When to Switch From Sole Proprietorship to S Corporation
It’s time to switch from a sole proprietorship to an S corporation (S corp) when your business becomes profitable and carries financial risk.
Unlike a sole proprietorship, an S corporation protects the owners from personal liability for the company’s financial obligations.
Recommended: If you have at least $60,000 in net earnings, an S corp may offer tax advantages. Let Northwest start your S corp today.
When to Become an S Corp
Many small business owners are just happy to get their business going and start making a profit without thinking about the best business structure for their company. As a result, businesses often start out as sole proprietorships.
A sole proprietorship is a fine business structure if it has only one employee and doesn’t carry any risk or liability. However, there are many advantages for electing S corp status with the IRS as your business grows.
What is a Sole Proprietorship?
A sole proprietorship is the simplest business structure. It’s unincorporated and isn’t legally separate from its owner.
There is no limited liability protection for the owner of a sole proprietorship. As a result, the owner could be required to use their personal assets to cover the company’s debts or other financial losses.
Limited Liability Protection: This protects the owner of a corporation from personal legal liability for the company’s financial liabilities, such as debts, court verdicts and settlements, etc. As a result, the owner’s personal assets don’t have to be used to pay these liabilities.
Another feature of a sole proprietorship is that the owner pays both income tax and self-employment (FICA) taxes on the net profits of the business. These profits pass through to the owner, who reports them on their personal income tax returns and pays the same tax rate on them as they do on their other income.
Pass-Through Taxation: In this tax system, a company’s profits and losses are taxed at the owner level rather than the company level. This means that the owner reports the company’s profits on their personal income tax returns and pays taxes on those profits at their personal income tax rate.
This tax arrangement can work for a while if the company doesn’t have much in the way of profits. However, as profits increase, paying both income tax and self-employment tax on all of the business’s net profits can become expensive.
What is an S Corporation?
An S corp is an IRS tax status that the owner of an incorporated business, including an LLC or C corporation, can elect. Like an LLC or C corp, an S corp confers limited liability protection on its owner.
As a small business owner, it is highly recommended that you have limited liability protection. Otherwise, you could lose some or all of your personal assets if your company is sued, a debt becomes due, or the business suffers some other type of financial setback.
To elect S corp status, a sole proprietorship first must form an LLC or C corp. However, because C corps offer advantages that S corps lack, we don’t recommend forming a C corp and then electing S corp status. If a C Corp is the best business structure for your company, it should remain as such.
We explain the process of changing from a sole proprietorship to an LLC in our guide.
If an LLC owner elects S corp status, the IRS considers the owner to be an employee of the company.
As a result, the owner only pays self-employment tax on the “reasonable salary” they receive from the company. The owner’s portion of the company’s net profits, otherwise known as distributions, are only subject to income taxes.
Although S corps have additional payroll and accounting costs, the way S corps are taxed can save the owner a lot of money overall in the right situation.
When Is an S Corporation Right for Your Business?
Whether an S corp election is right for your sole proprietorship will depend on the circumstances. Consider S corp status if at least a few of these are true:
You don’t want to expose your personal assets
If a sole proprietorship faces a lawsuit or some other financial liability, it doesn’t offer limited liability protection for the owner’s personal assets. An S corp (as well as other entity types) does offer such protection.
You’re looking for flexible ownership options
The owner of an S corp can transfer all of their interest to someone else without negative consequences. By contrast, if the owner of a sole proprietorship or LLC transfers more than 50% of their interest, the entity can be terminated.
You want to avoid adverse tax consequences of an ownership transfer
Transferring an ownership interest in a sole proprietorship can involve complex accounting rules and requires adjusting the property basis. Transferring an ownership interest in an S corp avoids these issues.
You’re able to draw a salary from your company
The owner of a sole proprietorship pays both self-employment tax and income tax on the company’s net profits. The owner of an S corp only pays self-employment tax on the salary drawn from the company, not distributions.
Recommended: Take a look at our article for a complete look into the pros and cons of electing S corp for your business.
How to Convert a Sole Proprietorship to an S Corp
To convert a sole proprietorship to an S corp, you will have to establish an LLC and elect S corp status with the IRS or you can hire a service like Collective to do it for you. To set up your S corp, follow these steps:
Step 1: Choose a State
Step 2: Choose a Name for Your LLC
Your LLC will need a unique name that is different from all other registered names. The company’s name will be listed in the LLC’s Articles of Organization.
Use our free Business Name Generator and our How to Name a Business guide for help naming your business.
Step 3: Designate a Registered Agent
You will need to choose a person or entity to be your LLC’s registered agent. A registered agent accepts tax notices and legal documents on behalf of the LLC and is listed in the Articles of Organization.
Step 4: File the Articles of Organization
The Articles of Organization are the documents used to officially register an LLC with the state. This is also known as a Certificate of Formation or a Certificate of Organization.
Step 5: Draft an Operating Agreement
An LLC operating agreement is a legal document that lists the LLC’s members and their duties.
You can use our free tool to help draft your operating agreement.
Step 6: Obtain an EIN and File IRS Form 2553
The IRS uses an EIN to identify and tax businesses, similar to a Social Security number for individuals. Applying directly with the IRS for an EIN is free.
Elect S Corp Tax Status
When applying for an EIN, fill out Form 2553 (the Election By a Small Business form). This is the form to elect S corp tax status for your LLC.
For more information, see our guide How to Convert a Sole Proprietorship to an S Corporation.
For S Corp Tax Questions:
Frequently Asked Questions About Converting to an S Corp
Can I switch from sole proprietorship to S Corp?
The owner of a sole proprietorship may elect S corp status once it establishes itself as a single-member LLC. To do this, finalize the articles of incorporation and operating agreement, register with the appropriate state agency, and apply for any necessary permits and licenses. After that, file Form 2553 with the IRS.
Why would a sole proprietor want to incorporate?
There are many benefits of electing S corp status as a sole proprietor. In particular, it allows the business to sell stock to investors and have more than one owner. It also allows the owner to save money on taxes and avoid personal liability for the company’s debts and other financial obligations.
Can an S Corp have a single member?
A single-member LLC can elect S corp status by filing Form 2553 with the IRS. The owner of a single-member LLC with S corp status is not considered self-employed, which means they will not have to pay self-employment taxes on dividends or distributions. However, the owner will have to pay themselves a reasonable salary from the S corp’s profits.