S Corp vs. Sole Proprietorship

Sole proprietorships are the default single-owner business organization in the United States. Their simplistic design and low cost make them an attractive option for small business owners. Alternatively, S corporations (S-corps) are a tax designation that requires more time, paperwork, and money to set up. But, they offer a higher degree of protection and tax benefits.

Suppose an individual has just begun their career as a freelancer. They are earning income but have not filed any paperwork with their state to register this self-owned business. At this point, the individual is operating a sole proprietorship. But when is the right time to consider switching to a business entity with S-corp status?

The truth is that there is never a wrong time to consider shifting a sole proprietorship over to an S-corp. An S-corp's ability to shield personal assets from business debts and obligations (also known as limited liability protection) is a good choice for any company conducting for-profit business with clients.

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Key Takeaways

• Sole proprietorships are the default type of single-owner business structure and appeal to freelancers just starting out.
• While taxed similarly, an S-corp tax designation provides more financial flexibility and a higher degree of protection of personal assets.
• A self-employed business owner can begin as a sole proprietorship and shift to an S-corp later if they so choose.
• There are benchmarks during a business's life that indicate when it's time to consider S-corp status for your business.

Sole Proprietorships and S Corporations: Defining the Difference

The law views sole proprietorships and their owners as a single entity for tax purposes. As such, the Internal Revenue Service (IRS) taxes sole proprietorships through an owner's income.

An S-corp is an IRS tax designation for a legal business entity such as a limited liability company (LLC) or corporation. Both LLCs and corporations have the added benefit of protecting owners' personal assets from their business's debts.

S-corps are named after Subchapter S in the internal revenue code. They are fundamentally different from sole proprietorships but can be taxed similarly. Both structures bypass taxation at the corporate level. Any profits or losses are documented on the owner's personal tax return and taxed accordingly. Importantly, S-corps pay less in self-employment taxes but are also subject to lower taxes in items such as payroll.

The IRS provides a tax withholding estimator for individuals seeking to determine what they owe based on their business's earnings.

How to Shift from a Sole Proprietorship to an S Corporation

Sole proprietorships do not protect your personal assets. To protect personal assets, an owner must establish their business as a separate legal entity.

For your business to become a legal entity, you must file paperwork with your state in a process called incorporation. This step is critical if a company seeks to obtain S-corp status. This is where you choose a business name and structure for your company. This structure is typically an LLC or corporation. A filing fee accompanies incorporation and varies by state.

Corporations often involve multiple shareholders, hiring employees, and more intricate regulations. They don't make much sense for most self-employed small business owners. Therefore, most of them choose the more straightforward LLC as their structure.

Once your business is registered as a legal entity, you can elect to be taxed as a C corporation (C-corp) or an S-corp. C-corps have what is called double taxation, where gains are taxed at both corporate and personal levels.

Because of this, most small business owners will apply for S-corp status, which has no corporate tax. This requires filling out an application with the IRS declaring your desire to be taxed as an S-corp. This application is called an IRS Form 2553.

When to Shift from a Sole Proprietorship to an S Corporation

Sole proprietorships are great for small business owners who want to keep things simple. However, these businesses grow riskier over time. Not only are your personal assets at risk, but your self-employment taxes start increasing as your small business generates a profit.

S-corps limit liability and reduce self-employment taxes. As a sole proprietor's business grows, they should reassess their structure regularly. Here are a few critical instances where incorporating and adopting S-corp status make sense:

• Does the business have clients?
• Is it generating a profit?
• Does the business need to hire employees or independent contractors?
• Does the owner want to reduce risk to their personal assets with limited liability protection?

Seeking Assistance

Every type of business has its own set of characteristics and challenges. How and when to turn a sole proprietorship into a legal business entity requires time and skillful know-how. It's always best to contact a small business lawyer for guidance. They are experts in the field and can help set you on the right path.

Related Topics

• LLCs
• Corporations
• Tax Differences Between C and S Corporations
• Sole Proprietorships