How to Convert Sole Proprietorship to S Corp: Everything You Need to Know
How to convert sole proprietorship to S corp is a major issue for small business owners looking to incorporate their operation. 3 min read
2. Benefits of the S Corporation
3. Steps to Becoming an S Corporation
How to convert sole proprietorship to S corp is a major issue for small business owners looking to incorporate their operation. The choice for most individuals or partnerships running a business and looking for a way to protect their personal assets is between becoming a limited liability corporation (LLC) or an S corporation.
While each of these entities has its benefits, the S corporation provides unique benefits that make it especially attractive to business owners who are legal residents of the U.S. looking to avoid double taxation, raise capital, and enjoy limited tax filings.
The Path to Incorporation
Many business owners start out as sole proprietorships or partnerships. This makes sense during the early stages for several reasons:
- There are costs, such as filing fees, for setting up a business as an LLC or corporation that are not required of sole proprietorships. It’s often necessary to devote finances to purchase inventory, pay rent and insurance, and advertise for business. Survival is far from guaranteed.
- Initially, the business owner may not feel the need to protect his or her personal assets. For instance, the business may only interact with customers over the internet, so there is no risk that anyone would suffer an injury on the company’s premises. However, that doesn’t mean that customer data could not be hacked and liability for damages determined.
- There’s not an immediate need to reach out to investors to raise capital in order to expand the business, and growth can be covered with a percentage of annual profits.
However, there are disadvantages to remaining a sole proprietorship if things begin to work out:
- The business might need to enter into agreements with other companies that may pose a risk to assets should contracts be breached.
- Opportunities for growth cannot be seized without an influx of capital that is beyond the owner’s ability to acquire bank financing. It is only available through individuals who want to invest in the company for shares of ownership.
- It is determined that one of the best ways to attract and maintain talent is through employee profit-sharing plans that include stock ownership or stock bonus plans.
Benefits of the S Corporation
There are several advantages to converting a sole proprietorship to an S corporation:
- Personal liability for damages is eliminated.
- Investors can be attracted through the sale of shares of stock.
- Shareholders retain pass-through taxation opportunities and avoid the double taxation that results from becoming a C corporation.
- Ownership is limited to 100 shareholders so owners can maintain tighter control of the company.
Steps to Becoming an S Corporation
In order to evolve from a sole proprietorship to an S corporation, several procedures must be followed:
- Eligibility Established: Federal regulations place restrictions on businesses seeking to file as S Corporations based on factors such as the types of businesses that can be owned, pay rates for employees, and foreign investment or ownership. Internal Revenue Service Form 2553 provides a complete list of restrictions.
- Transfer of Insurance: It is not always possible for a sole proprietorship to transfer required business insurance policies from their existing business to an S corporation. It’s a good idea to check before beginning the filing process.
- Consult a Tax Professional: There may be changes in the way taxes for shareholders are determined when operating as an S corporation. In addition, an S corporation cannot assume liability for payrolls and all wages due must be paid out before moving forward. A tax professional can provide oversight.
- Choose a Business Name: It is necessary to conduct a search to avoid infringing on existing business names or trademarks when filing as an S corporation.
- File Operating Agreement: An operating agreement must be filed with the state in which the S corporation is registering. As the name implies, this document outlines how the business will be organized and run. It usually includes articles of incorporation and bylaws. Every state has different filing requirements and agencies responsible for recording corporate documents. Start with the Secretary of State’s office.
- Draft a Shareholder Agreement: This is where the voting and management rights of the new corporation are presented. It’s a good practice to create this document even if no immediate plans to recruit investors exist. A corporation exists in perpetuity and plans should be in place should the founder become incapacitated or pass away.
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