When to Transition from Sole Proprietorship to S Corporation: A Guide for Small Business Owners


Bench Accounting


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December 20, 2023

This article is Tax Professional approved


Making the leap from a sole proprietorship to an S corporation is a decision that can reshape your business's tax strategy, liability, and overall structure. This guide will help you understand the whys and hows of moving to an S corporation.

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Signs it’s time to consider an S corporation

Growing liability risks: If you're noticing an uptick in your business's liability risks, it's time to think about an S corporation. This entity offers legal separation between your personal and business assets, safeguarding you against personal liability as your business ventures expand. 

Learn more about this transition and its benefits at Bench's guide to S corporations.

Increasing profits and tax savings: Seeing a rise in profits? That's great, but it also brings a heavier tax burden under a sole proprietorship. An S corporation could be a game-changer, allowing profits to pass directly to shareholders and sidestepping the double taxation common in C-Corporations.

For detailed insights on these tax nuances, check out how an S corporation could reduce your self-employment taxes.

Attracting investors: If you're planning to woo investors, the S corporation structure, with its ability to issue shares, could be more enticing compared to a sole proprietorship. It simplifies equity distribution, a vital aspect of attracting investment.

Find out more about making the switch from a sole proprietorship to an S corporation here.

The benefits of an S corporation

  • Avoiding Double Taxation: S corporations allow income to be passed through to shareholders, taxed at individual rates, bypassing the double taxation hurdle faced by C-Corporations. This can be a major tax advantage for many business owners.
  • Reducing Self-Employment Taxes: Unlike sole proprietorships, S corporation shareholders can split their income into salary and dividends, potentially lowering self-employment taxes.
  • Personal Asset Protection: S corporations shield your personal assets from business liabilities, offering peace of mind in legal disputes or business debts.

Related reading: Learn how to prepare for tax season as an S corporation.

Tax Implications of operating as an S corporation

An S corporation's main tax advantage is the ability to pass profits and losses directly to shareholders, avoiding double taxation. For example, if an S corp earns $100,000 in profits, this income is reported on the shareholders' personal tax returns, taxed at their individual tax rates. In contrast, a sole proprietorship's income is subject to self-employment tax in addition to income tax. However, S corps face scrutiny over reasonable compensation to shareholders-employees, impacting how much income can be classified as dividends (subject to lower tax rates) versus salary.

Growth opportunities with an S corporation

  • Funding opportunities: The distinct separation between owners and the business entity in an S corporation makes it a more attractive option for investors and lending institutions.
  • Employee management: As your team grows, the S corporation framework provides a more structured approach to managing increased headcount and associated liabilities.
  • Expanding client base: An S corporation can position your business favorably for larger contracts, preferred by many corporations and government entities for their structured approach to liability and professionalism.

Is your business eligible as a S corporation?  

To qualify as an S corporation, a business must meet certain IRS criteria. This includes being a domestic corporation, having only allowable shareholders (individuals, certain trusts, and estates but not partnerships or corporations), having no more than 100 shareholders, having only one class of stock, and not being an ineligible corporation (like certain financial institutions, insurance companies, and international sales corporations). Different industries might have unique considerations, such as regulatory environments for financial or healthcare sectors, which could influence the decision to elect S-Corporation status.

What does the transition to S corporation cost? 

Transitioning to an S-Corporation involves various costs, including the initial filing fee for the IRS S corp election (Form 2553), which varies by state. Additionally, legal fees for drafting the necessary corporate documents can add up. Ongoing costs include annual report filing fees, state-specific franchise taxes, and the potential for higher accounting and tax preparation fees due to the more complex nature of S corp taxation. Business owners should budget for these expenses and weigh them against the potential tax and liability benefits.

How long does the transition to S corporation take? 

To transition to an S-Corporation, first, incorporate your business as a corporation in your state. Then file IRS Form 2553 for the S-Corp election, ideally within two months and 15 days after the beginning of the tax year in which the election is to take effect. The process involves drafting corporate bylaws, issuing stock certificates to shareholders, and setting up a board of directors. The timeline can vary, but the entire process typically takes several weeks to a few months, depending on the complexity and the state's processing times.

Your personal liability and asset protection 

In an S corporation, shareholders’ personal assets are generally protected from business debts and legal judgments. This protection is vital in situations like business lawsuits or debt defaults, where only the assets of the corporation, not the personal assets of the owners, are at risk. However, this protection is not absolute; it can be voided in cases of fraud, negligence, or failure to observe corporate formalities.

Legal and compliance responsibilities as a S corporation

S-Corporations have ongoing legal and compliance responsibilities. These include filing annual reports, maintaining compliance with state and federal regulations, holding annual shareholder and director meetings, and keeping accurate and detailed records of corporate minutes and resolutions. Failing to adhere to these obligations can result in the loss of the S-Corporation status and potential legal and financial repercussions.

Employee implications

As an S-Corporation, the way you handle employee management, payroll, and benefits may change. For instance, shareholders who work in the company must receive reasonable compensation, which requires payroll setup and tax withholdings. Benefits provided to employee-shareholders with more than 2% shares in the corporation are treated differently for tax purposes. The shift also involves adhering to more rigorous employment laws and potentially more complex employee benefits administration.

State-specific regulations

Each state has its own set of rules for S-Corporations, affecting everything from tax rates to compliance requirements. Some states do not recognize the S-Corp election and treat the business as a C-Corp for state tax purposes. Others may impose franchise or other state-specific taxes. Understanding your state’s specific regulations is crucial to ensure compliance and optimize your tax position.

How Bench can help

Transitioning to an S corporation is a significant move that impacts your tax liabilities, legal exposure, and growth trajectory. By understanding the indicators and advantages, you can position your business for future success.

Bench is here to ease this transition. We understand the complexities of running a business, especially when it comes to blending personal and business finances. Our expert bookkeeping and tax filing solutions are tailored to fit your business, regardless of its structure. Whether you're a sole proprietorship, partnership, LLC, or corporation, Bench has the tools and expertise to keep your books compliant and in order. Discover how Bench can support your business.

This post is to be used for informational purposes only and does not constitute legal, business, or tax advice. Each person should consult his or her own attorney, business advisor, or tax advisor with respect to matters referenced in this post. Bench assumes no liability for actions taken in reliance upon the information contained herein.
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