best for you? 

Whether you should run your business as an S corporation or sole proprietorship depends on your personal and business needs. Discuss your options with legal and financial professionals to help ensure that you make the right selection. 

How to Form an S Corporation

Forming an S corporation requires you to first form an LLC or a C corporation at the state level, if you haven’t already done so. Once your LLC or C corporation formation is approved by the state, you need to file Form 2553, Election by a Small Business Corporation, to get S corporation status. 

The Internal Revenue Service requires that you complete and file your Form 2553 with the IRS: 

• Within 75 days of the formation of your LLC or C corporation, or no more than 75 days after the beginning of the tax year in which the election is to take effect

OR

• At any time during the tax year preceding the tax year the election is to take effect.

One note for LLCs wishing to file as an S corporation: If your LLC is past the 75-day election deadline, you’ll also need to file Form 8832, Entity Classification Election, to elect to be taxed as a corporation. Then you would file both Form 8832 and Form 2553 together via USPS-certified mail. 

The IRS has more information on when and how to file Form 2553 and other information about how to set up an S corporation on its website.

If you have more questions, take a look at our S corporation definition page.