Do you want to change your business entity from sole proprietor to S Corporation? If YES, here is 5-step guide on how to convert sole proprietorship to S Corp. For most new business owners, entrepreneurship is exciting, rewarding, and at times utterly confusing. From the very beginning, few people who wish to start a business spend much thought on their entity type or the tax structure of their business.
Some are also so eager to get things off the ground that they feel a sole proprietorship is just fine. And it makes sense, especially if they are starting a relatively simple business where they will be working for themselves, and won’t be hiring any employees in the near future.
But as a business grows and expands, reasons start piling up why a sole proprietorship may no longer be the right entity form. Then, these business owners start considering options like an S Corporation.
What is a S Corporation?
Subchapter S Corporations, aka S corps, is a special designation under the tax code. It offers its owners limited liability and flow – through tax status, allowing them to avoid double taxation. S corps is a tax status that a business “elects” by filing Form 2553. It simply means that the owners must first create a corporation or limited liability company, and then choose to be taxed as an S corporation by submitting the form.
Benefits of Changing to S Corp from Sole Proprietorship?
There are many reasons why sole proprietors start considering the S corp. status. One of the key reasons is the need to protect personal assets. Indeed many different entity types can protect owners’ personal assets, and S corps is chief among them. The bonus is that S corps has other benefits, too.
For instance, if you are a business owner who wants to take a salary as a tax – deductible expense, then an S corp. is the ideal option. S corp. rules mandates owners to pay themselves reasonable compensation, and your salary helps comply with those rules.
Furthermore, with an S Corporation, you enjoy a 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 tends to trigger the termination of the entity. Additionally, 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.
Also note that Corporations are expected to 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.
Corporations are great for protecting assets but they are 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.
How to Convert Sole Proprietorship to S Corporation
An S corporation is a federal law concept that allows an existing corporation to be taxed as a partnership with the U.S. Internal Revenue Service (IRS). If your business is operating as a sole proprietorship, and you are a U.S. citizen or equivalent, converting to an S corporation is relatively simple. The process for forming a corporation is pretty similar in most states.
1. Select a State and a Business Name
In most circumstances, you will have to form your new corporation in the state where you live, but there might be a situation when a different state makes sense.
For instance, if your company is buying a business or property in another state, or you company is admitting investors who prefer a well – known business jurisdiction such as Delaware or New York as the corporation’s governing law, or you want certain benefits offered by a tax – friendly state such as Delaware or Wyoming, then you can choose a different state.
However, before forming, you are expected to choose a name for your corporation, and state laws mandate corporations to have relatively unique names to avoid confusion. Most states have an online database where you can search for available names.
2. Have a Registered Agent
In the United States, each corporation is expected to have a registered agent residing in the formation state to provide the government, tax authorities, and private citizens and companies a permanent, reliable location to send mail and legal documents to the corporation. Note that you can also appoint yourself as the company’s registered agent if you live in the formation state, but most corporations hire a corporate services company as the registered agent.
Every sole proprietor that converts to an S corporation is expected to file articles of incorporation with the secretary or department of state. The articles of incorporation tend to contain the name and address of the business, the name and address of each incorporator, and the number of shares the company has the authority to issue. Note that Incorporators are in charge of filing the articles with the secretary or department of state.
The name and address of the person or business responsible for accepting legal documents on behalf of the S corporation must appear in the articles. However, depending on the state of incorporation, the articles may have to include the name and address of the company’s initial directors. The cost to file articles of incorporation vary based on the state of incorporation.
4. Capitalize the Corporation and Draft Initial Documentation
Note that once your corporation exists, you contribute the business assets you own personally in exchange for shares of stock. These contributions are usually documented with a bill of sale or simple contribution agreement. The company issues a stock certificate to you—and any other shareholders who may invest—and records it in the corporation’s stock transfer ledger.
Your new corporation will also need to draft a Bylaw, which spells out the rules by which the stockholders, directors, and officers manage the company. There are no specific guidelines to follow when writing bylaws for an S corporation.
The owners and directors of the business may include whatever provisions are deemed necessary to run the company effectively. The bylaws may contain the date and time of meetings, criteria for selecting new directors, the duties of company officers and procedures for amending the bylaws.
S corporations should keep their bylaws at the company’s primary office location. You will also need to draft Initial resolutions of the shareholder(s) electing directors to the board and adopting the bylaws, and also initial resolutions of the directors appointing officers.
5. Elect S Corp. Taxation and Complete Other Tax Requirements
Note that your corporation is expected to apply for an employer identification number (EIN), which is a federal tax identification number and often likened to a Social Security number for your business. The IRS website offers the fastest way to get an EIN or an EIN can be obtained by calling the IRS Business and Specialty Tax Line at 800 – 829 – 4933.
The name, location and description of the business are expected to appear on the EIN application. The application must include the number of people who work for the business. The name, address and Social Security number of an authorized individual must appear on the EIN application.
After issuing stocks and receiving an EIN, your business can elect S corp. taxation. To do this, you must file for Election by a Small Business Corporation under section 1362 of the Internal Revenue Code (Form 2553) with the IRS. Form 2553 requests the name and location of the business, the fiscal year of the company, EIN, date of incorporation, state of incorporation and the effective date of the S corporation election.
Every shareholder must sign Form 2553. The IRS will notify the company in writing regarding its acceptance or denial of S corporation status. An authorized representative must call 800 – 829 – 4933 if proper notification hasn’t been received within 60 days.
When looking to convert to an S Corporation, an attorney may help if you want to correctly draft your documents. Once your filings are complete and the conversion is approved, you’ll continue to receive the same benefits you had as a sole proprietor while reaping the rewards of business expansion, like admitting new members into your venture.