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As a result of these tumultuous times, many people who have spent their entire careers working for others have – either through choice or necessity – become freelancers. And whether these small businesses were started to follow a passion or to simply make ends meet, most were begun as sole proprietorships by default. In fact, according to the Small Business Administration, over 86% of non-employer establishments are sole proprietorships. In many cases, this may be the right move. For others, however, incorporating as a small business may offer significant benefits.
The Differences between a Sole Proprietorship and a Corporation
The IRS defines a sole proprietor as someone who owns an unincorporated business by himself or herself. You are automatically considered to be a sole proprietorship if you conduct business activities but don't formally register as any other kind of business. This is the simplest type of business to operate because there are no legal forms to file. It also means there is no legal distinction between the owner and the business itself.
A corporation, on the other hand, is a business entity that has a separate legal identity from the business owner. Different types of corporate entities for small businesses include the C Corporation (or C-Corp), S Corporation (or S-Corp), and Limited Liability Company (or LLC).
A C-Corp is a separate taxpaying entity that conducts business, realizes net income or loss, pays taxes, and distributes profits to shareholders. That means corporate profits may be taxed twice – first when the company makes a profit and then again on the shareholders’ personal tax returns. This structure offers the strongest protection to its owners from personal liability but also requires extensive record-keeping, reporting, and filing.
An S-Corp, on the other hand, passes profits and losses directly through to shareholders. Shareholders then report these amounts on their personal tax returns, avoiding the double-taxation effect of C-Corps. Each owner pays taxes on their company’s earnings without paying separate business taxes on the entity’s net income, alleviating the steep income and self-employment taxes that sole proprietors pay.
An LLC is the simplest corporate structure for small businesses since it has fewer legal requirements but offers many of the same benefits as an S-Corp or C-Corp. Profits and losses are passed through to the business owner without facing separate corporate taxes, and there is no need to file a separate tax form for the company. You should also be aware that an LLC is a business structure allowed by state statute and each state may use different regulations.
Advantages and Disadvantages of Sole Proprietorships
There are a number of advantages to being a sole proprietor. There is typically less paperwork since you don’t have to create and maintain a separate entity and file separate financial statements. Business income or losses can be filed as part of your personal tax return. And you can also deduct qualified business expenses on a 1040 Schedule C.
On the downside, unless you maintain separate financial accounts, you may miss out on business-related deductions and spend too much time juggling business and personal paperwork at tax time. And the lack of a formal business structure may mean you are not taken seriously by customers or by bankers when seeking a loan. But perhaps the biggest disadvantage to a sole proprietorship is the lack of separation between personal and business assets. You will be held personally liable for the business’s debts and obligations. If your business gets successfully sued, you could lose your personal assets – such as your home, vehicles, and savings – as well as your business assets.
Advantages and Disadvantages of Corporations
A separate corporate entity lends credibility and legitimacy to a small business. This can help you land bigger clients and allow you to more easily secure financing from banks. Forming a corporation also gives you the legal ability to expand your business by bringing on investors or a business partner who can offer help in exchange for a share of your business profits. Next, since a corporation is a separate and distinct entity from an individual, it can operate in your absence or be passed on to a partner or heirs. Corporations can also significantly reduce the amount of self-employment and payroll tax you pay to the government. But perhaps the biggest advantage of forming a corporation is the protection of your personal assets. With a corporation, personal assets are shielded from lawsuits and bankruptcies.
Running a corporation, of course, is not without its negative side. Formal paperwork must be filed to establish the corporation, requiring the service (and expense) of professionals before any profit is earned. There is also increased overhead in maintaining records and filing tax returns.
Consult with a Professional
This was just a quick overview and is not meant to provide tax, legal, or accounting advice. The best structure for your company is a difficult decision. You need to consider the type of business you have, the size of your income and profits, any assets you want to protect, and your plans for the future of your enterprise. This is where the services of a pro can help. A lawyer or tax professional can examine your unique business needs and help you reach a decision that will help you protect your assets, minimize taxes, and give you peace of mind.
Published on May 13, 2021
<p>This article explains the differences between a Sole Proprietorship and a Corporation and the advantages and disadvantages of each.</p>