If you’ve been running a successful sole proprietorship for some time, first of all, congratulations! It’s no small feat getting a business off the ground and turning a profit. But as your company grows, there are aspects of the sole proprietorship structure that may no longer serve you, like for example, the lack of legal separation between you and your business.
If your business does not operate as a separate legal entity, that means any business debts or legal obligations fall entirely on you. This is just one of several reasons why it can make sense to incorporate your business and form a separate entity. An S corporation has particular benefits—and tax advantages—that can make it a great next step for sole proprietors. In this article, we’ll walk through the decision to make the jump from sole prop to S corp, as well as the steps to convert your business entity should you choose to.
Quick Links
Business entity types
First, let’s get a refresher on the various entity types. There are five main ones to choose from. Here’s a quick breakdown:
- Sole proprietorship: This is your business type if you have started and operate a business but have not chosen a different business structure. It allows you to operate without any legal or tax complications—or protections.
- Partnership: When two or more people operate a trade or business as co-owners, they are by default considered a partnership.
- Limited liability company (LLC): A separate but flexible legal entity that can be taxed as you choose, either like a sole proprietorship or as an S or C corporation.
- S corporation: S corps have the limited liability of a corporation but are taxed as pass-through entities, meaning any business earnings or losses pass through to the shareholders and are reported on individual tax returns.
- C corporation: An independent legal entity that allows for unlimited shareholders and public trading, but comes with the most rules and regulations.
Each entity type has its pros and cons, and it’s important to consider several elements of your personal situation before deciding which structure makes the most sense for your business’s current needs. For burgeoning companies that are starting to need more in the way of legal and tax benefits, LLCs and S corps tend to be attractive options. Let’s take a look at why.
S corp vs LLC
Two of the most popular options for sole proprietors to consider are the S corporation and LLC. Both of them can be classified as pass through entities and limit an owner’s personal liability—but their differences may help you decide which one makes the most sense for your business. Let’s cover the main differences:
Management structure
LLCs are the go-to option for flexibility, and that extends to their management structure. Your company has the option of being “member managed,” meaning it’s managed by the owners, or “manager managed,” which means it’s managed by a designated manager. S corps on the other hand require you to have both a board of directors and officers.
Taxation structure
S corps are taxed as pass through entities, while LLCs have the option of being taxed as a pass through entity or as a corporation. What are pass through entities again? This type of tax structure means that the earnings, losses, deductions, and credits from an operation all pass through to the company’s shareholders. Instead of the business paying a corporate tax on its earnings, the shareholders receive an income and pay taxes on that amount on their individual returns.
This can be a major benefit for companies of a certain size. S corps can have up to 100 shareholders who take distributions of the company earnings, which are not subject to employment taxes (up to a certain amount). LLCs, on the other hand, have the option of being taxed either as a pass through entity or as a corporation. An LLC allows you to choose which payment structure best suits your circumstances.
Self-employment tax
S corporations have a unique benefit: S corp owners only have to pay self-employment tax on any wages taken as a salary by the shareholders. The rest of the company’s profits are essentially tax free. LLCs, however, pay self-employment taxes on all company profits.
Formal requirements
LLCs continue to be a more lax entity type in that there are few to no requirements of its owners, while S corps come with a number of formal business requirements, including regular meetings, detailed record keeping, appointed directors and officers, and more.
Benefits of an S corp
Incorporating your business as an S corp or LLC comes with protection of your personal assets from business liabilities like debts or lawsuits. But there are a few benefits unique to an S corporation that are worth considering:
Corporate benefits without double taxation
S corporations enjoy many of the benefits of larger C corporations—the ability to distribute company profits, buy and sell shares, limited liability, etc.—while only being subject to individual income taxes. C corporations pay both a corporate tax on company profits as well as individual income taxes on any earnings shareholders take from the company. While an LLC can elect to be taxed like an S corporation, this is a taxation structure unique to the S corp.
Once again, minimized self-employment taxes
Let’s take a look at an example, comparing how much self-employment or payroll tax you would incur as a sole proprietor or as an S corp with $75,000 in revenue and $40,000 in business expenses:
| Sole prop | S corp | |
| Total revenue | $75,000 | |
| Business expenses | $40,000 | |
| Salary | N/A | $25,000 |
| Employer payroll taxes | N/A | $2,346.50 |
| Taxable income | $35,000 | $7,652.50 |
| Self-employment tax | $4,945.34 | N/A |
| Employee payroll tax | N/A | $1,912.50 |
| Total payroll taxes paid | $4,945.34 | $4,259 |
S corp owners only pay self-employment taxes on wages taken from company earnings as opposed to their net business income. This means S corp owners can choose to take a smaller salary in addition to distributions of company profits, which are not subject to any employment taxes, to minimize their tax liability. You’ll want to be careful not to abuse this arrangement though, so be sure to consult our guide on paying yourself as an S corp.
Growth opportunities
An S corp, with its allowance of up to 100 shareholders, makes your company more attractive to investors, who can take distributions of any excess profit. S corps do have requirements that are similar to C corporations, which can mean more paperwork—but also meaning you’ll have a leg up with an established board of directors and officers to steward your company as it grows. The increased structure and stability of an S corp can make your business seem more reliable to both investors and clients.
Signs you should consider an S corp
As you operate a sole proprietorship, here are some signs that may indicate it’s time to consider an S corp:
- Uptick in liability risks: Is your business incurring debts that are difficult to keep up with? In the course of operating, have you encountered any lawsuits? Have you taken on loans or lines of credit? As these liabilities compound, it can be a smart financial and legal move to make your business a separate legal entity to protect your personal assets.
- Raking in profits: Don’t get us wrong, this is a GREAT problem to have. But as your profits grow, so does your tax burden. As we mentioned, S corps have multiple tax advantages that help you decrease the amount of your earnings that is subject to taxation.
- Investors: Once again, the S corp allowance of up to 100 shareholders makes it easy to bring in external investors as and when your company requires funding.
Is an S corp right for your business? Factors to consider
Before you form an S corp, you should be sure that your business can cover the additional associated costs, including:
- Owner’s salary
- Payroll taxes
- Payroll processing fees
- Tax preparation fees
- Annual state fees
- Bookkeeping and accounting fees
- Insurance
- Legal costs
It’s important to ensure that your cash flow is consistent enough to cover your payroll and any associated costs on a regular basis.
Crunch the numbers to see whether an S corp would be to your benefit from a tax perspective. You can run scenarios like the one above to calculate how much or little you stand to save based on your current revenue numbers and expenses. Understanding how much taxable income you’ll have is key, and an accountant can help you figure out when a jump to S corp may make the most sense.
You might also consider an S corp if your business income has reached a certain level that makes your tax burden untenable. The S corp payment structures of salary and distribution can help lower your tax burden and give you more options for paying yourself.
Finally, take stock of your plans for the future:
- Do you plan on looking for investors?
- Do you foresee a merger or acquisition by another business?
- Will you want to add one or multiple business partners?
Establishing an S corp gives you both the flexibility and structure needed as your business grows. Consider these factors with trusted financial and legal advisors to best understand whether making the leap to an S corp is right for your sole prop.
3 steps to convert from a sole prop to S corp
Once you’ve weighed your situation and options, it’s finally time to convert your sole prop to an S corp. Here are the 3 steps to get you there:
Step 1: Form an LLC
Yes, to form an S corp, you must first register as a limited liability company. We cover this process in depth elsewhere, but here’s a quick rundown of what it typically involves:
- Choose a business name.
- File your Articles of Organization, which includes your business name, address, members, etc.
- Create an operating agreement, which contains your financial and operating processes.
- Register your business with your state.
- Apply for an EIN and any licenses and permits required by your city, state, and county.
Step 2: Determine your eligibility
The IRS has several requirements of S corps, including the following:
- Must be a domestic corporation
- Must have only one class of stock
- Can have no more than 100 shareholders
- Can have no nonresident alien shareholders
- Shareholders must be individuals, estates, and certain trusts
If you meet all the requirements, you’re ready for the next step.
Step 3: File IRS form 2553
IRS form 2553 is also known as Election by a Small Business Corporation. Filing this form will convert your single-member LLC to an S corp. The main section you need to worry about is your Election Information, where you will list your name, EIN, address, the date of incorporation, your choice of Subchapter S election effective date, and just a few more items. Submit this form, and you’re on your way to S corp-hood.
