Can a Sole Proprietor Be an S Corp? Conversion Explained

Key Takeaways

• Sole proprietors can convert to S corporations, but cannot be S corporations themselves.
• Transitioning to an S corp can provide tax savings, limited liability protection, and growth opportunities.
• You must form a corporation or LLC first, then elect S corp status with the IRS.
• Owners must pay themselves a reasonable salary and follow corporate formalities.
• Conversion requires multiple steps, including filing incorporation documents, transferring assets, and obtaining a new EIN.
• Consider the increased administrative requirements and ongoing compliance costs.
• UpCounsel can connect you with experienced business attorneys to help with your transition.

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.

Can a Sole Proprietor Be an S Corp?

A sole proprietor cannot technically be an S corporation because they are not incorporated. An S corporation is not a type of business entity—it’s a tax classification available only to corporations or LLCs that meet certain IRS criteria. To elect S corp status, a sole proprietor must first form either a corporation or a limited liability company (LLC), then file IRS Form 2553 to elect to be taxed as an S corporation.

So, while you can’t remain a sole proprietor and be treated as an S corp, you can convert your sole proprietorship to an S corporation, unlocking potential tax advantages and liability protections. This process involves ending your sole proprietorship and creating a new legal entity.

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.

Key Differences Between a Sole Proprietorship and an S Corporation

These distinctions help explain why many ask, "can a sole proprietor be an S corp?"—while they can't directly elect this status, forming an S corporation offers potential savings and legal protections not available under a sole proprietorship.

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.

Tax Benefits of Electing S Corporation Status

One of the main reasons sole proprietors choose to convert to an S corp is to reduce their tax liability. Here's how the potential savings work:

• Self-Employment Tax Savings: As a sole proprietor, all net profits are subject to self-employment taxes (15.3%). In an S corp, only your salary is subject to these taxes. Any remaining profits are treated as distributions, which are not subject to self-employment tax.
• Deductible Business Expenses: An S corp can deduct certain employee benefits, such as health insurance and retirement plan contributions, which might not be available to sole proprietors.
• Qualified Business Income (QBI) Deduction: Both sole proprietors and S corps may qualify for this 20% deduction, but S corps may structure earnings to maximize this benefit.

However, these savings come with added responsibilities, such as running payroll, filing corporate returns, and maintaining detailed records.

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.

What to Know Before You Convert

Before you convert your sole proprietorship into an S corporation, it’s important to evaluate whether the change fits your business model. Consider these factors:

• Income Threshold: S corp status generally benefits businesses with consistent profits of at least $40,000–$50,000 annually.
• Administrative Burden: You’ll need to run payroll, maintain corporate records, and file separate tax returns.
• Compliance Risk: Improper classification of income or failure to pay a reasonable salary to the owner could result in IRS penalties.
• State-Level Requirements: Some states have additional rules or fees for S corps, including franchise taxes or separate filing requirements.

Timeline and Transition Tips

Here’s a general timeline and best practices to follow when converting:

1. Determine the best time to convert—many business owners do so at the beginning of a calendar year for simpler tax reporting.
2. Incorporate your business—form a corporation or LLC with your state’s business authority.
3. Transfer assets and accounts—move business bank accounts, equipment, and contracts to the new entity.
4. Apply for a new EIN—a new federal employer identification number is typically required.
5. Elect S corp status—file IRS Form 2553 within 75 days of forming your entity or by March 15 of the tax year you wish to elect.
6. Set up payroll—pay yourself a reasonable salary and begin withholding payroll taxes.
7. Update licenses and insurance—ensure all business permits and liability insurance reflect the new entity name.

Taking these steps ensures a smooth transition and compliance with both IRS and state regulations.

Frequently Asked Questions

1. Can a sole proprietor be an S corp? No, but a sole proprietor can form a corporation or LLC and then elect to be taxed as an S corp.

2. What’s the main reason to switch from sole proprietorship to S corp? The primary reason is potential tax savings—especially on self-employment taxes.

3. Do I need a new EIN when I switch to an S corp? Yes, forming a new legal entity typically requires obtaining a new EIN from the IRS.

4. When should I file Form 2553 to elect S corp status? Within 75 days of forming your entity or by March 15 of the year you want the election to take effect.

5. Can I still deduct business expenses after converting to an S corp ?Yes, and you may also gain access to additional deductible benefits like health insurance and retirement plans.

Consulting a tax professional or business attorney can help you assess whether switching to an S corp is the right move.

If you need help with transitioning from a sole proprietorship to an S corporation, 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.