Choosing the most suitable business structure for your business is one of the most important decisions you’ll make as an entrepreneur. Irrespective of whether you’re starting a large or new small business, the entity type you select should reflect your company’s goals for you to have the best possible benefits and results. Two of the most common business structures are sole proprietorships and corporations. However, each entity type has its own advantages and drawbacks. The following guide will outline the differences and similarities between sole proprietorships and corporations and help you make an informed decision.
What is a sole proprietorship?
Sole proprietorships are unincorporated businesses having only one owner. However, if more than one owner is involved, it is automatically considered a general partnership. A sole proprietorship’s profits or income is taxed as the owner’s personal income.
They are also one of the easiest entity types to set up and maintain, making them one of the most common business structures. However, it’s not considered a separate legal entity by the IRS like other structures such as limited liability companies and corporations.
When starting a sole proprietorship, there are no forms to file or fees to pay. You only need to consider if you’re going to be using your own name as your business name. If not, you’ll need to register a DBA or “doing business as” name per your state laws and regulations.
Sole proprietorship benefits
- Easy formation: One of the most obvious advantages of creating a sole proprietorship is the simple establishment of the entity. Aside from that is also quite inexpensive and less time-consuming than creating a corporation.
- No restrictions on the number of employees: Sole proprietorships don’t limit the number of employees you can have, allowing you to grow and get closer to incorporating your business.
- Business name protection: When running a sole proprietorship, your business’s legal name is, in fact, your name. If you’d like to change this or operate under a different name, you can register a trademark through the USPTO or file a DBA with your state or county clerk’s office.
- Complete control: As a sole proprietor or owner of your business, you have complete control of the day-to-day operations, decision-making process, etc.
Sole proprietorship drawbacks
- Unlimited legal liability: Since there’s no separation between the sole proprietor and the business, the sole proprietor is liable for all debts and obligations, malpractice claims, lawsuits, etc., brought against the business.
- Skills and experience: It can be quite challenging for sole proprietors to manage all aspects of the business alone. A sole proprietor must have the necessary skills and experience to make sound decisions that ultimately cause the business to succeed or fail.
- Backup and succession: If the owner does not want to run the business, it ends. Additionally, since sole proprietorships do not have separate legal identities, the business cannot pass any tangible assets from one owner to another.
- Limited access to credit: Other types of business structures like corporations, limited liability companies, and partnerships have more history and income when applying for credit than sole proprietorships, so it becomes increasingly challenging for sole proprietors to secure financing as they are seen as individuals and not businesses.
Check out our guide to sole proprietorships.
What is a corporation?
Corporations are considered legal entities that are distinct from their owners or shareholders. Therefore, corporations have limited liability protection, so owners’ personal assets are protected if the corporation is sued or has debts and business expenses to be paid.
However, you should be aware that corporations are subject to double taxation, which means that the profits of a corporation are taxed twice, first on the corporate level and then again on the personal tax returns of the owners or shareholders.
Therefore, corporations are subject to corporate and personal income tax on the shareholder’s tax returns.
Additionally, compared to sole proprietorships, corporations have many more corporate formalities involved, such as filing the Articles of Organization or Articles of Incorporation, nominating a registered agent, holding annual shareholder meetings, and keeping all important legal documents in a safe place.
- Personal asset protection: One of the benefits of incorporating your business is enjoying limited liability protection. Limited liability or personal liability means that your personal assets cannot be used to pay off business debts.
- Quicker funds and easy transfer: Corporation ownership can be transferred. Capital can be raised through a stock sale, and banks and financial institutions have faith in lending money to incorporated businesses.
- Tax benefits: Corporations can gain tax benefits by writing off certain expenses, such as savings on self-employment taxes, health insurance premiums, and life insurance.
- Privacy: If you value your privacy and don’t want your involvement with a small business to be public knowledge, then the best way to do this is to incorporate your business.
- Double taxation: The default corporation structure is the C corporation, which is liable for double taxation. Double taxation means the corporation is taxed at the corporate level, while individuals or shareholders are again taxed on their share of the dividends.
- Stringent formation and compliance requirements: The formation of corporations includes initial and annual record-keeping requirements compared to other types of entities like partnerships and sole proprietorships.
- Initial and ongoing fees: Incorporating a business is not a cheap affair. This is because you need to pay fees when forming and operating the business to keep it in good standing.
At a glance: How is a sole proprietorship different from a corporation?
- Corporations are considered legal entities that are distinct from their owners or shareholders. Therefore, corporations have personal liability protection, so owners’ personal assets are protected if the corporation is sued or has debts and business expenses to be paid.
- However, you should be aware that corporations are subject to double taxation, which means that the profits of a corporation are taxed twice, which is first on the corporate level and then again on the individual tax returns of the owners or shareholders.
- Additionally, compared to sole proprietorships, corporations have many more corporate formalities involved, such as filing the Articles of Organization or Articles of Incorporation, nominating a registered agent, holding annual shareholder meetings, and keeping all important legal documents in a safe place.
Should I start a sole proprietorship or corporation?
Deciding whether to form a sole proprietorship or corporation involves careful consideration. If you are trying out a new business idea and you’re not entirely sure if you will continue with it in the long run, a sole proprietorship could be a better option.
This is because you can run your business under a different name or DBA and enjoy a favorable tax advantage without investing too much money in forming the business.
However, if you plan on having more than one owner involved in your business, you anticipate that the business will grow at a speedy rate and will be in it over the long run. Therefore, you might find it beneficial to incorporate it.
Ultimately, there are several factors to consider when deciding whether to choose a sole proprietorship vs. a corporation.
Find more information on how to start a corporation.
Sole proprietorship vs. corporation taxes
There are quite a few differences between the sole proprietorship business entity type and the corporate structure. One of those differences involves how each of these structures pays taxes.
Sole proprietorship taxes
- Sole proprietors are responsible for reporting their business income and expenses on their personal income tax returns using the Schedule C Form.
- Therefore, your business income is liable for federal and state income and self-employment taxes. When you’re an employee, your Social Security and Medicare taxes are subsidized partly by your employer, who also withholds the other half of your pay.
- However, when you’re a sole proprietor, the full amount of Medicare and Social Security taxes fall on you solely.
- Social Security and Medicare taxes are also known as self-employment taxes.
- Additionally, estimated taxes on self-employment income must be paid by sole proprietors quarterly to avoid penalties, fees, and a huge tax bill in April of the following year.
- You can decrease taxable income by ordinary business expenses when forming a corporation. All expenses needed for the competent and effective operation and running of the business are fully tax-deductible.
- Any real estate or investments bought intending to bring in money for the company are also tax-deductible.
- Corporations are also allowed to deduct employee salaries, bonuses, health benefits, and tuition reimbursement. Furthermore, they can choose taxable income by deducting travel expenses, interest payments, insurance premiums, bad debts, excise taxes, sales taxes, and fuel taxes.
- The default corporation structure is liable for double taxation. This means that the company’s business income or business profits are taxed at the corporate level, and the shareholders are still taxed on the individual level on their portion of the dividends.
- Corporations may elect the S corporation or S corp status, allowing business profits to pass through to the company owners.
- The corporation will no longer be liable for corporate tax; however, each member or shareholder of the corporation will be liable for individual tax on their share of the profits.
Sole proprietorship vs. corporation: Formal requirements
The process of forming a corporation significantly differs from the process of forming a sole proprietorship. Let’s take a look at the key differences when it comes to formal requirements:
Formal requirements for sole proprietorships
- When it comes to starting a sole proprietorship, there are no official forms or documents for that matter to submit or file with the state.
- All you need to do is decide on a name for your sole proprietorship, and you can give your business another name aside from your own. However, you must register it with the appropriate authorities where you plan on conducting business.
Formal requirements for corporations
- Starting a corporation requires you to fulfill certain legal obligations and requirements to maintain ongoing compliance.
- Corporations must follow a few additional steps compared to forming a sole proprietorship.
- Corporations must file the Articles of Organization or Incorporation with the secretary of state and create bylaws similar to an operating agreement when forming an LLC.
- After that, a corporation is liable for filing annual reports, holding the annual shareholders meeting, and remaining in good standing by ensuring that business taxes, necessary filing fees, and so on are complied with.
Corporations have more complex compliance requirements such as submitting annual reports, paying annual fees, renewing licenses and permits, holding annual shareholders’ meetings, keeping records of those meetings, etc. On the other hand, a sole proprietorship will simply need to renew its licenses and permits and pay its taxes.
Sole proprietorship vs. corporation: Management structure
Sole proprietorships and corporations are managed differently. Let’s take a look at the key differences:
Sole proprietorship management
- The sole proprietor is the owner and the manager of his or her company.
- He or she is responsible for making all management decisions affecting the business.
- Starting when the business opens, the management duties involve setting the hours of operation and deciding the prices at which goods and services will be sold.
- If you need to hire extra help, you’ll need to hold the interviews, hire the right candidates, and provide training and ongoing management for your employees.
- Additionally, you will be solely responsible for this function as a sole proprietor when it comes to marketing or attracting additional business.
- A C corporation or C corp is a type of business managed by a Board of Directors, officers, and shareholders.
- These parties are responsible for the corporate governance and overall management of the corporation.
- The board appoints the officers who are ultimately responsible for the day-to-day management and operations of the company.
Sole proprietorship vs. corporation: Ownership structure
One of the most striking differences between sole proprietorships and corporations is the ownership structure. So let’s take a look at the key differences:
Sole proprietorship ownership
- Sole proprietorships are owned and operated by an individual who is also the business owner.
- It’s one of the simplest business entities to form due to the flexibility of ownership and management.
- Since the sole proprietor is also the manager of the business, there’s complete freedom in how the business is owned, operated, and managed daily.
- A single individual or a married couple may own sole proprietorships.
- Regarding corporations, ownership of the business is decided by who owns the shares.
- Therefore, all the shareholders in a corporation are the actual owners, while the Board of Directors is responsible for the corporation’s management.
A sole proprietorship is the ideal business structure if you own and manage the business yourself. It’s also a good choice if you’re unsure whether you will be in that specific industry or business type over the long term. However, a corporation may be the better choice if you plan on growing your business and running it over the long run. Whether you start a sole proprietorship or corporation, consider all the factors, including the advantages and disadvantages, before making your final decision.
When deciding to incorporate or form a sole proprietorship, you’ll need to determine which structure offers the most benefits. For example, incorporation provides greater liability protection than sole proprietorships or general partnerships.
One of the advantages that a sole proprietorship has over a corporation is the low start-up costs as well as maximum privacy. Additionally, the forming and running of your business is much simpler as you’re the only person involved in the decision-making process.
The disadvantages of a sole proprietorship include unlimited liability for the company’s obligations and debts, as there’s no legal distinction between the sole proprietor and the business. Additionally, keeping on high-caliber employees can tend to be a challenge.
Some of the disadvantages of incorporation include double taxation, the tedious and time-consuming formation process, and the rigid protocols and formalities that corporations need to follow.
A sole proprietorship is owned by one individual that is 100% liable for the company’s debts and obligations. A partnership is formed by a minimum of two people combining their resources and sharing losses and profits. On the other hand, a corporation is a separate legal entity with shareholders, and they enjoy more liability protection than the first two business structures.