Key Takeaways:

  • Converting from an S Corporation to a sole proprietorship involves dissolving the corporation and transferring assets.
  • A sole proprietorship has no legal separation between the business and the owner, leading to unlimited liability.
  • The IRS requires the filing of Form 966 and final corporate tax returns when dissolving an S Corporation.
  • Business licenses, registrations, and employer tax obligations may need adjustments.
  • Tax implications include changes in self-employment taxes, deductions, and filing requirements.
  • Consulting with a tax professional or attorney is recommended to ensure compliance.

If you want to change from S Corp to sole proprietor, you will have to go through several steps before making such a change. Many people who go into business on their own choose to operate as sole proprietors. But for those who are currently operating an S Corp with other business owners and want to go their separate ways, the other owners might agree to sell the assets of the company to one of the outstanding business owners who can then convert the business to a sole proprietorship.

Sole Proprietorship: An Overview

Many people operate sole proprietorships without even realizing it. There are no formal documents required to form a sole proprietorship; instead, once you start doing business on your own and holding yourself out as a sole proprietor, you are said to be operating a sole proprietorship. This means that there are no fees associated with forming a sole proprietorship, nor is there documentation that needs to be filled out and filed with the Secretary of State before doing business as a sole proprietor. Unlike other business structures, including the corporation, LLC, or partnership, the sole proprietorship is not a separate and distinct legal entity from its owner. For this reason, the sole proprietor personally owns all of the business’s assets.

S Corporation: An Overview

After forming a corporation, the business owners can elect to have the business taxed as an S Corporation. Specifically, the S Corp is a sub-category of the C Corporation and is a legal entity that provides different requirements and obligations for the corporation. Some of these requirements include the fact that the S Corp can’t have more than 100 shareholders (owners) and can only offer one class of stock.

During the life of a business, the business owners might choose to leave the company voluntarily or involuntarily. At this point, the owners can choose to go their separate ways. When this happens, the corporation might dissolve entirely, or the business owners might choose to sell their assets in the business to another owner, who can then take over the business entirely. If this occurs, the new business owner can then convert the S Corp to a sole proprietorship.

Steps to Convert an S Corp to a Sole Proprietorship

Converting an S Corporation to a sole proprietorship involves multiple legal and tax steps. Below is an outline of the key actions required:

  1. Board Resolution & Shareholder Approval:
    • Ensure all shareholders agree to dissolve the S Corporation.
    • Hold a formal meeting and document the resolution.
  2. File Articles of Dissolution:
    • Submit the required dissolution documents to the state where the corporation was registered.
    • Some states may require tax clearance before filing.
  3. Notify the IRS:
    • File Form 966 (Corporate Dissolution or Liquidation) with the IRS.
    • Submit the final corporate tax return (Form 1120-S) and mark it as “Final Return”.
  4. Liquidate Business Assets & Transfer Ownership:
    • Sell or distribute company assets to yourself as the new sole proprietor.
    • Record all transactions for tax reporting purposes.
  5. Cancel Business Licenses & Close Accounts:
    • Notify state and local agencies to cancel permits, licenses, and tax registrations.
    • Close business bank accounts and transfer assets to a personal or new business account.
  6. Register as a Sole Proprietor:
    • If operating under a different business name, file a DBA (Doing Business As).
    • Obtain any required local business licenses.
  7. Adjust Tax & Employment Filings:
    • Cancel employer tax accounts if you had employees.
    • Begin reporting income under Schedule C (Form 1040) for sole proprietorship tax filings.

Disadvantages to the Sole Proprietorship

There are two notable disadvantages to the sole proprietorship:

  1. Lack of limited liability protection
  2. Tax concerns

The owner is held personally liable for the outstanding debts and obligations of the business. This is not the case for corporations, LLCs, or most partnerships. So you’ll need to keep in mind that if a creditor or someone else files a lawsuit against your business for any outstanding debt, the lawsuit will actually be brought against you as the owner. Therefore, while the assets of the business can be used to satisfy the judgment, the assets of the business are actually your assets, which means that your other personal assets can be used to satisfy the debt. This could include your own personal bank account, savings, car, home, etc.

As a sole proprietor, you and your business are treated as one legal entity for tax purposes. The sole proprietorship, similar to that of the LLC and partnership, doesn’t pay federal income taxes or file returns. As a sole proprietor, any money that is made from the business will need to be reported on your IRS Form 1040 as interest income.

There is a benefit to the tax implication, as sole proprietors are eligible for up to a 20 percent tax deduction. In fact, all pass-through tax entities, which include the sole proprietorship, partnership, and LLC, can benefit from such tax deductions for those entities established by the Tax Cuts and Jobs Act.

With regard to self-employment tax, you will need to pay both Social Security and Medicare tax. Before converting to the sole proprietorship, you should find out what the current percentages are for each one, i.e., 12.4 percent Social Security tax subject to a certain monetary threshold and a 2.9 percent Medicare tax. However, unlike those businesses with employees, you don’t have to pay workers’ compensation insurance or liability insurance. You also don’t have to pay payroll taxes or withhold income tax from your paycheck.

Tax Implications of Converting an S Corp to a Sole Proprietorship

Shifting from an S Corp to a sole proprietorship affects your tax obligations in several ways:

  • Self-Employment Taxes: As a sole proprietor, you will be responsible for the full 15.3% self-employment tax (Social Security & Medicare).
  • Pass-Through Taxation Benefits: Sole proprietors can still benefit from the 20% Qualified Business Income (QBI) deduction under the IRS rules.
  • No Separate Tax Return for Business: Unlike an S Corp, which files a separate return, sole proprietors report business income on Schedule C (Form 1040).
  • Loss of Certain Deductions: S Corporations allow owners to deduct business expenses like healthcare premiums in a different manner than sole proprietors.

Frequently Asked Questions:

  1. How long does it take to convert an S Corp to a sole proprietorship?
    • The timeline varies by state but typically takes a few weeks to a few months, depending on state processing times and tax clearance requirements.
  2. Do I need a new EIN when converting my S Corp to a sole proprietorship?
    • If you had an EIN under the S Corp, the IRS generally requires a new EIN for the sole proprietorship unless you're operating under your Social Security Number.
  3. What happens to my business debts when I convert to a sole proprietorship?
    • Any outstanding business debts must be settled, transferred, or assumed personally before conversion.
  4. Can I still operate under the same business name after conversion?
    • Yes, but you may need to file a DBA ("Doing Business As") if your business name differs from your legal name.
  5. Do I need to notify my customers and vendors of the change?
    • Yes, it’s advisable to inform customers, vendors, and suppliers about the change to avoid confusion regarding payments, contracts, and legal obligations.

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