Can a Sole Proprietor Be an S Corp?
An S corp is a tax status, not a business entity. Learn how a sole proprietor must first change their business structure to become eligible for this election.
As a sole proprietor, you operate an unincorporated business owned and run by one individual, with no legal distinction between you and your company. This structure is simple but offers no personal liability protection. An S corporation, on the other hand, is not a business entity itself but a tax election granted by the IRS. This election allows a business’s profits and losses to be passed directly to the owners’ personal income without being subject to corporate tax rates. Many sole proprietors consider this transition to gain liability protection and potential tax advantages.
The Two-Step Conversion Process
A sole proprietorship cannot directly elect to become an S corporation. The transition is a two-step process that involves changing the fundamental structure of your business before seeking a new tax status from the IRS. This is because the S corporation is a tax classification applied to a formal business entity, not an unincorporated business.
The first step is to form a separate legal business entity. Most commonly, a sole proprietor will form a Limited Liability Company (LLC) or a C Corporation. This act of incorporation or formation creates a legal barrier between the owner’s personal assets and the business’s debts and liabilities.
Once the formal business entity is established with the state, the second step is to file an election with the IRS. By filing Form 2553, “Election by a Small Business Corporation,” the newly formed LLC or corporation requests to be taxed under Subchapter S of the Internal Revenue Code. This election is what confers the S corp status.
S Corporation Eligibility Requirements
To qualify for the S corp election, a business must meet several IRS requirements.
- It must be a domestic corporation or an eligible domestic entity, like an LLC, based in the United States.
- It can have no more than 100 shareholders. For this purpose, members of a family can be treated as a single shareholder.
- Shareholders must be individuals, certain trusts, or estates. Partnerships, corporations, and non-resident alien shareholders are not permitted.
- It is permitted to have only one class of stock, meaning all shares must confer identical rights to distribution and liquidation proceeds, though differences in voting rights are permissible.
Certain types of businesses, such as specific financial institutions, insurance companies, and some domestic international sales corporations, are also ineligible for S corp status.
The Transition Process: From Formation to Filing
The transition requires gathering specific information and filing documents with both state and federal agencies.
State Entity Formation
To begin, you must form a legal entity at the state level by filing formation documents, often with the Secretary of State. For an LLC, this document is the Articles of Organization, while for a corporation, it is the Articles of Incorporation. You will need to provide:
- A unique business name
- A physical business address
- A registered agent’s name and address
- The names and addresses of all LLC members or corporation shareholders
Federal S Corp Election
After establishing the legal entity, the next step is the federal S corp election using IRS Form 2553. To complete it, you will need the corporation’s official name, address, and its Employer Identification Number (EIN). If your business does not have an EIN, you must apply for one before filing. The form also requires the date of incorporation and the state where it occurred. All shareholders must consent to the election by signing the form and providing their contact information, the number of shares they own, and the date they acquired them.
Filing and Confirmation
Most states offer online filing portals for state documents, though mail is also an option. The completed Form 2553 must be submitted to the IRS by mail or fax. The correct address or fax number depends on the business’s location and is provided in the form’s instructions. The deadline for filing is typically no more than two months and 15 days after the beginning of the tax year the election is to take effect. After filing, the IRS will send a confirmation notice, such as Form CP261, if the election is approved, which can take several weeks to a few months.
Ongoing Compliance for S Corporations
Operating as an S corporation introduces new compliance responsibilities. A primary change is the requirement for owner-employees to receive a “reasonable salary.” This salary must be processed through a formal payroll system with payroll taxes withheld, a distinct shift from the owner’s draws in a sole proprietorship.
The tax filing process is also more complex. An S corporation files an annual corporate tax return using Form 1120-S. Each shareholder receives a Schedule K-1, which details their share of the company’s financial results, and they use this information to report the income or loss on their personal tax returns.
S corporations also have state-level compliance duties. Most states require annual reports and the payment of franchise taxes or other fees to remain in good standing with the state. Businesses are also expected to adhere to corporate formalities, such as holding annual shareholder meetings and keeping detailed minutes of significant business decisions.