S Corp vs. Sole Proprietorship: Taxes, Liability & Perks

Selecting the optimal legal and tax structure for your new business is one of the most consequential decisions you'll make. While there are several options available, including forming as an LLC or partnership, for many solo founders and small business owners, the choice often comes down to operating as a sole proprietorship or an S corporation. Each business entity offers a blend of simplicity, protection, and potential tax savings, but the right fit depends on your:

• Goals

• Profits

• Tolerance for administrative work

In this article, we’ll explore how each entity works, the tax and liability differences between the two, costs, and when switching from a sole proprietorship to an S corp can make the most financial sense. For business owners and entrepreneurs who have already made their selection, we’ll also walk you through the S corp election process and establish expectations for what comes next.

Key Highlights

• A sole proprietorship is the simplest way to operate a business, but it offers no legal separation between you and your company.

• An S corporation is a tax status that can apply to a corporation or eligible LLC, providing liability protection and potential self-employment tax savings.

• Sole proprietors report business income on Schedule C (Form 1040), Profit or Loss from Business (Sole Proprietorship), and pay self-employment tax on all profits.

• S corps must pay the owner a reasonable salary subject to payroll taxes, with remaining profits distributed free of self-employment tax.

• Liability protection is a significant advantage of the S corp structure over sole proprietorships, but it comes with added paperwork, payroll, and compliance costs.

• The S corp structure often starts to “pencil out” when profits can support a market-rate salary plus administrative expenses.

What Is a Sole Proprietorship?

How It’s Formed and Operated

A sole proprietorship is the default business structure that you'll operate as when you start selling goods or providing services without forming a separate legal entity. There’s no formal registration required at the federal level, though you may need the following depending on your location:

• A “doing business as” (DBA) name

• Local licenses

• Permits 

Since there’s no distinction between you and the business, you control all decisions—and you’re personally responsible for all debts and liabilities. This lack of personal liability protection is one factor compelling some owners and entrepreneurs to evaluate other business entities. 

Taxes & Filings

Sole proprietors report income and expenses on Schedule C of their personal income tax returns (IRS Form 1040, U.S. Individual Income Tax Return). Net earnings are subject to self-employment tax, currently 15.3% (12.4% for Social Security up to $176,100 in 2025, plus 2.9% for Medicare).

Because there’s no employer withholding, you’ll generally need to make quarterly estimated tax payments. Calculate and submit quarterly estimated tax payments on IRS Form 1040-ES, Estimated Tax for Individuals, by each deadline: 

• April 15

• June 15

• September 15

• January 15

Liability Exposure

The biggest drawback of operating as a sole proprietorship is the unlimited personal liability you're exposed to. If your business is sued or can’t pay its debts, your personal assets—like your home or savings—are at risk. This is the opposite of LLCs and S corps, which offer personal liability protection.

While business insurance and good bookkeeping practices can reduce exposure, they don’t change the fact that the business and owner are legally the same.

What Is an S Corporation?

An S corporation isn’t a separate type of business entity—it’s a tax status you can elect for a corporation or an eligible LLC.

Formation & Election

Unlike sole proprietorships, which are relatively easy to form, there are a couple of steps you must take to elect S corporation status. 

To become an S corp, you must:

1. Form a corporation or LLC under state law. 1-800Accountant's formation service simplifies this step. 

2. Meet IRS eligibility rules (e.g., no more than 100 shareholders, only one class of stock).

3. File IRS Form 2553, Election by a Small Business Corporation, by the deadline—generally within 2 months and 15 days after the start of the tax year. Late-election relief may be available, but submitting by the deadline is best. 

Taxes & Filings

Like LLCs, S corps are pass-through entities. The business files IRS Form 1120-S, U.S. Income Tax Return for an S Corporation, and issues each shareholder a Schedule K-1, showing their share of the company’s income or losses. That amount is then reported on the shareholder’s personal income tax return. 

In most cases, there’s no corporate-level income tax, which helps S corps avoid the double taxation that C corporations are subject to. 

Owner Pay: Salary + Distributions

The IRS requires S corp owners who work in the business to pay themselves a reasonable salary before taking additional profits as distributions. While there's no specific formula to determine a reasonable salary, it should be in line with wages in your industry and state for similar work. 

• Salary is subject to payroll taxes that fund Social Security and Medicare.

• Distributions are generally not subject to self-employment tax, which is the source of tax savings for S corp ownership in this scenario. 

Liability Protection

Because an S corp is a separate legal entity, owners typically have limited liability protection from business debts and claims. That protection can be lost if you personally guarantee debts or commingle personal and business funds.

Failing to adhere to S corp eligibility requirements can result in a loss of that status. 

Taxes: Sole Proprietor vs. S Corp (Head-to-Head)

Income Tax Treatment

Both structures are pass-through entities, but reporting requirements differ. 

• Sole proprietors report income via Schedule C on IRS Form 1040.

• S corp owners report income via their Schedule K-1 from IRS Form 1120-S.

Self-Employment vs. Payroll Taxes

Payroll and self-employment tax obligations are another area where these entities have significant differences. 

• Sole proprietors must pay the 15.3% self-employment tax on all net profits, although they can usually reclaim half of what they've paid via a deduction. 

• S corp owners pay payroll taxes only on their reasonable salary; distributions aren’t subject to self-employment tax.

QBI (199A) Deduction

Both entities may qualify for the Qualified Business Income deduction of up to 20% of eligible business income, subject to income and industry limits. While this deduction was scheduled to sunset after 2025, the One Big Beautiful Bill Act has made it permanent. 

Liability & Risk

Personal Asset Exposure

As established, S corps feature limited liability protection while sole proprietorships do not. Consider obtaining business insurance while establishing basic compliance protocols during formation. 

• Sole proprietorship: Unlimited personal liability.

• S corp: Limited liability if corporate formalities are maintained.

Costs & Administration

Setup & Ongoing Compliance

While S corps offer more benefits and protection, this structure comes with increased setup and ongoing compliance obligations that sole proprietors can avoid. 

Sole proprietorship

• Minimal setup.

• Annual business license renewal may be required.

S corporation

• Formation fees.

• Payroll processing.

• Bookkeeping.

• Annual IRS Form 1120-S filing and Schedule K-1 distribution.

• Year-round compliance requirements.

Key Deadlines & Paperwork

While specific deadlines may intersect for these business entities, much of the paperwork they'll need doesn't. 

For S corps:

• IRS Form 2553 (S election)

• Quarterly payroll deposits

• Annual IRS Form 1120-S and Schedule K-1s

For sole proprietors:

• Quarterly estimated tax payments

• Annual IRS Form 1040 with Schedule C

When an S Corp Starts to Pencil Out

An S corp can save on self-employment taxes when profits, after a reasonable salary, are large enough to outweigh extra payroll and compliance costs. This scenario is an example of your S corp "penciling out," which should result in a favorable outcome for your business.

If you’re unsure how to create actionable projections, the tax professionals at 1-800Accountant can model various scenarios for you.

How to Elect S Corp Status (Step-By-Step)

While sole proprietors can start operating with ease, there are several steps you must take to obtain S corporation status for your business. 

1. Form an eligible corporation or LLC.

2. Confirm shareholder and stock requirements. You can't operate as an S corp without maintaining strict eligibility requirements. 

3. File Form 2553 with the IRS by the deadline.

4. Set up payroll and bookkeeping systems to support your business expansion. 

Entity formation is quick and easy with 1-800Accountant's formation experts supporting your S corp election. 

Alternatives & Hybrids You’ll Hear About

Many small businesses start as LLCs, then elect S corp status (S corps are a status, not an entity type) when profits justify the change. This election combines the liability protection of an LLC with the tax advantages of an S corp. 

1-800Accountant's tax advisors can evaluate your business to see if the S corp election is advantageous for your current operations. 

FAQs

Do sole proprietors get QBI?

It's common for sole proprietors to take advantage of the QBI deduction. However, they must hit a certain income threshold to qualify, while adhering to other limitations. 

Does S corp income avoid SE tax entirely?

S corporations aren't typically able to altogether avoid the 15.3% self-employment tax. S corp distributions generally do, but your reasonable salary is subject to payroll taxes.

Can I switch later?

The entity you begin operating as isn't necessarily the optimal entity later on. You can switch from a sole proprietorship to an S corp later on, provided you plan the timing around IRS Form 2553 and your expected profits for that period.

Wrap-Up & Next Steps

When in doubt, use our quick checklist for choosing your optimal business structure:

• Expected profit level

• Personal liability tolerance

• Willingness to handle compliance

• Growth and hiring plans

• Desire for potential tax savings

Choosing between operating as a sole proprietor and forming an S corp isn’t just about taxes—it’s about your overall risk, long-term growth goals, and ongoing peace of mind.

Missteps can be costly, and operating as the suboptimal entity type can reduce your competitiveness in your industry. When faced with consequential business formation decisions, it's best to trust the tax professionals at 1-800Accountant, America's leading virtual accounting firm.

When you trust us with your complex financial work, your designated accountant can model your potential tax savings by entity type and walk you through state-specific costs to minimize surprises, while keeping your business compliant throughout the year.

Schedule time – typically 30 minutes or less – to speak to a 1-800Accountant small business specialist for assistance with filing Form 2553, setting up payroll, and staying compliant, among other affordable, tax-deductible services.