S-Corp vs. Sole Proprietorship: Key Differences

Choosing a business structure influences everything from day-to-day operations to tax obligations and personal liability. For many new business owners, the choice often comes down to a sole proprietorship or an S corporation. A sole proprietorship is an unincorporated business owned by one person, where the business is not legally separate from its owner. An S corporation is a formal legal entity that has elected a special tax status with the IRS, which allows the business’s profits and losses to be passed directly to the owners’ personal income without being taxed at the corporate level.

Formation and Ownership Structure

Establishing a sole proprietorship is simple, as it is the default classification for any individual who conducts business without forming a separate legal entity. It comes into existence automatically once business activities begin, and the owner and the business are considered the same in the eyes of the law. The single owner has complete control over the business.

Creating an S corporation is a two-step process. First, the business must be organized as a corporation or a Limited Liability Company (LLC) under state law by filing articles of incorporation or organization and paying any associated fees. This act establishes the business as a separate legal entity.

Second, the business must elect S corporation status for federal tax purposes by filing Form 2553, Election by a Small Business Corporation, with the IRS. This election must be timely and signed by all shareholders. The IRS imposes strict eligibility requirements for S corporation status. Ownership is limited to 100 shareholders, who must be individuals, certain trusts, or estates, and they are required to be U.S. citizens or residents.

Taxation and Owner Compensation

For a sole proprietor, the business is not taxed separately. All net income or loss is reported on the owner’s personal tax return using Schedule C (Form 1040). This entire net profit is subject to two forms of tax. It is added to the owner’s other income and taxed at their ordinary individual income tax rates, and the full amount is also subject to self-employment taxes for Social Security and Medicare, calculated on Schedule SE.

An S corporation also features pass-through taxation, so the entity itself does not pay federal income tax. The corporation files an informational tax return, Form 1120-S, and the profits, losses, deductions, and credits are passed through to the shareholders on a Schedule K-1 to report on their personal Form 1040.

The main tax difference is how owner compensation is structured. An owner who works for the S corporation is an employee and must be paid a “reasonable salary,” which is reported on a Form W-2 and is subject to FICA taxes paid by both the employee and the employer. The determination of a reasonable salary is based on factors like the owner’s duties and what similar businesses would pay for comparable services.

Any remaining profits of the S corporation can then be paid to the owner-shareholder as distributions. These distributions are reported on Schedule K-1 and are not subject to FICA or self-employment taxes. This potential for tax savings on distributions is a significant reason business owners consider the S corporation structure.

Liability and Legal Separation

In a sole proprietorship, no legal separation exists between the business and its owner. This means the owner has unlimited personal liability for all business debts and lawsuits. This direct exposure puts the owner’s personal assets at risk, as creditors can pursue their home, vehicles, and bank accounts to satisfy business liabilities.

An S corporation, as a formally created legal entity, provides a “corporate veil” that separates the business from its owners. This establishes the corporation as a distinct legal person responsible for its own debts and liabilities. As a result, the shareholders’ personal assets are generally protected from claims against the business, and recovery is limited to the assets owned by the business itself.

This liability protection is not absolute. If an owner personally guarantees a business loan, their personal assets can be seized if the corporation defaults. The corporate veil can also be “pierced” by a court if owners fail to maintain legal separation, for example, by commingling business and personal funds or engaging in fraud.

Administrative and Operational Requirements

The administrative requirements of a sole proprietorship are minimal. The primary compliance task is maintaining adequate records to accurately calculate business income and expenses for tax purposes. It is also a sound practice to maintain a separate bank account for the business to avoid commingling funds.

Operating an S corporation involves a higher level of administrative formality to maintain its legal and tax status. The corporation must strictly separate its finances from its owners by maintaining dedicated business bank accounts, and all transactions between the owner and the business must be properly documented.

A significant operational requirement for an S corporation is managing payroll for the owner-employee’s reasonable salary. This involves calculating and withholding income and FICA taxes, making regular payroll tax deposits, and filing quarterly and annual payroll tax returns, such as Form 941. This process adds a layer of complexity and cost not present in a sole proprietorship.

S corporations must also adhere to corporate governance formalities. This includes adopting corporate bylaws, holding and documenting annual meetings of shareholders and directors, and keeping formal records of major business decisions as corporate minutes. These steps are necessary to preserve the liability protection of the corporate veil.