New businesses must be classified for legal and tax purposes. Many start unincorporated, often as a partnership or sole proprietorship. However, entrepreneurs may opt to incorporate their business for better legal protection or tax reasons.
What Is a Sole Proprietorship?
Unless additional paperwork is filed, new businesses default to an unincorporated legal structure, like sole proprietorships or partnerships depending on the number of business owners involved. If there is a single owner, that business is considered a sole proprietorship. Two or more, and it’s considered a partnership. As long as the business has all of the proper licenses and permits required by applicable laws, it is legally ready to operate.
The sole proprietorship business structure is one of the most common types of business structures because setting it up is cost effective, faster than alternative options, and simpler, and it offers the most control for the business owner. Taxes are kept simpler, as business income is reported on the business owner’s personal income tax.
Despite the ease of establishing a sole proprietorship, there are disadvantages that business owners should be aware of. Legal liability protection is minimal, as the business assets and personal assets of the entrepreneur are not legally separated.
That means that if an owner faces financial trouble, they may find their personal assets—a house or car—at risk. A business owner also must pay self-employment taxes in addition to standard income tax.
What Is an S Corp?
An S corp is an incorporated business structure that has filed IRS Form 2253, indicating compliance with the requirements outlined in subchapter S of the tax code. To qualify as an S corp, businesses must:
- Only have one class of stock.
- Not have more than 100 shareholders, which:
- Can be individuals, certain types of trusts, and estates.
- Cannot be partnerships or other corporations.
- Be a domestic corporation.
- Not be an ineligible business type, such as certain types of financial, insurance, or international sales corporations.
An S corp provides legal distance between the personal assets and business assets of the business owners in case of legal action. Other advantages include pass-through taxation, where profits and losses pass through to the owner’s personal accounts and taxes and are reported on individual income taxes, employees can receive dividends, and the business may appear more credible to investors and lenders.
Business owners who choose not to pursue S corp may do so because it takes additional paperwork for the initial filing and for maintaining that status through the years. Financial records are also typically under more scrutiny and must be meticulously kept.
When a Business Changes From Sole Proprietor to S Corp
There is no universal rule for when it’s best to change from a sole proprietorship to an S corp, but doing so first requires forming a corporation or LLC. To do this, the business owner(s) must choose the state for incorporation, file articles of incorporation, and appoint a registered agent in that state.
Business owners who are considering the change would benefit from asking a series of reflective questions and then seeking out a professional for input and guidance. Some of the questions may include:
- Does the business carry significant financial risk? Some financial institutions may have a specific monetary or capital value in mind for a business to be considered “at risk,” but those institutions also evaluate other factors like the business’s nature and the owner’s assets.
- Does the business meet the S Corp requirements determined by the IRS? Business owners need to examine the qualifications for S corp and proceed only if their business meets all of them.
Switching From a Sole Proprietorship to an S Corp
Corporations must file for an S corp election with the IRS no more than two months and 15 days after the beginning of the corporation’s tax year. Businesses that aren’t already either incorporated or an LLC will need to complete the appropriate steps for establishing themselves as either a corporation or LLC before filing an S corp election.
There are resources to help you learn how to select the best business structure for your needs. Columbia Law’s A Legal Toolkit for Starting and Scaling Your Business is a 100% online non-credit certificate course, ideal for busy entrepreneurs who navigate common legal obstacles like contracts and tax structures with confidence.