Sole Proprietor, LLC or S-Corporation: Tax Differences & Benefits

Sole Proprietor, LLC or S-Corporation: Tax Differences & Benefits
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If you're an individual who wants to start a small business, you have another important decision to make besides the product or service you'll offer. You'll need to decide which type of legal business structure to use such as a sole proprietorship, limited liability company or S corporation – all of which are available to single-owner businesses. These all differ based on factors such as the complexity of the business formation process, limits to personal liability, tax treatment and the tax filing process. Read on to learn more about these three business entities and how they compare in terms of tax benefits and differences.

Defining a Sole Proprietorship

If you've operated as a single-person business and haven't completed an official business filing process with paperwork, then there's a good chance you're considered a sole proprietorship. This is the easiest business structure to adopt since it's usually automatic with no fees involved to start operating. This type of business usually involves operating under your legal name, though you can file for a fictitious business name through your state if you'd like.

Unlike with an LLC or S corp, operating a sole proprietorship means you face more risk and personal liability for business activities since you and your business are the same entity. So, if you get sued or take out business debts, the courts and creditors can come after you personally. This can mean losing personal assets like your house or bank funds. However, you can take out professional liability insurance as a sole proprietorship to reduce some risk.

When it comes to taxes, the Internal Revenue Service has you list your business income directly on your personal tax return using the Schedule C form. This means you pay self-employment taxes of ​15.3 percent​ (​12.4 percent​ for Social Security and ​2.9 percent​ for Medicare) and your personal income tax rate on business income, and you can take personal tax deductions and credits alongside claiming business expenses. Unlike other business structures like an S corp that can allow you to pay yourself as an employee and distribute the rest of the business income, you don't get this option with a sole proprietorship.

Exploring Limited Liability Companies

Unlike you can with a sole proprietorship, you can form an LLC whether it's just you as part of the company or you have others running the business alongside you. Forming this business entity requires investigating your state's process as it contains many steps and has some fees involved, and states can set their own rules on who can form LLCs. For example, the IRS mentions that your state might not let businesses that operate as insurance providers or banks become LLCs, but a variety of members such as other companies and individuals can be part of your LLC.

As the name implies, this type of business format comes with limited liability to the owners unlike with a sole proprietorship. The LLC itself holds liability for business debts, so you usually don't need to worry about creditors trying to take personal assets, and you usually don't personally get held liable for other LLC owners' liabilities either. However, Nolo warns that you can be personally held liable for bad actions, and some states may allow creditors more flexibility going after you for business debts if you're the sole owner.

When you're a one-person LLC, your tax filing process is just like that of a sole proprietorship in that you file Schedule C and pay personal income taxes and self-employment on business income. Although you have some separation from the business, there's no separate return for the LLC. But you get taxed like a partnership if there are multiple owners and you don't opt for the S corp tax status, and this means filling out Schedule E and paying income taxes on your share of the LLC's profits. Alongside the personal tax return you complete with this information, there's a separate tax return for the LLC itself along with Schedule K-1 forms to owners.

Understanding the S Corp Structure

Used as an alternative to other corporation types that can lead to double taxation, an S corp involves business income passing down to the shareholders (owners) like with an LLC so that you don't need to worry about corporate taxes. This business entity differs from an LLC in that you can make non-dividend distributions after all shareholders get a fair salary. Further, there are more restrictions on shareholders where you can't have ​more than 100​, they must be within the United States and they can't include corporations or partnerships. There's a thorough filing process and certain businesses – such as insurance and banks – don't qualify for this structure.

When you compare an LLC vs S corp in terms of liability protection, you get the same personal asset protection that you won't get with a sole proprietorship. The S corp will be separate from you as a shareholder, and only the S corp itself holds the liability. This type of business entity also survives even if a shareholder passes away or leaves the business, and this separates it from the other two business formats. Ownership can easily transfer to new people.

Handling the taxes for an S corp is more complex than with sole proprietorships and LLCs as there are more calculations and paperwork to handle. Based on the IRS guidelines, the S corp will have salaries distributed to each shareholder who will need to pay self-employment and income taxes on that money on their personal returns, and then the S corp needs a tax return for itself called Form 1120S filed along with several schedules. You also need to check your state laws since Bench warns your location may tax S corps as C corps instead, which would mean losing the benefit of avoiding double taxation.

Sole Proprietorship Tax Advantages and Disadvantages

The biggest advantage of this type of business entity is simplicity when it comes to handling your taxes. You don't have to worry about filing any additional paperwork with the IRS to opt for being taxed as a sole proprietorship like you need to do with an S corp. You don't need to request an employer identification number either as you can just use your Social Security number.

Reporting your business income and business expenses on your individual income tax return is as easy as filling out a Schedule C. You don't have to worry about completing a separate business tax return like you would with multiple-member LLCs as well as S corps and partnerships. As a sole proprietorship, you can benefit from the pass-through deduction that lets you deduct ​as much as 20 percent​ of your business's profits from your federal taxable income. You also have access to all relevant personal credits and deductions.

The main disadvantage of a sole proprietorship is shared with LLCs and S corps in that you'll have to pay self-employment taxes on your income that employees don't. This adds up to an ​extra 7.65 percent​ as you don't have an employer paying their half. You also don't get the potential benefit of an S corp where you could just pay self-employment taxes on a salary you're given and have other money distributed without the extra tax burden.

LLC Tax Benefits and Drawbacks

An advantage of an LLC is that as long as you're a single-member LLC, the tax filing process is like that of a sole proprietorship by default. This means you just need to list your business's earnings and expenses on Schedule C when you do your personal income tax return, and you pay self-employment taxes without needing to file any additional IRS paperwork for the LLC itself. You can also get the 20 percent deduction for pass-through income.

A downside is more tax complexity when you're forming an LLC with multiple members since the IRS treats such an arrangement as a partnership for tax purposes. That means filing a partnership tax return alongside having each owner report their portion of the earnings on their individual tax returns using Schedule E. It also means there's extra work creating a Schedule K-1 form to provide to all owners, and you need to take care to do this.

Both single- and multiple-member LLCs have the benefit of flexibility to complete IRS Form 8832 and become taxed as an S corp. This comes with the benefit of being able to pay yourself a salary and distribute the rest of the funds without self-employment tax, albeit with the extra paperwork required. This can lead to tax savings versus a sole proprietorship. However, the IRS requires that salaries be reasonable for the owner's contribution, so don't expect to take a very small one to avoid taxes.

S Corp Tax Advantages and Disadvantages

In contrast to operating a sole proprietorship or LLC that doesn't expect S corp status, an S corp offers the key tax advantage of allowing some of the profit to be used as self-employment tax-free distributions after all shareholders have been paid reasonable salaries. Since only income tax would apply to this leftover money, it can save you the ​15.3 percent​ you'd pay treating the money as a salary. Individual owners just need to report their salaries on Schedule E when they complete their personal tax returns and take relevant deductions and credits each year.

Another benefit is the lack of double taxation since the corporation itself isn't taxed on earnings at the corporate income tax rate alongside each of the owners paying their personal tax rates. Instead, income passes through so that owners will pay taxes on their shares. The downside is that not every state agrees with this federal classification and may double tax income as if you were a C corp. So, extra research is needed if you want to gain the benefits of forming this type of business entity.

The tax downsides of an S corp come down to more complexity since Form 1120S needs to be filed for the corporation's tax return and Schedule K-1 forms need to be distributed to owners. Corporate Direct also warns that a business's S corp status could be revoked in certain situations, and this comes with penalties like back taxes and a lengthy waiting period to become an S corp again. Tax-free company benefits also aren't available to owners with ​at least two percent​ ownership in the S corp, so this is a limitation to keep in mind.

Deciding for Your Small Business

Now that you understand the tax differences and benefits of these three business entity types, you can decide which best fits your business. When doing so, keep in mind that you can usually easily change your business structure if you're the only owner even if your needs do change. But if you end up with more owners, you'll need to come to an agreement and expect some more legal tasks to do so.

If you're just starting out and want to keep things as simple as possible, you can simply operate as a sole proprietorship without doing anything special or spending money on filing fees. You'll just want to keep in mind the full liability you face with this kind of business entity as it could mean losing your personal property if something financially goes wrong.

If you'd rather lessen the risk and have the ability to add more owners over time, an LLC or S corp can be a good alternative with their liability protection. You just need to be willing to complete the formation processes in your state and with the IRS. Opting for the S corp structure can lead to more complexity but with additional potential tax savings. It can be worth speaking to a tax lawyer to further examine your business startup and discover which of these two options would yield better tax advantages.