Sole Proprietorship vs. S Corp – What’s The Difference?

One of the most important aspects of setting up a small business is deciding which legal formation you’re going to use. For small businesses, two main options to consider are a sole proprietorship and an S Corporation (S Corp).

While both business models can work well for smaller companies, they have several key differences in how they operate. Understanding the pros and cons between sole proprietorships and S Corps can help you decide which solution will work best for you.

What Is a Sole Proprietorship?

A sole proprietorship is a business structure where the entire business is owned and operated by a single person. Legally, there is no distinction between the owner and the business—they are one and the same. The business is usually not incorporated and requires minimal paperwork. In many states, no paperwork is required to set up a sole proprietorship.

In a sole proprietorship, the business owner has personal responsibility for all of the business’s liabilities. Business income and expenses are reported on Schedule C of your individual tax return.

What Is an S-Corp?

S Corps are a type of business entity where corporate income, credits, losses, and deductions are passed through to shareholders. An S Corp is required to have only one class of stock. In addition, some businesses, such as international sales organizations or certain financial institutions, cannot form an S Corp.

One distinction of S Corp business is that it doesn’t have to pay federal corporate taxes. Instead, they operate as passthrough organizations. As mentioned, taxable income and losses are passed directly to shareholders as salary or dividends. The S Corp setup also offers liability protection for shareholders.

Differences Between a Sole Proprietorship vs. S Corp

Here are a few key differences between sole proprietorships and S Corps worth considering.

Breaking this down even further, here are the general realms where a sole proprietorship and S Corp differ:

1. Ownership Model

A sole proprietorship can only be owned by an individual. It cannot be owned by partners or a group. An S Corp offers more ownership flexibility, as it can have up to 100 shareholders.

2. Liabilities

Operating as a sole proprietorship does not provide any legal separation between personal and business assets. The owner is fully responsible for any of the business’s liabilities or debts. This means your personal assets could be claimed to repay business debts. On the other hand, shareholders in an S Corp have limited liability protection that offers legal separation of personal and business assets.

3. Formation

Forming a sole proprietorship generally doesn’t require much paperwork. While you may need to obtain a business license to carry out your activities, many states don’t require any type of application to begin operations.

With an S-corp, you must first form an LLC in your state. After ensuring that you meet the IRS’s S Corp requirements, you must submit Form 2553 to the IRS. This is a time-consuming and costly process since you must go through the application process for both an LLC and an S-corp.

4. Compensation and Taxes

As a sole proprietor, your compensation is determined by your business’s net profit or net loss. Whatever you’re able to earn after accounting for business expenses is your compensation. All of your profit is subject to self-employment tax.

With an S Corp, you can pay yourself in the form of salary or dividends. As a result, your earnings from an S Corp are generally taxed at the standard personal income tax rate.

Benefits of a Sole Proprietorship

There are several valid advantages of operating as a sole proprietorship. Forming a sole proprietorship is extremely simple, with many states not requiring any paperwork or legal formalities to begin operations. This also reduces startup costs compared to other types of businesses. Taxes are simple and straightforward since your business income and expenses are reported on your personal tax return.

As a sole proprietor, you have full control over your business activities. You can quickly change your operations as needed. And, of course, you get to retain all profits produced by your business activities.

Drawbacks of a Sole Proprietorship

The most notable disadvantage of a sole proprietorship is liability. A sole proprietorship doesn’t provide legal protection for the owner’s assets. If your business fails, you could be required to pay outstanding debts and liabilities using your own assets.

In addition, operating as a sole proprietorship means you will be required to pay self-employment tax on your earnings. This means you’ll be taxed at a higher rate than if you earned a salary from a business.

Benefits of an S Corp

One of the chief advantages of S Corp arrangements comes through tax savings. Because your earnings come in the form of salary or dividends, you will generally have a lower self-employment tax liability. The business also won’t have to pay federal corporate taxes.

As an S Corp, you can also expand your operations to include additional shareholders or employees, giving you more flexibility to scale your business from a one-person operation. Your status as an S Corp can also give you added credibility with potential investors, lenders, or suppliers.

Another key benefit of S Corp formation is limited liability. Separation between personal and business assets helps mitigate the financial risk of business ownership, particularly in higher-risk industries.

Drawbacks of an S Corp

While S Corp owners can reduce self-employment tax, the business is still responsible for payroll tax and unemployment insurance (because the owner is also considered an employee). Salary distributions are also subject to Social Security and Medicare taxes.

As a result, while your total tax responsibility can be lowered, taxes and accounting become more complicated overall. The IRS subjects S-corps to much greater scrutiny than sole proprietorships. S Corp owners must be careful to remain compliant in how they make shareholder distributions or pay salaries.

Plus, forming an S Corp is much more expensive and time-consuming than working as a sole proprietor. S Corps must submit articles of incorporation in their home state and pay a variety of fees. State laws also generally require that an S Corp establish a board of directors (even if it’s just one person), keep minutes of business meetings, and so on.

Switching From a Sole Proprietorship to an S Corp

While you can convert a sole proprietorship to S Corp, this process can be time-consuming and complicated. However, many sole proprietors feel this process is worth the effort as their business expands the scope of its operations. Liability protection and the potential to reduce the burden of self-employment taxes is often an attractive proposition, even if you will continue to run your business on your own.

Here’s how to change from sole proprietorship to S Corp:

1. Incorporate as an LLC in your state. Filing fees and guidelines can vary from state to state, so be sure to check with your local Secretary of State’s office for all applicable requirements.
2. After you have incorporated as an LLC, you will need to submit Form 2553 to the IRS. Make sure that you meet the IRS’s standards for S Corp status, such as having only one class of stock, having no more than 100 shareholders (with no partnerships, corporations, or non-resident aliens as shareholders), and being a domestic corporation.

In-Summary: Sole Proprietorship vs. S Corp

As this article illustrates, there are major differences between sole proprietorships and S-corps in terms of their organization, liability protection, tax setup, and more.

While factors like tax savings are important, what is most important is to consider how you plan to operate your business. Starting an S Corp is more time-consuming, costly, and complex. Sole proprietorships may be easier to manage, but they come with self-employment tax and potential liability risks.

Consider how you want to run your business, and form it accordingly—and remember, you can always switch if you need to.

Sole Proprietorship vs. S Corp FAQs

Can I change my S Corp to a sole proprietorship?

Changing an S Corp to a sole proprietorship is possible, though difficult. You must follow the S Corp’s dissolution procedures, which include getting member approval at an official meeting. You must then create a dissolution agreement that determines how assets will be divided and inform any employees. At dissolution, assets are transferred personally to individual shareholders. At this point, you may continue to do similar work as a sole proprietor.

Can I change my sole proprietorship to an S Corp?

Switching from a sole proprietorship to an S Corp requires first forming a single-member LLC within your state. After ensuring that you meet all requirements for an S Corp, you will then need to file IRS Form 2553 to convert the LLC to an S Corp.

What is a passthrough sole proprietorship vs. an S Corp?

A passthrough sole proprietorship is just a standard sole proprietorship where business income and losses are addressed on your personal tax return. S Corps also allow for passthrough taxation, where the salary or dividends you receive are reported on your personal tax return rather than requiring a corporate federal tax return. However, because this is considered income, it is not subject to self-employment tax. Unlike sole proprietorships, S Corps offer limited liability protection.