No. A sole proprietorship can’t elect or change to an S Corp directly. Instead, the owner will first have to form either an LLC or a C Corp before electing S Corp status with the Internal Revenue Service (IRS). To be taxed as an S Corp, a sole proprietor would need to change their business structure into a corporation or LLC.
However, experts suggest using an LLC especially since a corporation would very rarely benefit from electing S Corp tax status. A good number of small business owners are just very excited to start their business and start making a profit without taking into consideration what the most suitable business structure for their company is.
Owing to that, new businesses most often start as sole proprietorships. However, as a business grows, there are a good number of valid reasons why a sole proprietorship may not continue to be the ideal business structure. A sole proprietorship is a good business structure, especially if the business has only just an employee and doesn’t carry any risk or liability.
However, numerous benefits come with electing S Corp status with the IRS as your business grows. A sole proprietorship is the simplest business structure; it’s unincorporated and is not considered legally separate from its owner and equally offers no limited liability protection for the owner.
Another issue with the sole proprietorship is that the owner pays both income tax and self-employment (FICA) taxes on the net profits of the business. These profits pass through to the owner, who reports them on their personal income tax returns and pays the same tax rate on them as they do on their other income.
However, this tax arrangement can be suitable for a while as long as the company doesn’t have much in terms of profits. Howbeit, as profits increase, paying both income tax and self-employment tax on all of the business’s net profits can become exorbitant.
Owing to that, a sole proprietorship may seek ways to elect to be taxed as an S Corp. The S corporation is a tax status that is applied to a business entity if it qualifies and is registered. Just like an LLC or C Corp, an S Corp offers limited liability protection to its owner.
But to elect S Corp status, a sole proprietorship will have to first form an LLC or C Corp. However, since C Corps offers advantages that S Corps lack, it is not always advisable to form a C Corp and then elect S Corp status. If a C Corp is the best business structure for your company, it should remain as such.
How a Sole Proprietor Can Elect S Corp Status
The owner of a sole proprietorship can elect S Corp status but will first have to establish itself as a single-member LLC. To do this, here are steps to follow;
Establish a Single-Member Limited Liability Company (LLC)
Starting an LLC and electing S Corp tax status remains the most viable route for a sole proprietor. Have it in mind that the LLC will be your legal entity structure. However, note that every state tends to have its own set of rules when it comes to establishing an LLC. Most often, it will include the following three steps:
- Get your paperwork in order. This will more or less consist of your: a) Articles of Incorporation (“Certification of Formation” or “Certification of Organization”). This tends to contain the basic information of your LLC: its business name, member (you), and who your registered agent is; b) Operating Agreement: the document most often states how the LLC will be managed, coupled with other bylaws, rules, and responsibilities of the member
- Register with the secretary of state. You will be expected to choose an available name for your business and also register with the secretary of state where it will be domiciled. As a single-member LLC, note that you are allowed to use your Social Security Number for tax filings, or you can apply for an employer identification number (EIN).
- Apply for licenses and permits. This will most often depend on the sort of business you are running or the services you offer. However, it may be necessary to apply for licenses or permits to run the business legally. Ensure to research your city and county governments to find out what requirements exist.
You can reach out to an experienced and trusted attorney to help you with these items; howbeit, if your business will be pretty basic, then you can do all these yourself especially since it is easy to handle.
File for S Corp Status
To elect for S Corp Status for your newly formed LLC, you will have to file IRS Form 2553 Election by a Small Business Corporation. Note there are four sections to a Form 2553, but a good number of small businesses looking to elect S Corp may only have to another about one of them:
Part I: Election Information: This part of the form tends to include all vital information about your company. Information you will need includes your business name, EIN, address, the date it was incorporated, when you want the Subchapter S election to be effective, your tax year, and many other minor but vital information.
In this part of the form, you will also be expected to provide details about all the shareholders, but if you’re running a sole proprietorship, that will have to be just you. While this Part I will be enough for a good number of new businesses, you might have to fill the other parts quickly, just in case:
Part II: Selection of Fiscal Year: This part of the form tends to apply to businesses whose tax year will not operate on a calendar year. Most often, they can be for seasonal businesses and others that have an aim of operating on a year other than the calendar. If as a business owner you believe you might need an alternate tax year, then reach out 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 believe this might apply to you, ensure to consult with your accountant.
Part IV: Late Corporate Classification Election: As long as you file IRS Form 2553 by the relevant deadline, then you do not need to bother about this section.
All in all, a sole proprietorship business isn’t eligible to directly convert to an S Corp. If you are running a small business as a sole proprietorship or looking to start a business, it might be ideal to elect an S corporation (S Corp) status.
An S Corp will help protect your personal assets and ensure that you can save on self-employment taxes compared to a sole proprietorship. Starting an LLC and electing S Corp tax status is easy, you just have to leverage the guide and directions explained above to do it yourself.