Understanding that a business structure affects more than just management is an important first step to selecting the right company type. Because a sole proprietorship provides an owner with the ability to operate under his own name, total responsibility remains with him. When it comes to the payment of taxes, knowing how to achieve the benefits of pass-through taxation without having to alter the business structure can be very important. An S corporation and a sole proprietorship both pass tax liability on to the owner or shareholders. However, because the business structures differ greatly, so do the filing processes.
All of the business affairs of a sole proprietorship are tied to the owner, including profits and losses. For tax purposes, the company shares the same name as the owner and files a single return covering all personal and business financial transactions. In contrast, an S corporation is separate and distinct from the owner and must make a Subchapter S election. Because of the differences in form, the Internal Revenue Service will not accept the filing paperwork related to an S Corporation for a company operating as a sole proprietorship, unless and until the owner decides to incorporate.
Sole Proprietorship Taxes
The IRS does not require the owner of a sole proprietorship to file a separate return for the business. Instead, all profits and losses are recorded on the personal tax return of the owner and thus "pass through" the company. Specifically, income and expenses are indicated in Schedule C of the sole proprietor's personal tax return.
Read More: Tax Differences Between an LLC & a Sole Proprietorship
Initial S Corp Filing
While an S corporation can also be viewed as a pass-through entity for tax purposes, the procedure is considerably different from that of a sole proprietorship. First, the organizers must have gone through the corporate formation process, which generally requires the selection of a name and the filing of certain documents with the state Secretary of State's office. Next, the corporation must have elected to not be taxed at the entity level and, instead, pass the liability on to its shareholders to be reported on their personal income tax returns and paid at their individual tax rates. This is accomplished by filing IRS Form 2553, Election by a Small Business Corporation, signed by all shareholders.
S Corp Reporting
Once a company has elected to be treated as an S corporation, the business must file Form 1120S and K-1 to put the IRS on notice and distribute the completed forms to its shareholders to ensure that no errors are made in reporting. The individual shareholders will then report any income and expenses on Schedule E of the 1040 return they will file. This differs significantly from reporting on Schedule C as a sole proprietor.
Wayne Thomas earned his J.D. from Penn State University and has been practicing law since 2008. He has experience writing about environmental topics, music and health, as well as legal issues. Since 2011, Thomas has also served as a contributing editor for the "Vermont Environmental Monitor."