This article is written by our friends at Gusto.
When new business owners are eager to get things off the ground, a sole proprietorship makes sense, especially if they are starting a relatively simple business where they’ll be working for themselves and won’t be hiring any employees in the near future.
As a business grows, however, there are many reasons why a sole proprietorship may not continue to be the right entity form. If this sounds like you, you’re in luck. This post covers a good solution for a new structure: the small (but mighty) S corporation, commonly known as the S corp.
Business structures, tax status, and S corps—what you need to know
Before we dive in, we’ll point you to some useful resources on business entities and revisit tax structure just so you’re familiar with them.
Let’s start with entity types. There are five main entity types:
- Sole proprietorship
- Limited liability company
- S corporation (or S corp)
- C corporation (or C corp)
Your entity choice (or type of business) has a direct impact on how you’re taxed, what degree of liability you’re exposed to, who your owners can be, and more. Each entity type has its pros and cons, so you’ll want to think carefully about your options.
How an entity is taxed is one of the chief drivers of decisions on entity types. S corporations, for example, are often considered a smart choice because of the tax benefits they offer.
Self-employed individuals such as sole proprietors generally must pay self-employment tax as well as income tax at their individual tax rate, just like before they started the business. They report their income and expenses on their personal tax returns, rather than on a separate business tax return like a corporation would.
S corporations don’t pay corporate income taxes. Instead, they are treated as pass-through entities, which means earnings from the business will “pass through” to be included on the owner(s)’ personal income tax returns.
Subchapter S Corporations, aka S corps, operate under a special designation of the tax code. The S corporation provides its owners with limited liability and flow-through tax status, allowing them to avoid double taxation (more on that below).
It’s important to remember that S corporation status is a tax status that a business “elects” by filing IRS Form 2553. That means the owners must first create a corporation or limited liability company and then choose to be taxed as an S corp by submitting the form to the Internal Revenue Service.
How to know when an S corp is right for your business
There are a few key indications that should cause a sole proprietor to consider S corp status. If at least two of the following points are of high interest to you, an S corp will probably be the way to go.
- You want to protect your personal assets: Many different entity types offer personal liability protection, and S corps are chief among them. The bonus is, S corps have other benefits, too.
- You want to draw a salary: If you’re a business owner who wants to take a salary as a tax-deductible expense, then an S corp is the way to go. S corp rules require owners to pay themselves reasonable compensation, and your salary helps comply with those rules.
- You want flexible ownership: Interests in an S corporation can be transferred without triggering adverse tax consequences. In a partnership or LLC, the transfer of more than a 50-percent interest can trigger the termination of the entity. Also, an S corporation does not need to make adjustments to the property basis or comply with complicated accounting rules when an ownership interest is transferred.
- You want accounting to be easy: Corporations must use the accrual method of accounting unless they are considered to be small corporations. S corporations, however, usually don’t have to use the accrual method unless they have inventory.
- You want to avoid double taxation: Corporations are great for protecting assets, but they’re not so great for taxes. C corporations pay tax on their profits, and their shareholders pay tax on dividends or other distributions they receive. By electing S corp status, any dividends or distributions will only be taxed once: at the shareholder level.
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How to convert from a sole prop to an S corp
If your business is operating as a sole proprietorship, and you’re a U.S. citizen or equivalent, converting to an S corporation is relatively simple.
Step 1: Establish a single-member limited liability company (LLC) (assuming that you haven’t already done so). This LLC will be your legal entity structure. Forming an LLC is also relatively simple, but keep in mind that every state will have its own set of rules. In general, there are three steps to creating an LLC:
- Get your paperwork in order. This typically consists of your: a) Articles of Incorporation (aka “Certification of Formation” or “Certification of Organization”). This has the basic information of your LLC: its business name, member (you), and who your registered agent is; b) Operating Agreement: the document that states how the LLC is run, along with other bylaws, rules, and responsibilities of the member (again, you).
- Register with the secretary of state. You should name and register your business with the secretary of state where it will be domiciled. As a single-member LLC, you can use your Social Security Number for tax filings, or you can apply for an employer identification number (EIN).
- Apply for licenses and permits. Depending on your business, it may be necessary to apply for licenses or permits to operate it legally. Check with your city and county governments to find out what requirements exist.
An attorney can help you with these items, but if your business will be pretty basic, completing them shouldn’t be too difficult.
Step 2: File IRS Form 2553 Election by a Small Business Corporation to convert your single-member LLC to an S corp. There are four sections to a Form 2553, but most small businesses really only need to worry about one of them:
- Part I: Election Information: This will include all pertinent information about your business. Its name, EIN, address, the date it was incorporated, when you want the Subchapter S election to be effective, your tax year, and a few other minor items. It will also ask for the details for all the shareholders, but if you’re running a sole proprietorship, that should only be you.
Filling out the required information in Part I will suffice for most businesses, but we’ll cover the other parts quickly, just in case:
- Part II: Selection of Fiscal Year: This section only applies to businesses whose tax year will not operate on a calendar year. This can be applicable for seasonal businesses and others that have a purpose for operating on a year other than the calendar. If you think you might need an alternate tax year, talk to an accountant or other business advisor.
- Part III: Qualified Subchapter S Trust (QSST): A QSST owns shares in an S corporation and pays its income to the trust beneficiary. If you think this might apply to you, talk to your accountant.
- Part IV: Late Corporate Classification Election: If you file IRS Form 2553 by the relevant deadline, then you can skip this section.
Tax advantages to S corps
There are a few tax advantages to converting to an S corporation.
- First, because the owner of an S corp is required to pay themselves a “reasonable salary,” the business can deduct this expense for bookkeeping and tax purposes.
- Likewise, an S corp must withhold and pay its share of FICA payroll taxes. Those are deductible expenses, too. Those expenses reduce your S corp’s overall profit, which, in turn, reduces its owner’s taxable income. Pretty great, right?
- What’s even better is that by converting to an S corp, a business owner can avoid the 15.3% self-employment tax. Your sole prop, even if it’s organized as an LLC, can’t do that.
These are just a few of the S Corp tax advantages, for more details, check out this simple guide to S Corp Taxes.
Here’s a simple example to help illustrate the tax savings
*Assumes FUTA wage base and rate for: $7,000 and 6% respectively.
**Includes SE tax of 15.3% and the SE tax deduction of 50%.
Whether your sole proprietorship is relatively new or well established, in many cases, converting it to an S corp has too many benefits to ignore.