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.
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.