How to Change a Sole Proprietorship to an S Corp
A sole proprietorship can’t be changed to an S corp directly. Instead, the owner must first form either an LLC or a C corp and then elect S corp status with the Internal Revenue Service (IRS).
Because C corps have distinct advantages over S corps that would be lost by electing S corp status, we recommend forming an LLC when electing to become an S corp.
Sole Proprietorship vs. S Corp: What’s the Difference?
A sole proprietorship is the simplest form of business structure. It’s an incorporated business that’s considered legally indistinguishable from its owner.
By contrast, an S corp is an LLC or corporation whose owner has elected S corp status for their company.
For more information, see our Sole Proprietorship vs. S Corp guide.
A sole proprietorship is a type of business that isn’t legally separated from its owner. As a result, a sole proprietorship doesn’t provide the tax savings or limited liability like an S corp.
Sole Proprietorship Taxes
Sole proprietors must pay income and self-employment taxes on the net profits from their business. In other words, business income passes through to the owner personally, and they pay taxes on this income on their personal income tax returns.
Paying both self-employment tax and income tax is expensive, which is one reason that many sole proprietors seek to convert their business to an S corp.
What Is an S Corporation?
An S corp is a tax status that business owners elect by filing a form with the IRS (Form 2553). Only LLCs or corporations can elect S corp status.
If an LLC or corporation owner makes this election, the business will benefit from the tax advantages offered by an S corp.
A sole proprietorship must become an LLC or C corp before making the S corp election. You can read more about this in our How to Change From a Sole Proprietorship to LLC guide.
S Corp Taxes
The owner of an S corp is considered an employee of the company for tax purposes. As a result, they pay both income tax and self-employment Federal Insurance Contributions Act (FICA) tax on their reasonable salary.
However, S corp owners only pay income tax on distributions. Although the resulting tax savings can be significant, they will be at least partially offset by additional payroll taxes and accounting expenses.
How to Form an LLC
Step 1: Select Your State
Most business owners should form an LLC in the state where they live and wish to operate their company. If you plan to have a storefront or other physical presence in multiple states, you will need to register a foreign LLC in those states. Our state-specific guides will show you how to start an LLC in your state:
- New Hampshire
- New Jersey
- New Mexico
- New York
- North Carolina
- North Dakota
- Rhode Island
- South Carolina
- South Dakota
- Washington D.C.
- West Virginia
Step 2: Name Your LLC
Before you settle on a name, search online to make sure it hasn’t been taken and meets your state’s naming guidelines.
For more on naming your business, read our How to Name a Business guide.
Step 3: Choose a Registered Agent
Your business will need someone who is responsible for accepting legal documents, state filing notices, and other official papers on behalf of the company. That person is called a registered agent.
In most states, every LLC has to designate a registered agent. This person must be a resident of the state where your company does business or a corporation authorized to do business there.
Check out our What Is a Registered Agent article to learn more about what you should consider when choosing a registered agent.
Although anyone who meets the basic criteria can serve as a registered agent, it is best to hire a professional registered agent service with enough experience to make sure you comply with the law.
Hire a service provider like Collective for all your S corporation needs, including:
- S corp formation or to convert an existing business
- Registered agent services and obtaining an EIN
- Managing your monthly accounting (payroll, bookkeeping)
- Personalized service with a back office team
- Keeping your business compliant with regulatory obligations
- Helping you find potential business tax savings, and more.
Connect with Collective to set up your S corp.
Step 4: File Your LLC’s Articles of Organization
Your LLC’s Articles of Organization is the necessary formation document that needs to be filed with the appropriate state agency. The Articles of Organization are also known as a Certificate of Formation or Certificate of Organization.
You can complete and file the Articles of Organization yourself online or through the mail. Alternatively, you can hire an LLC formation service to do this.
Filing the Articles of Organization costs about $100, but fees vary by state.
Step 5: Create an LLC Operating Agreement
An operating agreement designates how your LLC is owned and structured. Although you don’t have to have an operating agreement, it is recommended that you obtain one in order to lay out specific procedures for management, voting, capital contributions, distributions, membership changes, and dissolution.
Step 6: Obtain an EIN
The IRS uses an Employer Identification Number (EIN) to identify your LLC for tax purposes. This is also known as a Federal Employer Identification Number (FEIN), or Federal Tax Identification Number (FTIN).
How to Change an LLC to an S Corp
First, consider whether electing S corp status is right for your LLC. An S corp election could save about 17% on your share of company distributions if:
- The business can pay the owner(s) a "reasonable salary.”
- There are substantial distributions of at least $10,000 per year.
- There is a positive return on investment for payroll service costs.
- The business meets S Corp eligibility requirements.
To elect S corp status, an LLC must file Form 2553 with the IRS. This involves three steps:
- Check Eligibility for S Corp Status
- Check Due Dates for Form 2553
- Complete and File Form 2553
Check Eligibility for S Corp Status
To elect S corp status, all of the following must be true of your company:
- Form 2553 was filed on time by an eligible business entity. Eligible business entities include corporations and LLCs.
- Your company has no more than 100 shareholders.
- Shareholders are individuals, tax-exempt organizations, or estates.
- Shareholders are resident aliens or US citizens.
- Your company has issued only one class of stock.
- Every shareholder has consented to the S corp election.
Check Due Dates for Form 2553
Form 2553 is due:
- No more than two months and 15 days after the start of the tax year that you want S corp status to begin.
- Any time in the year before the tax year that you'd like S corp status to begin.
Looking to convert your business to an S corp? Get a personalized advisor for S corp formation to handle your monthly accounting, manage requirements and regulatory compliance, calculate your potential tax savings, and more with Collective.
Steps to Take After Converting to an S Corp
Once you formalize your S corp, consider adding a business phone line to protect your personal information with phone.com.
For business banking check out our guide on the best banks for small businesses.
Sole Proprietorship to S Corp FAQ
Can an S Corporation own a sole proprietorship?
No. An S corporation is an IRS tax status that the owner of an LLC or C corporation can elect. A sole proprietorship can’t elect S corp status directly. However, it can do so after becoming an LLC or C Corp.
Is a sole proprietorship the same as an S Corp?
No. A sole proprietorship is the simplest form of business organization and consists of a business owned by one person with no limited liability. An S corp is an IRS tax status that can be elected by an LLC or C corp.
Can an S corp owner be self-employed?
An S corp owner is considered an employee of the company. As a result, the owner pays self-employment taxes on the “reasonable salary” they earn from the company but not on distributions.