Choosing the right business structure is one of the most important decisions an entrepreneur makes when starting a business. The business structure impacts everything from day-to-day operations, to taxes, to personal liability. When it comes to one-owner businesses, two of the most common structures are sole proprietorships and S corporations. Both have their advantages and disadvantages depending on the business's goals.
A sole proprietorship is the simplest business structure. It is an unincorporated business owned and run by one individual. All that is required to form a sole proprietorship is obtaining the required licenses and permits. The business itself does not exist as a separate legal entity, meaning there is no legal separation between the business and the owner. The owner has complete control of the business, but also faces unlimited personal liability for its debts and obligations.
Sole proprietorships can be a good choice for low-risk businesses, especially when first testing out an idea. But the lack of liability protection puts personal assets at risk.
An S corporation is a legal entity formed by filing articles of incorporation with the state and electing S corporation status with the IRS. It gets legal protections of incorporation while being taxed similarly to a partnership or sole proprietorship. Income and losses pass through to owners’ personal tax returns.
S corporations have up to 100 shareholders. All shareholders must be U.S. citizens or resident aliens, and other corporations or partnerships cannot be shareholders.
S corps allow business owners to shield personal assets from liability while avoiding double taxation. This makes them an appealing choice, especially for higher-risk businesses.
Sole proprietors have unlimited personal liability. This means creditors can seize personal assets to settle business debts. S corporation shareholders have limited liability protection similar to that of C corporations.
Sole proprietors can only raise funds through debt financing, making it more difficult to fund expansion. S corporations can raise capital by issuing stock.
Sole proprietor business income is subject to self-employment tax (15.3%) as well as personal income tax. Only reasonable salaries paid to S corporation shareholder-employees are hit with self-employment tax. The remaining pass-through income is only taxed once (no corporate level taxes).
Sole proprietors only need to file a personal tax return. S corporations must file articles of incorporation, hold director and shareholder meetings, keep corporate minutes, and file corporate returns in addition to owners’ personal tax returns.
Any type of business can be a sole proprietorship. S corporations cannot be used by financial institutions, insurance companies, or large firms. Some states also limit S corporation eligibility.
There is no definitive threshold dictating when a business should switch from a sole proprietorship to and S corporation. Some key triggers include:
If business activities frequently expose your personal assets to liability claims, an S corporation helps shield your personal assets. The protection is especially valuable for higher-risk industries like construction or healthcare.
Sole proprietors can only use debt to fund growth. Equity financing options like selling shares of stock allow S corporations to raise larger amounts of capital.
Weigh the added tax preparation costs and reporting requirements against the potential self-employment tax savings from distributions (rather than salary) to see if an S corporation is worthwhile for your business.
Every business situation is different. Speaking with accounting and legal experts can provide the personalized guidance needed to determine if transitioning to an S corporation makes sense.
Sole proprietorships and S corporations each have advantages and disadvantages for small business owners to consider when structuring their company. Sole proprietorships offer administrative ease, but expose owners’ personal assets to substantial risk. S corporations provide liability insulation and access to equity capital markets, but come with legal formalities and front-end costs. As companies evolve, structural choices should be revisited to ensure business needs are fully addressed in the most beneficial manner possible. With the input of trusted advisors, entrepreneurs can confidently put the right foundational elements in place to set their endeavors up for lasting success.