When you start a business, choosing a business entity is one of the first decisions you’ll make, and it’s also one of the most important decisions, too. Understanding the benefits and drawbacks of each one is necessary to making an informed decision. While we’ve already discussed the tax benefits and drawbacks of an LLC, our small business accounting firm wanted to provide a comparison of a sole proprietorship vs an S corporation to help you determine which one would have the greater benefit.
Most people start their business as a sole proprietorship simply because there is nothing you need to do to establish this business entity. If you begin running your business and don’t form an LLC or incorporate, you default to a sole proprietor.
A sole proprietorship is a “pass-through” entity meaning your business earnings and losses pass through to your personal tax return. Instead of filing tax returns as a business, you report the revenue and losses on your personal tax returns. Profits are added to your total household income and losses are included in your deduction.
While you do have to pay self-employment taxes, including a 12.4 percent tax for Social Security and a 2.9 percent tax for Medicare, you may be eligible for a 20 percent income tax deduction as a self-employed business owner on your 1040 return.
With a sole proprietorship, there is no liability protection in place for the owner. This means that if you have business debts you can’t pay, you have unlimited liability, meaning your personal assets are subject to legal claims in addition to your business assets.
An S Corporation, or S corp, is a type of corporation that you can form by filing a certificate of formation with the North Carolina Secretary of State (assuming this is where your business is headquartered) along with tax documentation with the IRS. Any shareholders receive income directly via distributions, while the corporation stays as a separate entity from the shareholders. These corporations are strictly regulated and require you to keep corporate bylaws, shareholder meeting records, and more intensive record keeping related to finances and operations.
Like a sole proprietorship, an S corp is a pass-through entity in which your income and losses are reported on your personal return. The main difference is you can save on self-employment taxes. As S corps allow profits to be dispersed through distributions, rather than income, there are no Social Security taxes or Medicare taxes taken out on them.
However, if you are the only shareholder in the business, and you work at your business, you can’t mark all your income as a “distribution.” Legally, you must treat yourself as an employee and pay yourself a reasonable salary, and of that salary, self-employment taxes have to be paid on it.
If your business is an S corp, you have more protections related to liability. If there are business debts, typically, the corporation is liable for them, rather than the owner, meaning your business assets may be at risk, but your personal assets are not. However, if someone is injured due to negligence, you may still be personally liable and if your business is small, you may have to personally guarantee loans and other debts.
There isn’t a blanket correct answer related to choosing between a sole proprietorship vs an S corporation. While there is significantly more paperwork and regulation with an S corporation, you may find the tax benefits and liability protections are beneficial, plus you can raise capital more easily through investors. If you’re unsure, it’s important to speak with an experienced accountant, as well as your attorney, who can discuss your unique needs and help you get set up.
If you’re struggling to choose and set up a business entity and aren’t sure which option is right, or you need assistance in setting up your business entity, we can help. Schedule a consultation today with an experienced small business accountant in Raleigh today by calling (919) 420-0092 or filling out the form below to get started.