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Outgrowing Sole Proprietor Status
Starting a small business involves numerous decisions and detailed logistical planning. Many entrepreneurs become so absorbed in the operational and sales aspects of the new enterprise that they forgo the perceived expense and complexity of incorporation and elect to open as a sole proprietor.
However, as the business begins to grow and prosper, examining the benefits of converting to S corp from sole proprietor will often justify the time and expense of the incorporation.
There are several advantages that S corporations have relative to sole proprietor status. All corporations regardless of classification offer a significant degree of personal liability protection. As the corporation exists legally as its own entity, product liability and most other forms of business related civil lawsuits can only be directed against the corporation itself and not its shareholders or directors. Subsequent monetary awards in the event of an unfavorable court decision typically apply only to the corporation as well. An incorporated company also has the ability to seek bankruptcy protection without affecting the credit or finances of the individual owners.
Conversely, sole proprietors assume personal liability for many of these same occurrences. As such, this aspect alone motivates many sole proprietors to reclassify as an S corporation once they are aware of the legal protections it affords. It is important to recognize that any business that generates revenue has potential liability no matter how small or isolated it may seem to be.
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Differences Between a C and S Corporation
When the decision to incorporate has been made, many small businesses choose an S election over a traditional C corporation primarily because of the differences in tax treatment.
A C corporation faces the potential of double taxation on all of its retained earnings. After the business pays its corporate taxes, any dividends that are dispersed to shareholders are taxed again at individual rates.
Subchapter S provides the same legal protection of a C corporation in terms of personal liability but avoids the double taxation. By filing I.R.S form 2553 and with the consent of its shareholders, the corporation elects to obtain the special tax status. Any retained earnings are passed through to the shareholders who include their disbursement on their individual returns where it is treated like ordinary income.
Likewise, business losses are also passed on to shareholders. These losses can be used to offset income earned from different sources and other interests. This can prove to be very advantageous, especially in the developmental stages of a new business where initial losses are not uncommon.
Incorporating also lends additional credibility to the perception of the business. This may prove important when trying to obtain funding or attempting to attract qualified employees.
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Sole Proprietor Status to S Corporation
Technically, since a sole proprietorship is not considered separate from the business owner, it is not regard as a stand alone legal entity. Therefore it is not necessary or possible to actually “convert" to an S corporation.
Instead the sole proprietorship would simply no longer exist and the new corporation would assume daily business functions. Some states require a certificate of formation while all states require the filing of the Articles of Incorporation with the Secretary of State. These documents will include the corporation's name, officers, board of directors, stockholders, purpose of the corporation, establshment of the annual meeting, and any other essential information as required by the laws of the incorporating state.
Most states have a requirement for a person to receive process notices or legal notices on behalf of the corporation. This individual is often referred to as the “statutory agent" and is usually a corporate officer or in some cases the legal representative for the corporation.
There are potential tax and liability considerations that should be addressed prior to filing for the subchapter S designation. This would include any loss recapture as a result of the incorporation as well as an analysis of individual liability from activities prior to the incorporation.
Any creditors that held debt under the sole proprietorship will have to agree to convert the debt to the new corporate entity. Otherwise, it will remain the sole responsibility of the individual and all personal obligations remain intact. All existing business contracts should also be examined and potentially rewritten if there are provisions prohibiting reassignment to a new or different entity.
The restrictions and requirements for an S corporation are relatively simple. These include limiting the number of shareholders to 100 as well as dividing disbursements equally as a percentage of ownership.
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Other Incorporation Options
Converting to an S corp from sole proprietor can have significant advantages both personally and monetarily, but it is always best to consult a tax professional and a legal expert to determine if the change is necessary and beneficial.
Bright Hub offers a wealth of information on choosing a legal classification for a new or existing business. The provided links can help in making this very important decision.
- Forming Your Business: Choosing Your Business Structure
- Sole Proprietorships: The Simplest Business Structure
- Forming Your Business: Is a Business Partnership Right for You?