Small Business Smarts: What's the Difference Between Sole Proprietorship, LLC and S Corporation?
Part of a series | Small Business Smarts
It's essential for small business owners and solopreneurs to know the key differences in business structures between sole proprietorships, limited liability companies (LLCs), and S corporations (S-corps). The third video in the Small Business Smarts series explains that sole proprietorships are easy to set up but expose personal assets to liability, and that LLCs provide legal protection and allow for a choice of tax treatment. Finally, while S-corps offer tax benefits, they require more regulatory compliance.
"When embarking on a new business venture, choosing the right legal structure is crucial," says Victoria Jordan, founder and executive creative director of Pureworks, LLC. "As someone who established my business as an LLC, I understand the importance of understanding the various business formations available. Each option, sole proprietorship, LLC, and S corporation, has its own legal and tax implications."
Below are summaries of the main differences between these types of business structures.
What are the features of a sole proprietorship?
A sole proprietorship is the simplest form of business structure, involving a single individual who runs the business. The three key elements to understand are the lack of paperwork requirements, how the taxation works and the risk of liability:
- There are no formal documents to file to start a sole proprietorship; you simply begin operating your business.
- All business income and expenses are reported on your personal tax return. As a sole proprietor, you are subject to self-employment taxes (Social Security and Medicare) on the profits.
- There is a risk of liability. The owner and the business are considered a single legal entity. This means that personal assets, such as a home or car, can be at risk if the business faces lawsuits or debt.
What are the main elements of a limited liability company (LLC)?
An LLC offers greater liability protection compared to a sole proprietorship. The three key features are legal status, ownership and tax flexibility:
- An LLC is recognized as a separate legal entity, providing personal asset protection from business debts and lawsuits.
- An LLC can have one or more owners, known as members.
- LLCs can choose to be taxed as a sole proprietorship or elect to be taxed as an S-corp. However, this requires filing paperwork with the state and adhering to periodic filings.
What are the benefits of forming an S corporation or S-corp?
An S-corp is primarily a tax designation rather than a distinct type of business structure. The elements to consider are tax treatment, IRS requirements and complexity:
- In terms of tax treatment, income is received, expenses are paid, and salaries are issued to owners and employees. The remaining profits are distributed among owners based on their ownership percentages and these distributions are not subject to self-employment taxes.
- To qualify as an S-corp, businesses must meet specific IRS criteria, and this structure involves more formalities, such as regular meetings and strict record-keeping.
- While there are tax benefits, managing an S-corp is more complex and has additional regulatory requirements.
Download Plan, Launch, Thrive: The Small Business Owner's Toolkit today.
Summarizing the different business structures
Choosing between a sole proprietorship, LLC, or S-corp depends on various factors such as liability concerns, tax implications, and operational complexity. Each structure has its own advantages and drawbacks, so it's vital to choose one that aligns with your business goals. Regardless of the structure you prefer, managing payroll taxes and compliance can become complex quickly.
Partnering with a reliable service like ADP can help simplify these processes. They offer software and services to automate payroll, handle tax filings, ensure correct employee classification, and provide compliance support tailored to businesses of all sizes.
For more information on solutions for your business, visit ADP.com/RUN.
Video transcript
The speaker is Victoria Jordan, founder and executive creative director of Pureworks, LLC.
My business is an LLC, but honestly, when I first set it up, I wasn't 100% sure why I chose that type of formation. When you're starting your business, it's really important to know what different formations mean legally and for tax purposes. So here are the basic differences between an LLC, a sole proprietorship, and an S-corp. Let's start with the sole proprietorship. Simply put, a sole proprietorship is one person running a business. There's no formal paperwork. You just start doing business. All of your business income and expenses go on your personal tax return, and you pay self-employment taxes, like Social Security and Medicare, on the profits.
This is definitely the easiest setup, but because the owner and the business are legally the same, personal assets, like a house or a car, can be at risk if the business gets sued or goes into debt. This is sometimes why people choose to form a limited liability company.
An LLC is a separate legal entity, so your personal assets are generally protected from business debts and lawsuits. A sole proprietorship is one person. LLCs can have one or more owners called members. LLCs can choose to be taxed like a sole proprietorship, which we just talked about, or like an S-corp. You have to file paperwork with the state that you're forming the business in, and there are periodic filings that you have to keep up with, but it's way less strict than the next category, the S-corp.
An S-corp is not a type of business structure. It allows for a choice of tax treatment that LLCs or corporations can apply for with the IRS. This is the easiest way that I can explain the tax benefits of an S-corp; income comes in, you pay your business expenses, you pay your salary and your employee salaries, and you distribute the rest of it, the profit, amongst the owners according to the percentage of the company that they own. So, if somebody owns 30% of your company, they get 30% of the profits. And then they pay income taxes on their share of the profits. So, unlike the salaries that you paid, these payments aren't subject to self-employment taxes, the Social Security and the Medicare.
Another benefit which is very similar to the LLC, is that the S-corp provides a shield for your personal assets. The drawback is that there are a lot of rules. You have to meet specific IRS requirements, and there are more formalities like regular meetings and recordkeeping.
No matter which structure you choose, managing payroll, taxes and compliance can get complicated quickly, which is why it's great to have a partner like ADP that has software and services to automate payroll, handle tax filings, classify your employees correctly, and get compliance support that fits even the smallest of businesses.
Check out these solutions and more at ADP.com/RUN.
