Change From S Corp to Sole Proprietor: Everything to Know
If you are currently operating an S Corp and you want to change to sole proprietor, you will have to go through several steps before making such a change.3 min read updated on February 01, 2023
Updated July 13, 2020:
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.
Disadvantages to the Sole Proprietorship
There are two notable disadvantages to the sole proprietorship:
- Lack of limited liability protection
- 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.
If you need help learning more about converting your S Corp to a sole proprietorship, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law, and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.