Sole Proprietorship vs. S Corp: A Guide to the Differences

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If you’re starting a small business by yourself anywhere in the US, you might default to sole proprietorship. It’s easy to do so. The US Internal Revenue Service automatically designates any individual transacting business as a sole proprietor. But you have other options—including an S corporation (or S corp). It’s worth understanding the pros and cons of operating your small business as a sole proprietorship or as an S corp, so you understand what’s best for your and your business.

What is a sole proprietorship?

Many individuals running small businesses without employees in the US operate as sole proprietorships. In fact, if you start a business by yourself and don’t choose any other structure, the Internal Revenue Service (IRS) considers you a sole proprietor. The main distinguishing characteristic of sole proprietorships is that they are not separate legal entities from their owners. The proprietor owns all of the business’s assets and is responsible for its long-term and day-to-day operations, as well as its debts and obligations.

The popularity of the sole proprietorship as a business entity is due in large part to its simplicity, startup ease, and cost-effectiveness. You don’t have to do anything to establish a sole proprietorship other than start a solo business and file your taxes at the end of the year.

What is an S corp?

Companies that operate as S corporations have a tax status under IRS rules that can apply to two business structure types: the limited liability company (LLC) or C corporation. This means that a sole proprietorship must incorporate as an LLC or C corp before obtaining S corp status.

Sole proprietorship vs. S corp

Operating as a sole proprietorship and S corp are mutually exclusive, and it’s important to note the differences and similarities so you can make an informed decision about how your small business will proceed.

Income

Sole proprietorships generate income in a very simple, streamlined manner. A product or service is sold by the proprietor and money comes in, ideally more than enough to cover expenses. The proprietor then pays taxes on any profit. S corps can distribute income to owners in two ways: as a corporate distribution (dividend), or as a reasonable salary for an owner acting as an employee, otherwise known as an owner-employee. Salary received by an owner-employee is subject to the same Social Security and Medicare tax as profit generated by a sole proprietor.

Liability

Because an S corp is either an LLC or a C corporation, there is a legal distinction between the business and ownership—thus providing owners with a degree of liability protection. Members of an LLC or shareholders in a corporation that elect S corp status will not be personally liable for most of the corporation’s debts or in the event of litigation, any damages awarded. This protection does not exist with sole proprietorships, which enjoy no legal separation between the proprietor and the business.

Taxes

The S corp gets its name from being taxed under Subchapter S of the IRS code. Under this designation, S corps enjoy certain tax benefits because the IRS considers the business owner an owner-employee. The IRS, therefore, doesn’t subject the owner to self-employment tax, which they might have been obligated to pay as a sole proprietor or member of an LLC. Sole proprietorships, meanwhile, pay both self-employment taxes and income taxes on the profits of the business. S corp owner-employees still pay Federal Insurance Contribution Act (FICA) tax, or Social Security and Medicare taxes, as well as income tax on any salary they draw from the business. S corps must also pay payroll taxes and unemployment insurance coverage as a result of having employees. But by avoiding self-employment tax, those who operate S corps can enjoy substantial tax savings.

How to choose between a sole proprietorship and an S corp

Choosing between a sole proprietorship and an S corp ultimately comes down to two considerations: liability and cost. If you are looking to limit personal liability and taxes on profits from your business, you may want to incorporate as an LLC or C corp and then elect S corp status. However, this process is complex, and incorporating may be subject to certain startup costs—including state business registration fees or attorney fees for preparing the necessary paperwork. If you favor simplicity, ease of setup, and cost-effectiveness, continuing to operate your small business as a sole proprietorship may be the right move.

Sole proprietorship vs. S corp FAQ

When should sole proprietorships become an S corp?

Sole proprietorships should be incorporated as LLCs or C corps before electing S corp status. Typically LLCs and C corps are formed by registering in the state in which they intend to be based and do business (though sometimes, for tax purposes, they may incorporate elsewhere). After incorporating as an eligible entity, the business may elect S corp status by filing a Form 2553 with the IRS.

Can a sole proprietor file as an S corp?

A sole proprietor is not eligible to file as an S corp. A sole proprietor must first incorporate as an LLC or C corp before electing S corp tax classification.

What are some disadvantages of a sole proprietorship?

There are a few disadvantages to operating your small business as a sole proprietorship including:

No personal liability protection/unlimited liability. Because the sole proprietorship is not a separate legal entity from the owner, the proprietor enjoys no personal liability protection against debts and/or legal damages incurred by the business. Creditors and litigants potentially can claim an owners’ personal assets as a result.
Self-employment taxes. In addition to paying FICA and income taxes on profits generated by the sole proprietorship, sole proprietors pay self-employment taxes, which in 2022 is 15.3% at the federal level.

What are some disadvantages of an S corp?

Some disadvantages of forming an LLC or C corp and electing S corp status include:

Startup costs. Because electing S corp status requires that you incorporate your small business as an LLC or C corp first, you will need to pay certain administrative costs, such as registration or attorney’s fees.
Liability concerns. Although S corps enjoy a degree of liability protection, if your business is particularly small, you may be required to personally guarantee certain corporate debts. And acts of negligence and malfeasance are not subject to limited liability protection, even in an S corp.
Tax concerns. Distributions from the S corp in the form of salary to an owner-employee will be subject to their own taxes, such as including Social Security and Medicare taxes. S corps also may be subject to minimum annual state taxes, regardless of their business income bracket. California, for example, charges S corps a minimum $800 yearly tax.

Why might you choose to be an S corp rather than a sole proprietorship?

There are two primary reasons for electing S corp tax status for your small business. First, S corps enjoy a degree of liability protection that sole proprietorships do not. Small business owners who’ve elected S corp tax status are not responsible for most business debts and legal damages. Second, S corps can avoid having some of their income taxed at the high rates typically applied to sole proprietorship income by distributing a portion of the profits as corporate dividends, and as a reasonable salary to owner-employees.