Converting a sole proprietorship to S corp provides many benefits for small businesses. By applying for this status, you are choosing to legally separate yourself from your business, which protects your personal assets from liability. Also, electing to become an S corporation allows your business to request special tax treatments from the Internal Revenue Service (IRS) if you meet certain criteria.

What Is a Sole Proprietorship?

Sole proprietorships are the most common type of a small business entity because they are the easiest and most affordable to create. In a sole proprietorship, you are the only owner of the company. You do not have to file any legal paperwork to begin doing business, and all profits belong to you. You report your business income and expenses to the IRS by including the Profit or Loss from Business form (Schedule C) with your personal tax return.

From a legal standpoint, there is no distinction between you as the business owner and the business itself. Because the government views you and your business as a single entity, you are personally liable for your business's debts and obligations.

What Is an S Corporation?

Although S corporations are more complicated and costly to form than sole proprietorships, they are the most common type of the corporations created by small businesses. This is because they offer several advantages, such as protecting shareholders from liability and avoiding the double taxation that other corporations face.

Businesses must meet many requirements to file as an S corporation with the IRS, including:

  • The corporation must be based within the United States.
  • The corporation cannot have more than 100 shareholders.
  • Shareholders can only be individuals, estates, certain trusts or partnerships, or tax-exempt charity groups. They cannot be other corporations, limited liability companies (LLCs), other trusts or partnerships, or non-resident aliens.
  • The corporation can only issue common stock. If your business has issued both common and preferred stock, it isn't eligible for S corporation election.
  • The corporation's tax year must end on December 31.

If you aren't sure whether your business qualifies for an S corporation election, it is recommended that you seek professional assistance.

Advantages of Incorporating

There are several advantages of incorporating a sole proprietorship:

  • Separating your personal assets from the business protects your property if the business faces bankruptcy or a lawsuit.
  • It allows you to take advantage of pass-through taxation. Like a sole proprietorship, S corporations aren't required to pay corporate taxes. Instead, S corporations pass all the business's profits directly to its shareholders. The shareholders, even if there is just one shareholder, then pay taxes on the income they receive.
  • It provides you with growth and investment opportunities if you choose to offer stock to shareholders.

Converting From a Sole Proprietorship to an S Corp

S corporations require that all shareholders unanimously elect to become an S corporation. Once everyone has voted, the business must perform the following steps to convert from a sole proprietorship to an S corporation:

  1. Register the corporation's name with the state where it will be based. This name must be distinct from any other businesses' names within the state.
  2. Appoint a board of directors to manage business decisions. The board typically appoints officers to run the daily operations of the business.
  3. Designate a registered agent for the corporation. This person must live within the state where the corporation is based and will receive all legal correspondence on behalf of the organization.
  4. Draft the articles of incorporation and bylaws and file them with the secretary of state where the corporation will be operating. These articles must include the company name, business's purpose, officers' contact information, corporate structure outline, number of shares the company will issue, and the voting rights for each share.
  5. Transfer assets from your sole proprietorship to the corporation.
  6. Apply for a federal employer identification number. All corporations need this number even if they don't plan to hire employees.
  7. Apply for federal S corporation status with the IRS by submitting an Election by a Small Business Corporation form (Form CBT-2553). Some states also require businesses to file for S corporation status at the state level as well.

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