S Corporation and Sole Proprietorship: Why They Matter? 12-21-15

The S Corporation and the Sole Proprietorship: Why They Matter for Tax Purposes

In the United States of America (USA), organizations usually take the form of corporations, limited liability companies, partnerships, S corporations and sole proprietorships. An organization’s owner decides on the form of the organization after carefully considering the applicable tax and legal criteria, inter alia. Such considerations have resulted in the S corporation and the sole proprietorship being two of the most common types of organization in the USA.

An S corporation is an entity that is formed and taxed on the basis of Subchapter S of the Internal Revenue Code’s Chapter 1, whereas a sole proprietorship is an unincorporated entity for which tax liabilities vary according to the income of the sole proprietor. Legally, the S corporation has a structure that is similar to that of a standard corporation: shareholders’ rights and responsibilities are separate from the S corporation’s rights and responsibilities. Unlike the standard corporation, the S corporation has no obligation to pay federal corporate tax; the S corporation’s shareholders are individually responsible for their share of any tax liability attributable to the entity. The sole proprietorship’s tax liability is easily determined because no legal distinction is made between the sole proprietorship and the sole proprietor: the sole proprietor’s income or loss is the sole proprietorship’s and any applicable tax liabilities are determined in this context.

With the S corporation being exempt from any federal corporate tax, its shareholders must declare their proportion of the entity’s income or losses in their individual income tax filings; any related deductions and credits are treated similarly. Individual income tax rates apply in the assessment of each shareholder’s tax liability. If S corporations retain their profits as working capital, such profits are deemed to be distributed to the shareholders and are subject to tax. Consequently, each shareholder may be taxed for income they did not actually receive. The taxing of the S corporations’ profits, via the shareholders, means that these organizations’ corporate income and dividends are at no risk of double taxation. This taxation mechanism does not eliminate the S corporation’s obligation to pay taxes concerning federal unemployment, the Federal Insurance Contributions Act, passive income and specified capital gains.

Taxes paid by sole proprietorships include

  • federal income taxes,

  • state income, excise, franchise and sales taxes,

  • self-employment taxes,

  • unemployment tax and

  • property taxes.

For the purposes of federal income tax, the sole proprietorship’s tax computation is a straightforward matter since no distinction is made between the sole proprietor and the entity. A sole proprietor uses the Internal Revenue Service’s Form 1040 and the supporting Schedule C to report the sole proprietorship’s income or losses and any tax liability. In this exercise, losses from the sole proprietorship can offset income from other sources and thereby help to reduce the income tax liability.

For the purposes of federal income tax, the S Corporation and the Sole Proprietorship matter because they help to minimize corporate and individual tax liabilities whilst contributing to the national economy. Additionally, the S-Corporation’s tax regime eliminates risks of double taxation.