Problem here is, "Sie" is at the beggining of the sentence, so it is always capitalized... independent of the case. My first translation would have been "They are vegetarians", which seems to be a more natural thing to say (to me). Though the giving translation is not grammatically wrong, I would say that it is not likely to be used.
They should both be accepted since there is no context (if not, report it), and can expect to encounter both equally in English (can't speak for German, but I would imagine it is the same). If I had two coworkers over for supper and I cooked steak, they might say..."Uhm...sorry Hohenems, but do you have any salad? We don't eat meat." To which I would reply "Oh man! You're vegetarians? I'm so sorry!"