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.
What Is the Difference Between a Sole Proprietorship and a S Corporation?
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.
What exactly is a sole proprietorship?
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.
Taxes on a Sole Proprietorship
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.
What exactly is a S Corporation?
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.
Taxes on S Corporations
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.
The Tax Difference Between a Sole Proprietorship and a S Corporation
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.
Selecting a Business Structure: Sole Proprietorship vs. S Corporation
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:
Use an LLC that is taxed as a S corp.
Run your business as a single proprietorship.
Use an LLC that is taxed in the default manner.
When Should You Form an LLC Taxed as a S Corp?
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:
You know you’ll want to take a significant amount of money out of your firm rather than reinvest profits to develop it year after year.
You are certain that your company will create enough profit to provide the owner(s) a respectable salary as well as at least $10,000 in yearly dividends.
Your company is an LLC or a corporation.
The company satisfies the S corp standards.
S Corporation Requirements, Benefits, and Drawbacks
Salary that is Reasonable
LLC owners become workers under a S corp election. The IRS requires owner-employees to be paid a fair wage. A fair salary is any wage that would be paid to someone to accomplish the same work.
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.
Profitability and Distribution
The S corp election permits a company owner to distribute the profits of an LLC to owner-employees as pay and distributions. Only the salary is then subject to FICA and income taxes by the IRS. Only income tax is levied on distributions.
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.
Return on Investment that is positive
It takes money to form and manage a S corporation. The IRS filing expenses are small, but the added accounting and payroll expenditures are not. This element will be less important for LLCs that already have workers and payroll expenditures.
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.
IRS S Corporation Requirements
Businesses that choose S corp status must have 100 shareholders or fewer and may only issue one class of stock, according to the IRS.
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.
When to Use a Sole Proprietorship
Sole proprietorships are ideal for organisations that have the following characteristics:
They HAVE TO BE SAFE (low chance of liability or financial loss)
They serve a limited number of customers, who are often friends, family, and neighbours.
Photography, blogging, or video streaming are examples of hobbies.
Advantages of a Sole Proprietorship
The main benefit of forming a single proprietorship is its simplicity; beginning a firm couldn’t be simpler or less costly.
Disadvantages of a Sole Proprietorship
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).
When Should You Form a Standard LLC?
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:
When requesting your employee identification number, organise an LLC and obtain S corp tax status from the IRS (EIN)
By creating a company and applying to the IRS for S corp status
Forming an LLC and Choosing S Corp Status
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:
Step 1: Choose a State
Step 2: Give Your LLC a Name
Step 3: Select a Registered Agent; Step 4: File the Articles of Organization; and Step 5: Draft an Operating Agreement.
Step 6: Obtain an EIN and complete Form 2553 to elect S Corporation Tax Status.
Step 1: Choose Your State
Step 2: Give Your LLC a Name
When you submit your LLC formation forms, you must offer your state with a unique name that is distinct from all other registered names.
Step 3: Select a Registered Agent for your LLC.
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.
Step 4: File the Articles of Organization for your LLC.
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.
Step 5: Draft an Operating Agreement for your 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.
Step 6: Apply for an EIN and fill out Form 2553 on the IRS website.
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.