Watching what was once an idea blossom into a tangible business is an exciting moment in a founder’s life. But to get that idea off the ground, you must establish a proper business structure.
There are four basic business structures in the U.S. — sole proprietorship, partnership, corporation, and S corporation. Each structure has its own tax and income rules along with varying degrees of liability.
These variances directly affect the operational and financial aspects of a business. Doing your research before diving straight into the launching phase is wise.
In this article, we’ll discuss the essential differences between two of these business structures — an S corp and sole proprietorship. We’ll look at how each entity operates and how its financial framework affects aspects of your business.
Sole Proprietorship vs S Corp
Navigating the business world with zero experience is, at times, overwhelming. Founders have many choices when submitting legal documents to become a business. This can lead to difficulty deciphering all the different options and leave you with more questions than you had initially, such as:
- Is a sole proprietorship the same as an S corp?
- Is an LLC the same as an S corp?
- Does your business and tax structure really matter?
Short answer? Yes, your legal business structure makes a huge difference.
Each business layout has specific requirements for tax filing, income, and operational structure. These essential pillars affect the way your business runs, how it can expand, and if you’re able to get funding.
So, let’s take a closer look at each of these set-ups.
What Is An S Corporation?
An S corporation, or S subchapter, is not a business model; it is a tax classification given to LLCs (limited liability companies). Small businesses and startups that file as an S corp are granted the same benefits as a corporation, like personal liability protection.
S corps with under 100 shareholders are taxed as a partnership rather than a C corporation. S corps under 100 shareholders are taxed as partnerships at 24%; full S corps have a tax rate of nearly 27%.
S Corporation Benefits And Limitations
To operate as an S corp, a company must first form an LLC by applying with the state where they would like to conduct business.
According to the IRS, to qualify for S corp status, your company must have the following:
- Under 100 shareholders
- No more than one stock option
- Be a domestic company
1. Pass through taxes: As we said above, an S corp is a tax status, not a legal entity. All income passed to owners and investors generated by an S corp legally qualifies as the owners’ income, not company income. Therefore, income and corporate taxes do not have to be paid on that money.
2. Liability: S corps have limited liability protection that shields owners’ personal assets from being used in claims from litigation or contracts.
3. Credibility: Providing a formal stable environment with traditional financing, bookkeeping, and liability shows dedication to prospective investors, employees, and vendors.
1. Restrictive stock options: Stocks must be issued to employees at the price investors paid, limiting the type of stock to one. In comparison, C corps can have multiple stock options.
2. Shareholder limitations: S corps cannot exceed 100 shareholders, severely limiting a company’s potential growth.
3. IRS Scrutiny: Payments considered pass-through taxes are categorized as salaries and dividends. If the IRS sees an uneven distribution, such as high dividends and low wages, they can legally make changes to increase the salary amount leading to an unexpected tax hike.
What Is A Sole Proprietorship?
A sole proprietor owns their company individually and pays personal income taxes from their business. No separate entity is necessary. Debts and profits belong to the owner. No state registration is needed, but a license might be required. Small business owners likely fall into this category rather than startups.
Perceived Pros And Cons Of Sole Proprietorship
Sole proprietorship, like the S corp, has benefits and limitations. Think specifically about your company's cost savings, expansion, and liability needs. Not all startups need to operate as an LLC or S corp to be successful.
1. Single entity: Sole proprietors can use their SSN as a replacement for an EIN, which the IRS does not require. There is no need to deal with fees and licensing associated with opening a separate entity.
2. Flexible structure: Unlike formal corporations, sole proprietorships don’t need traditional business structures to operate legally. There is no need for a bookkeeper, separate business bank accounts, employees, or upper management. Although, many business owners choose to bring on staff or keep finances separate from personal spending and expenses
3. Direct income: all company income goes directly to the owner aside from tax deductions.
1. Tax responsibility: Local, state, social security, and medicare tax are typically taken out by employers per paycheck. These would fall on the owner’s shoulders. Speaking with a tax advisor to calculate how much money to set aside for outlier taxes is a must.
2. Liability: Owners are 100% personally liable for their business. Individual assets and finances are not protected.
3. Expenses and debts: All expenses are paid out of the owner’s pocket, and any debts the company has are considered the owner’s debts.
Corporation Vs Sole Proprietorship Examples
Different businesses have different needs. Look at the examples below to help you gauge what type of business identity and tax structure might fit best with your situation.
Let’s say company X is launching a new online conference software for mid-sized businesses. Company X needs developers and a sales team to produce and sell its product.
In this situation, choosing to be an S corp is the best option. A startup with these goals and production requirements needs payroll, operational expenses, and product development funding. S corps have the structure to show profitability to prospective investors by documenting sales, operating income, and revenue with traditional bookkeeping.
Multiple levels of management allow founders to pass over responsibility to experienced leaders in their field. Production and sales can grow without needing to be handled by a busy founder already wearing many hats.
In another scenario, say you want to start a tutoring business as a side job. You work from home and use a personal computer. Eventually, you purchase an upgraded webcam for virtual sessions.
In this situation, funding and management outside the owner aren’t necessary. Finances are simple and low-maintenance. Any cost associated with the business becomes a tax write-off. If you want to expand your business, you can transfer to an LLC. Otherwise, a sole proprietorship is the best.
Managing Finances As A Startup
Sole proprietorships and LLCs can transfer over to an S corp; however, consider the company’s finances first. Expansion is costly and can quickly be the canon that sinks the ship.
Expanding S corps will deal with larger business accounts, higher or more vendor payments, business loans, and payroll changes. Sole proprietors transferring to an S corp will have a whole new world in terms of finances. This change can be hard to juggle even with the most organized founder running the show.
Our Zeni dashboard breaks down your finances into easy-to-read sections like cash balance and card balance. As your company expands, you can monitor net income by month, quarter, or year. LLCs who qualify for S corp status will access consistent net income reports. You can calculate the burn rate through our net income widget too.