S Corp vs. Sole Proprietorship: Critical Differences

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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 are the default structure for single-owner businesses in the United States. They are easy to set up and operate, making them an attractive option for small business owners. Alternatively, S corporations (S-corps) are a tax status for a corporation, requiring more time, paperwork, and money to set up. However, S-corps offer a higher degree of liability protection and tax benefits, often making it worth the time and effort.

Suppose an entrepreneur has just started a business doing mobile car detailing. They operate under their name as the business or register for a DBA (doing business as) to operate under a trade name. Although they need to file for business licenses and permits, they do not have to register their business with the Secretary of State. 

A corporation, however, must be set up by filing articles of incorporation with the Secretary of State.

Sole Proprietorships and S Corporations: Defining Differences and Similarities

Personal Liability Protection

The business owner is personally responsible for any business liabilities and debts. And if someone sues the business, the business owner’s personal assets are at risk. However, if the business owner formed a corporation and filed for S-corp status, the S corp owner has limited liability protection. There is a legal separation between the owner and the corporation. Any lawsuits, debts, or liabilities of the business stay in the business. An S-corp is a good choice for any company conducting a for-profit business with clients.

Tax Treatment

Although the legal structures are fundamentally different, there are similarities when it comes to reporting income tax and the tax advantage of avoiding corporate taxes.

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 by taxing the owner’s personal income. A sole proprietor includes their business income on their personal income tax return.

An S-corp is an IRS tax designation for a legal business entity such as a limited liability company (LLC) or corporation. S-corps are named after Subchapter S in the Internal Revenue Code. Both structures bypass taxation at the corporate level. Any profits or losses are documented on the owner’s personal tax return and taxed accordingly.

Administration, Ownership, and Credibility

A sole proprietorship is easy to set up and requires little paperwork. To establish a corporation, you must file articles of incorporation with the Secretary of State, create bylaws, and follow up with annual reporting and record-keeping requirements.

A sole proprietorship is owned by one person. A corporation may be owned by many people, which allows for multiple investors and easier transfer of ownership. If an owner of a corporation dies, their stock ownership goes to their beneficiaries but the corporation continues to operate. If an owner of a sole proprietorship dies, the business ceases to exist and all assets or debts of the business go to their estate.

Finally, a corporation gives your business more legitimacy as a business organization. Many customers, vendors, and business partners prefer dealing with a corporation because it is a more formal structure recognized by their state.

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 such as an LLC or corporation.

For your business to become a legal entity, you must file paperwork with your state. 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. You must file the paperwork and pay the state filing fee. 

Once your business is registered as a corporation, you are taxed as a C corporation (C-corp) unless you elect an S-corp status. 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 wanting tax savings will apply for S-corp status, which may have no federal or state taxes on corporate income. 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.

One caveat: 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. For more information about LLCs, read FindLaw’s article about Forming an LLC.

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 or CPA 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