October 1, 2020 Business Growth en_US As your small business grows, you may decide to switch from a sole proprietorship to an S corporation. Explore the details of both and some alternatives. https://quickbooks.intuit.com/cas/dam/IMAGE/A7kMeTu4U/Switch-from-self-employed-to-s-corporation.jpeg https://quickbooks.intuit.com/r/business-growth/how-to-switch-to-s-corporation/ How to switch from a sole proprietorship to an S corporation
Business Growth

How to switch from a sole proprietorship to an S corporation

By Priyanka Prakash October 1, 2020

When starting a business, one of the most important decisions you’ll make is choosing your business entity’s structure. From sole proprietorships to limited liability companies and corporations—and beyond—you have several options.

It’s not a decision you should take lightly. Different business structures come with advantages and disadvantages, especially in regards to legal liability and taxes. The good news is you’re not locked into the entity you choose when you first register your business. You can change your entity structure.

As your small operation grows, you may decide to switch from a sole proprietorship to an S corporation, for example. Let’s explore the details of both entities, how to change your entity from a sole proprietorship to an S corporation, and some alternatives.

What is a sole proprietorship?

A sole proprietorship is the simplest and most common business entity. As of 2010, there were more than 23 million operating in the U.S. A sole proprietorship is an unincorporated business with one person or a married couple as its owner.

While a sole proprietorship is a business entity, it is not a legal entity. Sole proprietors report business income and losses on their personal tax returns. They are solely responsible for any business debts or legal obligations. One of the pros of a sole proprietorship is how easy they are to establish. Typically, you don’t need to register a sole proprietorship with the state, and you don’t need to file separate taxes.

But because you don’t register a sole proprietorship, your business name will default to your legal name. You’ll need to file a DBA or “doing business as” to establish your business’s trade name.

While they’re easy to start and manage, sole proprietorships come with many legal, financial, and business risks. If somebody sues a sole proprietorship, the individual or couple who owns the business is personally responsible for any damages a judge awards. Additionally, sole proprietors often find it harder to get business loans or land big clients. They also have certain tax disadvantages compared to other business entities.

What is an S corporation?

An S corporation is organized under subchapter S of the IRS tax code, known colloquially as the “small business corporation.” S corporations pass their corporate income, credits, and deductions to their shareholders. Instead of paying income taxes, company shareholders split up business income or losses and report them on their personal income tax returns. This is known as a pass-through entity, and it’s one way that S corporations and sole proprietorships are alike.

S corporation status allows businesses to avoid “double taxation”—or being taxed at the corporate level and the business owner level. That is the case with C corporations.

Unlike sole proprietorships, S corporations are separate legal entities from their owners. So if someone sues your business, your personal assets are protected. S corporations and sole proprietorships also differ in how they’re structured. With an S corporation, shareholders who hold stock in the business own the business.

S corporation advantages

So why should you consider becoming an S corporation? There are a couple of key advantages. Of course, you should always consult your business attorney or accountant before making any changes to your business structure.

1. You can save on your taxes

As previously discussed, the main tax benefit of becoming an S corporation is avoiding double taxation. Rather than pay a corporation tax and taxes on your individual tax returns, S corporations pay just once.

S corporations only pay employment taxes—Social Security and Medicare—on employee wages. Sole proprietors pay these as self-employment taxes, while corporations pay them as payroll taxes. S corporations can save money on payroll taxes by paying some of their profits as wages and some as distributions. Because only wages are subject to payroll taxes, S corps can cut down on their tax burden.

There is one catch, however. You might be a shareholder and an employee of the company, like most individuals running an S corporation are. So before you can give yourself a tax-free distribution, you must pay yourself a “reasonable salary.” The IRS does not clarify what a reasonable salary is. But you might base it on whatever you’d earn doing your job at a comparable business. Don’t try to minimize the salary you pay yourself, or you might find yourself in trouble with the IRS.

As pass-through business entities, shareholders report business expenses, deductions, profits and losses on their personal tax returns. Profits and losses are taxed at the shareholders’ personal income tax rates rather than a corporate income tax rate. (S corporations must still file Form 1120-S with the IRS for informational purposes.)

S corporations must also provide each shareholder with a Schedule K-1, which lists each partner’s share of business income and losses. Income reflected on your Schedule K-1 is also reported on your Form 1040 and will increase your personal taxable income.

Let’s say your Schedule K-1 shows $80,000 in S corp income and $15,000 in business tax deductions. Your Form 1040 will show $65,000 in business income. After the Tax Cuts and Jobs Act passed, many S corporations became eligible for a 20% deduction on business income. Considering you can write off business losses on your personal income, an S corporation can be a major income tax-saving advantage.

Additionally, if you ever sell your business, S corporations pay significantly less in taxes than C corporations do after a sale.

2. You can safeguard your personal assets

Unlike sole proprietorships, S corporations offer limited liability protection. Despite filing your business and personal taxes together, your finances and your business finances are separate.

Let’s say your business runs into legal or financial trouble—someone sues your business, or you default on a business loan, for example. Your personal assets are safe. Only your business assets can be seized.

S corporation disadvantages

As with most business decisions, there can also be drawbacks to switching to an S corporation. That’s why, again, it’s important to consult an expert before making any final decisions.

1. Your business may be less attractive to outside investors

Growing a company requires money. Sometimes, you need that money to come from outside sources. If you expect to seek venture capital, you’ll likely want to stick with a C corporation. While S corporations are the only other type of business that lets you issue stock, they are limited to 100 shares. If you expand past that limit, your company must file and pay taxes as a C corporation. That stock limitation is fine for a corporation of three or four people. But the average startup has 10 million shares, giving it far greater growth potential.

S corporations are also limited to one class of stock, which limits who can be a shareholder. For instance, all S corporation shareholders must be U.S. citizens or residents. There is virtually no opportunity for foreign investment in an S corporation.

2. Your business may be subject to corporate formalities

Compared to a sole proprietorship, you’ll have a lot of corporate formalities to comply with as an S corporation. These formalities include creating bylaws and holding board and shareholder meetings.

For smaller businesses, this may seem like an unnecessary and time-consuming process that takes away from other aspects of running your business. You’ll want to make sure you understand the ongoing requirements of running an S corporation before choosing this entity type for your business.

How to switch from a sole proprietorship to an S corporation

As we mentioned, a sole proprietorship does not require registration with the government, which is one of its primary advantages. If you’d rather take advantage of the benefits of an S corporation, follow the steps to register your business as such.

Step 1: Make sure you qualify

Not all businesses can become S corporations. Before you apply for S corporation status, you should verify that your company meets IRS requirements.

  • The corporation may have no more than 100 shareholders (a husband and wife count as one shareholder).
  • Shareholders may be individuals, estates, and certain trusts.
  • Shareholders may not be non-U.S. residents.
  • You must be a domestic company in any state.
  • The corporation must have only one class of stock.
  • You are not an insurance company, bank, or international sales corporation.
  • All shareholders must agree to the S corporation structure.

If you meet all of these requirements, you’re ready to proceed.

Step 2: File articles of incorporation

To go from a sole proprietorship to an S corporation, you must file articles of incorporation with your secretary of state’s office. In most states, you can file the appropriate forms and pay a nominal fee online.

Step 3: Apply for an Employer Identification Number

All new corporations must apply for an Employer Identification Number (EIN) from the IRS. You can apply online for free in a few minutes. Think of an EIN as a Social Security number for your business. You’ll need this number to file your taxes, apply for business loans, open a business bank account, and more.

Step 4: File Form 2553

The final step to switching to an S corporation is submitting IRS Form 2553, signed by all of your company’s shareholders. Make sure you go through it with a tax expert who is familiar with your company. There are several components you’ll want to make sure you fill out correctly.

What if an S corp isn’t right for you?

If you’re not sure if an S corporation is the right structure for your business, you might consider other popular business entity types.

LLC

LLC stands for “limited liability company.” It limits the owner’s personal liability should their business run into legal or financial issues.

LLCs are treated, by default, as pass-through entities for tax purposes. So the LLC itself doesn’t pay income taxes. The LLC’s profits and losses pass through to the owners’ tax returns, which is the case with S corporations and sole proprietorships. However, an LLC can be taxed as a C corporation instead.

This type of business entity requires more paperwork than a sole proprietorship or general partnership. But the process is less intense than if you incorporate. Compared to corporations, LLCs need less record-keeping and do not require shareholder or director meetings.

C corporation

Unlike an S corporation, a C corporation’s profits are taxed separately from their owners. C corporations must elect a board of directors who make business decisions and oversee policies. Usually, C corps must report financial operations to the state attorney general. When you file for incorporation, a C corporation is the default business entity.

Since the Tax Cuts and Jobs Act, C corporations pay a flat 21% business tax rate, regardless of income or company size. The law provides a significant tax cut for C corps, but it does not help you avoid double taxation. First, the company is taxed at the 21% corporate tax rate. Then dividends are subject to taxes on the personal income tax return. As we covered before, S corporations help you avoid double taxation.

If your business is growing fast, you may plan to reinvest most of your profits back into the business rather than pay frequent dividends. That reinvestment may make C corporation taxes work in your favor.

Likewise, if your business is growing and you’re ready to accept venture capital, you may prefer a C corporation. C corporations allow you to offer multiple types of stock, accept foreign investments, and go well beyond the 100 shareholder limit.

The bottom line

A sole proprietorship is an attractive business entity for a few reasons. Among others, it requires hardly any setup and is a pass-through entity, so you don’t have to file separate business taxes. But it doesn’t offer any liability protection, leaving your personal assets vulnerable if your business runs into any legal or financial issues.

If you’re looking for a greater degree of protection but want to remain a pass-through entity, you may switch to an S corporation. This business entity requires more setup and ongoing corporate formalities. But you can avoid the double taxation of C corporations while keeping your personal assets safe.

Choosing a business entity type is a complex decision, so consult your business attorney or accountant before making a change. You may find that another business entity, like an LLC or a C corporation, is the better fit for your business.


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Priyanka Prakash

Senior Staff Writer at Fundera

Priyanka Prakash is a senior staff writer at Fundera, specializing in small business finance, credit, law, and insurance. She has a law degree from the University of Washington and a bachelor's degree from U.C. Berkeley in communications and political science. Priyanka's work has been featured in Inc., Fast Company, CNBC, and other top publications. Read more