An S Corporation is a special tax status that helps entrepreneurs maximize tax savings. Learn how to switch from a sole proprietorship to an S Corp today.
Are you thinking about switching from a sole proprietorship to an S Corp? It can be a strategic move for small business owners seeking a balance between the simplicity of a sole proprietorship and the tax advantages and personal liability protection of an S Corp.
Changing from a sole proprietorship to an S Corp can improve your business credibility and pave the way for growth, but it doesn’t have to be complicated. We’re here to help you make a smooth transition for your business with three simple steps.
Key Takeaways
Changing from a sole proprietorship to an S Corp protects your personal assets and results in potential tax savings.
An S Corporation (S Corp) is not a business structure. It’s a tax status that eligible small businesses can elect.
To claim S Corp status, you must register a corporation or an LLC, determine S Corp eligibility, and file IRS Form 2553.
What Is an S Corp?
An S Corporation (S Corp) is a tax classification that combines elements of a corporation and a pass-through entity, providing certain tax benefits to its owners, known as shareholders. The "S" in S Corp refers to Subchapter S of the Internal Revenue Code, which defines the rules and requirements for this type of corporate structure.[1]
Contrary to popular belief, an S Corp is not a business structure. It’s a tax status that eligible small businesses can choose for their existing corporate structure. The S Corp election allows the business to enjoy the advantages of pass-through taxation, where profits and losses flow through to individual shareholders' tax returns to the IRS.
S Corp vs. LLC
An LLC is a popular entity type for entrepreneurs. Like a corporation, an LLC provides limited liability protection to its members, safeguarding their personal assets. LLCs are also pass-through entities, allowing their owners to report business income on their personal tax return for income tax purposes.[2]
When deciding between an S Corp and an LLC, there are several things to consider.
Pass-Through Taxation
Both LLCs and S Corps share the advantage of pass-through taxation, making them an attractive option for business owners who want to avoid corporate taxes.
In both structures, the business itself does not pay federal tax at the entity level. Instead, the profits and losses "pass-through" to the individual tax returns of the owners or members. This means that the business's income is only taxed at the individual level, avoiding the double taxation associated with corporations.
Self-Employment Tax
Shareholders who are also employees of the S Corp can receive a portion of their income as salary, subject to payroll taxes. They can then receive the remaining portion as distributions, not subject to self-employment taxes. Maintaining a reasonable salary is essential to avoid internal revenue service scrutiny.
In contrast, members of an LLC are typically subject to self-employment taxes on the entire business income. While LLC members can take "draws" from the business, these are still generally subject to self-employment taxes, including Social Security and Medicare taxes.
Fringe Benefits
S Corp shareholders who are employees may be eligible for certain fringe benefits, such as retirement plans and health insurance, which can be tax-advantageous. In turn, members of an LLC may have fewer options for tax-advantaged fringe benefits compared to S Corp shareholders.
Final Thoughts: S Corp vs. LLC
The decision between an S Corp and an LLC involves careful consideration of the specific goals of the business and its owners. Entrepreneurs looking to minimize self-employment taxes, strategically allocate income, and maintain a corporate structure often find S Corp status appealing.
How to Change From Sole Proprietor to S Corp
Are you ready to make the switch from a sole proprietor to an S Corp? Follow the three steps below for an easy and stress-free transition.
1. Form an LLC or Corporation
Remember, an S Corporation is a tax status, not a business structure. To get S Corporation status, business owners must first form a C Corporation (C Corp) or a limited liability company (LLC).
Choose a Business Name
Selecting a business name for your C Corp or LLC lays the foundation for your brand identity and legal entity. The chosen name should be distinctive, reflective of your business's nature, and compliant with the naming conventions of your state.
The naming conventions vary from state to state, but you should typically consider the following factors when deciding on your business name:
Availability: Conduct a thorough business name search to ensure that the name is available, unique, distinct, and not already in use by another business.
Trademark Infringement: Check the U.S. Patent and Trademark Office (USPTO) database to ensure your business name doesn't infringe on existing trademarks.
Prohibited Words: Be aware of words that are prohibited or restricted by authorities. Terms related to finance and law may require special permissions or licensing from your state.
Legal Structure Indicators: In many jurisdictions, the name should include a proper indicator of the legal structure, such as "LLC" for limited liability companies or "Corp" or "Inc" for corporations.
Misleading Names: Your business name should not mislead the public about the nature of the business.
File Articles of Organization or Articles of Incorporation
To formally establish an LLC or a C Corporation with the state, you must file Articles of Organization or Articles of Incorporation, respectively. These documents serve as the official registration of your separate legal entity and outline essential details about your business.
The information you must provide in the Articles varies by state. However, you can typically expect to include the following information:
Articles of Organization (LLC):
Include the legal name of the LLC, ensuring it is unique and compliant with state naming rules
State the purpose of the LLC, describing the primary business activities
Provide the registered agent's name and address – the person or entity responsible for receiving legal notices on behalf of the LLC
Specify the management structure (member-managed or manager-managed)
Disclose the names and addresses of the members or managers
Outline the duration of the LLC, whether it is perpetual or has a specified end date
Articles of Incorporation (C-Corp):
State the corporation's name, adhering to naming conventions and ensuring uniqueness
Specify the purpose of the corporation, indicating the type of business activities it will engage in
Declare the authorized capital, including the number of authorized shares and their par value (if applicable)
Provide the registered agent's name and address
Outline the initial board of directors, including their names and addresses
Specify any additional provisions or restrictions related to the corporate structure
Disclose the name and address of the incorporator – the person or entity responsible for filing
You must file your Articles of Organization or Articles of Incorporation with the Secretary of State. This is also typically the stage of the incorporation process where you’ll need to pay your filing fee. The pricing depends on your state.
Hire a Registered Agent
A registered agent is a designated individual or entity responsible for receiving legal documents, official correspondence, and IRS notices on behalf of your business.[3]
You can appoint yourself as your registered agent or hire a registered agent service. Hiring a registered agent helps protect your privacy, provides greater flexibility, and minimizes the risk of missing important documents. Enroll in our registered agent service to easily remain compliant.
Create an LLC Operating Agreement
An LLC operating agreement is a legal document that defines the internal workings, structure, and regulations of your limited liability company. While not always required by law, having an operating agreement is recommended for LLCs because it provides a clear framework for decision-making and operations.
Here are key elements commonly included in an LLC operating agreement:
Organization details
Business purpose
Members’ contributions
Distribution of profits and losses
Management structure
Voting rights
Meetings and decision-making
Dissolution
Tax treatment
Governing law
You only need to draft an operating agreement if you’re forming an LLC. If you’re filing for a small business corporation, you will draft corporate bylaws.
Obtain an Employer Identification Number
An employer identification number (EIN) is a unique tax number assigned to businesses by the IRS. It is used for tax purposes, similar to how your social security number is used for personal identification.
You typically need an EIN to open a business bank account or hire employees. You can apply for an EIN on the IRS website or have us do it for you.
2. Determine Your S Corp Eligibility
To complete the S corp election, you need to meet the specific criteria set by the Internal Revenue Service (IRS). Here are the key factors that determine whether your small business qualifies for S Corp status:[4]
Must be a domestic corporation
Can only have allowable shareholders (individuals, certain trusts, and estates)
May not have partnerships, corporations, or non-resident aliens as shareholders
Can not have more than 100 shareholders
Can only have one class of stock
Can not be an ineligible corporation (certain financial institutions, insurance companies, domestic international sales corporations)
If your business complies with the criteria above, it can qualify for S Corp status.
3. File IRS Form 2553
IRS Form 2553, officially titled "Election by a Small Business Corporation," is the form eligible corporations use to elect S Corporation (S Corp) status for federal tax purposes. You can download the most recent version of Form 2553 from the IRS website and fill out the required sections, including your business name, address, and EIN.
FAQs
How is income taxed when a sole proprietor converts to an S Corp?
In a sole proprietorship, the business income is considered the owner's personal income. When the business converts to an S Corp, you can report your business income on your personal tax return, and it won’t be subject to self-employment taxes. You’ll also need to pay yourself a reasonable salary, subject to applicable taxes.
How easy is it to change from a sole proprietorship to a corporation?
Changing from a sole proprietorship to a corporation is a formal process that involves multiple steps, but it doesn’t have to be complicated. You can start your S Corp in as little as 10 minutes with our reliable and easy filing service.
How do you convert a sole proprietorship to an S Corp?
To convert a sole proprietorship to an S Corp, you must form an LLC or corporation, meet S Corp election requirements, and file IRS Form 2553 (Election by a Small Business Corporation).
What are the benefits of an S Corp over a sole proprietorship?
S Corp status offers the advantage of pass-through taxation, allowing you to report your business profits and losses on your personal income tax return, potentially resulting in tax savings. Forming a corporation also protects your personal assets from business debts and liabilities.
What are the drawbacks of an S Corp?
An S Corp needs to adhere to corporate formalities, which can be difficult to navigate for some entrepreneurs and small business owners.
Is it better to be a single-member LLC or S Corp?
The choice between a single-member LLC or an S Corp depends on various factors. An S Corporation may be more beneficial if the business generates significant income because it allows for potential tax savings.
What is the S Corp tax rate?
S Corps themselves don’t pay federal income tax at the corporate level. Instead, the income, losses, deductions, and credits "pass-through" to the shareholders, who report this information on their tax returns.
Bibliography
Internal Revenue Service. “S Corporations.” Accessed December 11, 2023.
Internal Revenue Service. “Single Member Limited Liability Companies.” Accessed December 11, 2023.
U.S. Small Business Administration. “Register your business.” Accessed December 11, 2023.
Internal Revenue Service. “S Corporations.” Accessed December 11, 2023.