If you’re starting your own one-owner business, which is better: Operating as a sole proprietor or forming an S corporation? It depends.
The majority of people in business by themselves are sole proprietors. Many have attained this legal status without even realizing it. Quite simply, if you start running a business by yourself and do not incorporate or form an limited liability company, you are automatically a sole proprietor.
Unlike a corporation, LLC, general partnership, or LLP, a sole proprietoship is not a separate legal entity. The business owner (proprietor) personally owns all the assets of the business and is in sole charge of its operation.
One big reason sole proprietorships are so popular is that they are by far the simplest and cheapest way to organize a one-owner business. You don’t have to do anything special or file any papers to set up a sole proprietorship, other than the usual license, permit, and other regulatory requirements your state and locality imposes on any business.
Sole proprietorships do have one big drawback: They offer no limited liability protection. Corporations, LLCs, and LLPs provide limited liability, which is the main reason why many business owners use them. However, when you run a one-person business, the limited liability you’ll obtain by forming a corporation or limited liability company is not by any means all encompassing. For example, you’ll still be liable for any damages caused by your personal negligence. For this reason, it ‘s a good idea to have liability insurance.
When you’re a sole proprietor, you and your business are one and the same for tax purposes. Sole proprietorships don’t pay taxes or file tax returns. Instead, you must report the income you earn or the losses you incur on your own personal tax return (IRS Form 1040). If you earn a profit, the money is added to any other income you have—for example, interest income or your spouse’s income if you’re married and file a joint tax return—and that total is taxed.
When you’re a sole proprietor you are not an employee of your business entity. Instead, you are a business owner—also called self-employed. Your business doesn’t have to pay payroll taxes on your income or withhold income tax from your pay. It need not file employment tax returns or pay state or federal unemployment taxes. You need not be covered by workers’ compensation insurance. All this can save hundreds of dollars per year.
However, you do have to pay self-employment taxes—that is Social Security and Medicare taxes—on your business income, called self-employment income by the IRS. Self-employment taxes consist of a 12.4% Social Security tax on income up to an annual income ceiling, and a 2.9% Medicare tax not subject to any ceiling. Self-employment taxes are equivalent to the total Social Security and Medicare tax paid for an employee.
Even if your business has only one owner—you—it can still be legally organized as a corporation, with you as the sole shareholder as well as the president and director. One-owner corporations are common. After you form your corporation in whatever state you choose, you can choose to have it taxed as an S corporation by filing an election with the IRS. This simply involves filing IRS Form 2253 with the IRS.
Since an S corporation is a corporation, it provides its owners—the shareholders—with limited liability. In theory, the shareholders are not personally liable for any of the corporation’s debts. In practice however, such limited liability often has holes in it, particularly where the corporation is small. You’ll often be required to personally guarantee corporate debts. And you’ll still be personally labile for your own negligence or other wrongdoing.
The main reason business owners form S corporations is because of the tax benefits. First, an S corporation is a pass-through entity—income and losses pass through the corporation to the owner’s personal tax return. The income taxes you’ll pay on your business income, and the business deductions you’ll be allowed to take, differ little from being a sole proprietor.
Where S corporations shine is in the realm of Social Security and Medicare taxes. When you’re a sole proprietor, all the profit you earn from your business is subject to these taxes. However, this is not necessarily the case if your business is organized as an S corporation.
S corporation tax treatment can provide a way to take some money out of your corporation without paying Social Security and Medicare taxes. This is because you do not have to pay this tax on distributions (dividends) from your S corporation—that is, on earnings and profits that pass through the corporation to you as a shareholder. The larger your distribution, the less Social Security and Medicare tax you’ll pay. The S corporation is the only business form that makes it possible for its owners to save on Social Security and Medicare taxes. This is the main reason S corporations have been, and remain, popular with small business owners.
However, not all the money you get from your S corporation can be in the form of a corporate distribution. An S corporation shareholder who performs more than minor services for the corporation will be its employee for tax purposes, as well as a shareholder. A shareholder-employee must be compensated for his or her services with a reasonable salary and any other employee compensation the corporation wants to provide. This salary will be subject to the same amount of Social Security and Medicare tax as the profit earned by a sole proprietor from his or her business.
Example: Mel, a consultant, forms an S corporation in which he is the sole shareholder and employee. In one year the corporations has profits of $70,000. It pays Mel $35,000 as employee salary and $35,000 as a corporate distribution. The salary is subject to Social Security and Medicare taxes, but the distribution is not. As a result, he pays $5,355 less than he would have had Mel been a sole proprietor and the entire $70,000 subject to these taxes.
However, when you form an S corporation you will have some additional expenses that will eat into your tax savings. For example, most states require that each employee be provided with workers’ compensation and unemployment insurance coverage, which costs at least several hundred dollars per employee. Some states also require all corporations, including S corporations, to pay minimum annual state taxes, no matter how much money they earn. In California, for example, there is an $800 minimum annual tax. You will also have a more complex tax return to file.