Biz Owner Guide Blog

S Corp vs Sole Proprietorship

by | Jun 12, 2022 | Blog

S corporations vs Sole proprietorships. Which is better for you?

Being an S Corp vs sole proprietorship, which is better? It depends on a number of factors like business income, liability protection, and the tax benefits for the business owner.

There’s a big misconception when it comes to S Corp vs sole proprietorship. One will usually require a reasonable salary subject to self-employment taxes while the other business entity does not.

We’ll break down tax benefits of each and when it could be good to be a S Corp vs sole proprietorship.

S Corp vs Sole Proprietorship

When it comes to your business entity, it’s important to understand how business income is treated and the tax benefits of each. For example, requirements of a sole proprietorship vs an s corporation are relatively few.

Sole Proprietorship

If you wanted to start business today without creating a business entity, you could. That’s a sole proprietorship. You would report the business income from your sole proprietorship on your personal tax return.

As the business owner of the sole proprietorship, you not only have to pay income taxes on the business income, you are also subject to self employment taxes. Those taxes consist of social security and Medicare taxes.

If business income ends up being quite large, then the sole proprietor will have to pay a large amount of self employment taxes in addition to income taxes on their tax return.

Limited liability protection of a Sole proprietorship

When it comes to limited liability protection, there is essentially none for a sole proprietorship. So when you think about business debts and being personally liable, it’s usually not limited with a sole proprietorship.

Is it bad not having no limited liability protection as a business owner? It depends. A sole proprietor is usually okay choice for very small business owners.

Sole proprietorships also need think about if they would be personally liable for anything as a business owner. Even for very small business owners it may be best to seek legal services or advice to determine if staying a sole proprietorship would be okay.

If you are a sole proprietor would pay more taxes on your own personal tax return? Depends.

Income Taxes and Self employment taxes of a Sole proprietorships

A part from personal liability protection, a business owner also needs to consider income tax on the owner’s personal tax return. There could be tax savings being an s corporation instead of being a sole proprietor. However, s corporations don’t automatically mean you pay less in income tax or less in payroll taxes.

Being a sole proprietorship means less tax returns. That’s right, as a s corporation, you will have to file two tax returns per year. One for the s corporation and the owner’s personal tax return. Furthermore, being an S Corp does not mean you are completely excluded from paying self employment tax. You still have to pay payroll taxes with your reasonable salary taken for the s corp.

So a sole proprietorship vs an S Corp would be simplicity when it comes to tax returns. Sole proprietorships also require less legal documents than s corporations do. Just remember no legal documents also means no personal liability protection either.

Self employment tax is a factor to consider as a sole proprietor. Self employment tax includes social security and Medicare in addition to income tax that the sole proprietor will have to pay.

Breakdown of taxes of a Sole proprietor

For tax purposes, it’s important to know that a sole proprietorship business will be taxed on self employment income. Self employment taxes consists of medicare tax and social security tax. Federal income tax will also imposed (and possibly state.)

Now, if business deductions exceed income, you have a net loss and you won’t pay taxes on self employment or income taxes on the sole proprietorship business.

Keep in mind it’s not always good that social security and medicare taxes are not paid. If you are not paying into these systems, then could receive a substantially lower benefit upon retire.

Or worse, nothing at all.

As a sole proprietor medicare tax and social security tax are paid when you file your individual tax return. So, if you have self employment income (meaning net profit from your business), you pay self employment tax (social security and medicare taxes.)

This is one of the reasons why an S corp is used for tax purposes. It can lower the amount of self employment taxes you pay on your personal tax return.

Tax Classification

Business income and expenses of sole proprietorship are reported on personal tax returns.

Because it is not a separate entity, you also need to realize that tax on income will be imposed on a federal level. If it is substantial, you may want to consider switching to an s corporation or making estimated tax payments to the IRS.

An S Corp the right business structure for your business?

S Corporations

When sole proprietors determine that it is they want to convert to an s Corp, there are several steps to implement. Remember, sole proprietors have unlimited liability, so before

S Corporations are Not a Business Entity

That’s right, an s corp is not a separate legal entity; it’s a tax election. S corporations are C-Corporations or a limited liability company (LLC). A limited liability company (LLC) is most common because it is less complicated and less costly to set up.

After the legal entity has been step up whether by you or other legal services, you then have to elect to be taxed as an S corporation using the 2553 form.

Does S-Corp Pay tax?

An S Corporation does not pay taxes on a federal level. They are pass through entities. This means the S Corporation passes through to the owner’s individual tax return. On a state level, the s corporation could be business taxed.

States like California have imposed taxes on the S Corp level. Be aware that a small business would have to pay additional taxes even when it’s business structure is changed to an S Corporation. This is one reason, sole proprietors aren’t always bad.

Reasonable Salary – S Corporations

To be taxed as an s corp, the internal revenue service requires you have what is called a reasonable salary. This reasonable salary is subject to social security and medicare taxes and you should withhold income tax on this salary as well.

This requires that you have a payroll provider like QuickBooks Payroll or Gusto to process a salary for you from the S Corporation. The payroll provider will withhold social security and medicare, federal income and unemployment taxes. For sole proprietors, you are not required to take out a salary.

This is another reason why an S Corp could be more cost than benefit if there is not enough net profit.

S Corp vs Sole Proprietorship? Who’s Wins?

No one! The S Corporation is not a one size fits all. The S Corp is best at certain stages and sizes of a business. Likewise, being a sole proprietorship is best income is small and personal assets are not at risk for potential litigation.

Sole proprietorship can still get an LLC

When some one says they’re taxed as an S corporation, that clearly explains they tax classification. When some says they’re taxed as LLC, I know the small business owner might not be too familiar with their tax classification.

An LLC can be taxed several different ways. Including as S Corps, an LLC can be taxed as a sole proprietorship, a partnership, or as a C Corporation.

Taxed as a sole proprietorship means your business has no legal separation from your personal returns. It is all reported on the same return. Even if being taxed as a sole proprietorship appears to be your best option, best to get an LLC. Always consult an attorney on this, but the LLC can give you legal protection on your personal assets if you are ever sued.

Each state has different laws and treatments on how personal assets are protected. So, if this would ever seem like a concern, consult a business law firm in your state.

Daniel Sleep, CPA

About the Author

Daniel is a Certified Public Accountant (AZ), Charted Retirement Planning Counselor (CRPC), Certified Tax Coach (CTC) and a Registered Investment Adviser (Series 65). He’s worked for large accounting firms like Deloitte & Touche to the small family businesses.

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