Sole Proprietorship vs S-Corporation :: Wamhoff Financial & Accounting


Sole Proprietorship vs S-Corporation

By Jackie Laberer

When starting up a business, there are many factors to consider and what the advantages and disadvantages are when choosing the type of entity to be. A business owner must also consider the costs and tax consequences as well.

Sole Proprietorship

The most common and simplest form of business is the sole proprietorship. This type of business allows the business owner the most freedom.

Advantages:
  1. This is the easiest and least expensive form of ownership to organize. There are minimal legal costs involved to forming a sole proprietorship, and few formal business requirements.
  2. The business owner is in complete control, and within parameters of the law, may make all decisions about the business and run it as (s)he sees fit.
  3. There are no corporate income tax payments that the business has to make.
  4. The business owner receives all income generated by the business to keep or reinvest.
  5. Profits and losses from the business flow through directly to the business owner’s personal tax return.
  6. The business is easy to sell, transfer or dissolve (“close”), if so desired.
Disadvantages:
  1. The business owner can incur unlimited liability and become legally responsible for all debt and liabilities against the business. Personal assets, as well as business assets, are at risk.
  2. The business owner relies totally on his own assets to run the business, and oftentimes, may be at a disadvantage in raising funds, therefore, turning to personal savings, investments and consumer loans.
  3. The business may have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a “piece” of the business.
  4. The business may not totally deduct certain business expenses, such as owner’s medical insurance premiums, which are only partially deductible as an adjustment to income.

S-Corporation

Some business owners choose to become S-Corporations. Why? An S-Corporation is an entity, for federal tax purposes, that is treated as a pass-through entity. It is granted this treatment through an election approved by IRS. The S-Corporation is created through filing an Articles of Incorporation with the Secretary of State’s office. It issues stock to its shareholder(s), and it follows all the rules that governs all corporations.

Advantages:
  1. Protected Assets – An S-Corporation protects the assets of its shareholders by not making their personal assets at risk for the debts and liabilities of the corporation. Creditors cannot pursue the personal assets of the shareholders for the business debts, whereas in a sole proprietorship, they can.
  2. Pass-Through Taxation – An S-Corporation doesn’t pay federal taxes at the corporate level. Most, but not all, states follow the federal rules. Therefore, any business income or loss is “passed through” to the shareholder personally and reported on his/her personal income tax returns. This means that business losses can offset other income on the shareholder’s personal tax returns. This can be extremely helpful, since most new businesses draw losses in their start-up phases/years.
  3. Tax-Favorable Characterization of Income – An S-Corporation’s shareholders can be employees of the corporation and draw salaries as employees. They can also draw dividends and tax-free distributions from the corporation, as long as they have positive retained earnings in the corporation. This is a plus in that it helps to reduce self-employment tax liability that would ordinarily be charged to net profit on a sole proprietorship. In addition, it generates business expenses of salaries and payroll taxes for the corporation.
  4. Straightforward Transfer of Ownership – A transfer done through an S-corporation can be done without triggering adverse tax consequences and can be done without adjustments to property basis, when done in compliance with proper accounting rules.
  5. Heightened Credibility – Operating as an S-Corporation, as opposed to as a sole proprietorship, may help to heighten credibility with potential new customers, vendors, employees, partners, etc. because they see formal commitment to the business by the owners.
Disadvantages:
  1. Formation and On-Going Expenses – Operating an S-Corporation requires ongoing fees and expenses to maintain the business’ corporate status from year to year. From the beginning, the legal fees and state fees for incorporation to the annual costs of filing the annual registration report, franchise tax report and other state-imposed returns can become costly.
  2. Tax Qualification Obligations – Any missed filing requirements with IRS or the state or mistakes regarding various requirements and elections, consents, etc. can cause an S-Corporation to accidentally terminate its own active status, and therefore become quite a hassle and costly to re-instate its corporate charter.
  3. Stock-Ownership Restrictions – An S-Corporation can have only one class of stock (common), is limited to 100 shareholders, and no foreign ownership is allowed.
  4. Closer IRS Scrutiny – Because an S-Corporation can pay its shareholders either salary or dividends, IRS scrutinizes these payments more carefully. Under audit, these payments can be re-characterized however they deem necessary, costing the corporation possible deductions and an increased tax liability.
  5. Less Flexibility in Allocating Income and Loss – Since an S-Corporation is limited to one kind of stock, its shareholders are not allowed to easily allocate the income or losses any way they want. Income and losses must be allocated according to stock ownership in the business.

Therefore, when you want to start your own business and can’t decide what type of business you want to be, please don’t take the advice of a friend, and do what (s)he tells you to do. Instead, consult the advice of your tax professional, who can steer you in the right direction. Then, if becoming an S-Corporation is your choice, seek the help of an experienced legal professional, who can assist you with preparing all of the necessary incorporation documents. In the long run, you’ll be glad you did.