If you own a small company as a single proprietor (or are thinking about beginning one), it may make sense to form a S corporation (S corp).
When opposed to a sole proprietorship, a S corp will help preserve your personal assets and also help you save on self-employment taxes.
In our Sole Proprietorship versus S Corp guide, we will explain the fundamental distinctions between a sole proprietorship and a S corporation, as well as how to make the best decision for your company.
A sole proprietorship is an unincorporated business in which the owner has no legal separation from the company.
An S corp is a limited liability company or corporation that has decided to be taxed as a S corporation.
S Corporation vs. Sole Proprietorship The primary distinction between a sole proprietorship and a S corporation is that S corporations have limited liability protection and tax alternatives, whilst sole proprietorships do not.
A sole proprietorship is an unincorporated business form in which the owner is not legally separated from the company. Sole proprietorships do not provide restricted liability or tax benefits.
Protection from Liability A sort of legal protection that protects a business owner’s personal assets from the company’s losses and obligations.
Sole owners pay income tax and self-employment tax on the net profit of their firm. The money generated by the firm is reported on the owner’s personal tax return.
Taxation through Pass-Through A taxation system in which the earnings or losses of a firm are not taxed at the business level. Instead, they “pass-through” to the owners’ personal tax returns and are taxed at the individual income tax rate of each owner.
When a lone proprietor has a large profit and little costs, paying self-employment tax and income tax might result in a considerable tax burden. An electrician or other skilled crafts expert is an example.
An S corporation (S corp) is a tax status available to incorporated entities such as LLCs and corporations.
In reality, an LLC or company may only choose the S corp tax classification. This implies that any firm that operates as a S corporation, like any other LLC or corporation, has limited liability protection.
Most small companies should obtain liability insurance to safeguard the owner’s personal assets in the case of a company loss.
Subchapter S of the Internal Revenue Code applies to S companies. The IRS sees the firm owner as an employee under the S corp tax election. The business owner does not have to pay self-employment tax on their percentage of the company’s earnings as an owner-employee.
The owner-employee of a S corporation pays FICA and income taxes on their fair remuneration. Only income taxes apply to distributions.
Under the appropriate conditions, this may result in large tax savings. Tax savings must be balanced against increased payroll and accounting taxes.
Sole entrepreneurs must pay self-employment taxes as well as income taxes on their business’s net earnings.
The firm owner pays FICA and income taxes on their “reasonable compensation” in a S corp, but solely income taxes on distributions.
To be taxed as a S corp, a single owner must convert their company form to a corporation or LLC. Because a corporation would seldom profit from adopting S corp tax status, we advocate utilising an LLC as your S corp company structure.
TIP: Unless the firm is already constituted as a corporation, a corporation with S corp status makes no financial sense.
We will assist you in determining whether it is appropriate to:
A company may incorporate an LLC and subsequently elect S corp status. Under the correct conditions, S corporation tax status permits company owners to pay less tax on their revenues.
If the following four conditions are met, you should decide to be taxed as a S corporation:
The IRS has enhanced its scrutiny of LLCs taxed as S corporations. If the owner is not given a fair compensation, the IRS may reject S corp status and levy penalties and back taxes.
You may examine comparable wages on websites like Glassdoor or the US Bureau of Labor Statistics to establish a realistic compensation for your job.
If the LLC does not generate enough profit to support a decent salary and distribution, the S corp tax classification will not make financial sense. Furthermore, if the LLC owner(s) choose to forfeit compensation for whatever reason, they may be vulnerable to IRS penalty.
The expense of sustaining these services should be weighed against the fiscal tax benefits of choosing the S corp classification. In general, a decent salary plus $10,000 in yearly payments is frequently sufficient to make the S corp financially sustainable.
The company’s owners must be US citizens or permanent resident immigrants. Owners must also be private persons rather than corporate, LLC, or trust entities.
Sole proprietorships are ideal for organisations that have the following characteristics:
The main benefit of forming a single proprietorship is its simplicity; beginning a firm couldn’t be simpler or less costly.
There is no personal liability insurance. Personal liability protection is not provided by sole proprietorships. This implies that your personal assets (vehicle, home, bank account) are at danger if your company is sued or defaults on a loan.
There are no tax advantages. Sole entrepreneurs are subject to self-employment taxes as well as income taxes on their net profit. When a firm becomes prosperous, taxing it as an informal corporate structure will be prohibitively costly.
Potential for Growth is Limited. A high tax load plus a lack of liability protection might prevent a firm from succeeding.
Credibility and branding opportunities are diminished. Unless their state enables them to establish and maintain a doing business as (DBA) name, a lone proprietor or partnership must invoice, collect payment, create a bank account, and promote under their surname(s).
Any firm that is both risky and profitable should form an LLC.
How to Form a S Corporation
There are two major methods to form a S corporation:
It is simple to form an LLC and choose S corporation tax status. You may form your own LLC with the S corp status by following our instructions.
Six Basic Steps to Forming an LLC and Choosing S Corp Status:
When you submit your LLC formation forms, you must offer your state with a unique name that is distinct from all other registered names.
Legal paperwork and tax notifications will be accepted on your LLC’s behalf by your registered agent. When you submit your LLC’s Articles of Organization, you will name your registered agent.
The Articles of Organization, also known as a Certificate of Formation or a Certificate of Organization, is the document that will be filed with the state to legally establish an LLC.
An LLC operating agreement is a legal document that defines your LLC’s ownership and member responsibilities.
Our operating agreement generator is a free tool for company owners.
An EIN is a number assigned by the US Internal Revenue Service (IRS) to companies in order to identify and tax them. It is basically a business’s Social Security number.
When you apply directly with the IRS, EINs are free.
Select S Corporation Tax Status
The IRS will give a link to Form 2553, the Election by a Small Business form, during the online EIN application process. This form is used to elect S corporation tax status for your LLC.