When to Switch From Sole Proprietorship to S Corporation: A Small Business Owner’s Guide

Recent data shows that over 70% of businesses in the US operate as sole proprietorships, but as businesses grow, many make the switch to S Corporations (S Corps) for the tax benefits and liability protection.

By 2024, the number of S Corps in the US has zoomed past 4.5 million!

This isn’t just a US trend — globally, businesses are following suit. Transitioning from sole proprietorships to more formalized entities as they expand.

Now, why the shift? Because as your business grows, so should your structure and strategy.

Transitioning to an S Corp isn’t just an upgrade; it’s a smart move that brings: tax advantages, better protection and more room for expansion.

This guide will break down when and why to make the switch, and how it could be a game-changer for your business.

And when you’re ready to make the leap, doola is here to make the transition seamless — from forming your S Corp to managing taxes and payroll—making sure you’re not just switching, but soaring.

Sole Proprietorship vs. S Corp: Understanding the Basics

Before diving into the specifics, let’s first break down what it means to be a sole proprietor versus an S Corporation owner.

✅ Sole Proprietorship

The simplest form of business ownership, where you, the owner, are the business. You’re personally responsible for all debts, taxes, and liabilities.

✅ S Corporation

A special type of corporation that passes income, losses, deductions, and credits through to shareholders for tax purposes.

This structure combines the liability protection of a corporation with the tax advantages of a partnership.

Why Make the Switch from Sole Proprietorship to S Corporation?

As your business grows, you may find that a sole proprietorship is no longer the most efficient way to operate.

The tipping point often comes down to taxes, personal liability, and long-term business goals.

Below are key indicators it might be time to transition to an S Corp.

1. You’re Paying High Self-Employment Taxes

In a sole proprietorship, your income is subject to self-employment taxes, which cover Social Security and Medicare.

As of 2024, the self-employment tax rate is 15.3%. If your business is making significant profits, this can become a hefty tax burden.

✔️ S Corporation Advantage:

With an S Corp, you can pay yourself a “reasonable salary” and take the rest of the profits as distributions, which are not subject to self-employment tax. This can result in substantial tax savings.

Example:

Let’s break down a comparison of taxes for a sole proprietor versus an S Corp, assuming $80,000 in revenue and $45,000 in business expenses:

In this scenario, while both structures pay taxes, the S Corp allows you to reduce taxable income by paying yourself a salary, resulting in lower overall taxes compared to the sole proprietorship model.

2. You Want Liability Protection

As a sole proprietor, you’re personally responsible for all business debts and liabilities. This means your personal assets — like your home or car — could be at risk if your business faces lawsuits or financial challenges.

✔️ S Corporation Advantage:

An S Corp provides liability protection. This means your personal assets are generally protected from business-related debts and liabilities.

3. You’re Ready to Take on Investors

Sole proprietorships can be limiting when it comes to raising capital.

Investors typically prefer to invest in corporations due to the structure and clear separation between personal and business assets.

✔️ S Corporation Advantage:

With an S Corp, you can issue stock to investors, making it easier to raise capital and grow your business.

4. You’re Expanding and Hiring Employees

As your business grows, you may find yourself needing to hire employees.

While you can certainly do this as a sole proprietor, an S Corp offers more structure and allows you to establish formal payroll systems, benefits, and other employee-related matters.

✔️ S Corporation Advantage:

An S Corp can provide a more professional image, which can be appealing to potential employees.

Additionally, you may be able to offer tax-advantaged benefits like retirement plans or healthcare options.

Set up your LLC S Corporation with doola and experience the benefits.

Why S Corps are Better for Small Businesses

Switching to an S Corp offers far more than just tax breaks and liability protection.

Here’s why making the switch could be a smart move for your growing business:

1. Tax Savings on Distributions

One of the primary benefits of an S Corporation is the ability to distribute profits to shareholders as dividends, which are not subject to self-employment tax.

For business owners, this can significantly reduce the overall tax burden, especially for businesses with high net profits.

No better way to put more money back in your pocket!

2. Avoid Double Taxation

Unlike traditional C Corporations, S Corps sidestep the headache of double taxation.

In a C Corp, the company’s profits are taxed, and then shareholders are taxed again on dividends.

But with an S Corp, profits flow directly to the shareholders, who only pay taxes on their personal returns.

Simple and effective.

3. More Credibility

Incorporating your business as an S Corp can enhance your company’s credibility. This can be beneficial when seeking business loans, partnerships, or even contracts with larger clients.

An incorporated business often appears more legitimate and professional.

4. Flexibility in Profit Distribution

S Corps allow for greater flexibility in how profits are distributed. Owners can take a reasonable salary, and then distribute the remaining profits as dividends.

This flexibility can be a powerful financial management tool for growing businesses.

How to Make the Switch: Transitioning to an S Corporation

Switching from a sole proprietorship to an S Corporation might seem daunting, but the process is more straightforward than it appears.

Here’s how to make the transition smoothly:

Step 1: Set Up a Single-Member LLC

The first step is to create a legal business entity. You need to establish a single-member Limited Liability Company (LLC) (if you haven’t already).

Forming an LLC is relatively simple, but the exact process varies by state.

Typically, you’ll need to complete three main tasks:

✅ Prepare the Necessary Documents

You’ll need to file:

1. Articles of Incorporation

Sometimes called “Certificate of Formation” or “Certificate of Organization”, it outlines basic details about your LLC like its name, the member (you), and your registered agent.

2. Operating Agreement

A well-crafted operating agreement explains how your LLC will operate, including the roles and responsibilities of the member.

✅ Register With Your State

File your LLC’s name and details with the Secretary of State in the state where your business will be based.

You can use your Social Security Number for tax purposes or apply for an Employer Identification Number (EIN) if preferred.

✅ Obtain Necessary Licenses and Permits

Depending on your industry and location, you may need licenses or permits to operate legally. Check with local authorities to determine what’s required.

Step 2: File IRS Form 2553 to Elect S Corporation Status

Once your LLC is set up, you’ll need to file IRS Form 2553 to elect to be taxed as an S Corporation.

Although the form contains four sections, most small businesses only need to focus on:

✅ Part I: Election Information

Here’s what it covers:

• Business details (name, EIN, address)

• Date of incorporation and the date you want the S Corp election to take effect

• Tax year (typically the calendar year for most businesses)

• Shareholder details (since you’re the sole proprietor, this would just be you)

For most businesses, filling out Part I is sufficient. However, here’s a quick overview of the other sections just in case:

✅ Part II: Selection of Fiscal Year

Only fill this out if your business operates on a fiscal year different from the calendar year (this applies to some seasonal businesses).

✅ Part III: Qualified Subchapter S Trust (QSST)

If you have a QSST that owns shares in your S Corporation, this section applies—consult with an accountant if needed.

✅ Part IV: Late Election

If you file Form 2553 on time, you can skip this part entirely.

With Form 2553 submitted, your LLC will be taxed as an S Corporation, offering potential tax savings while maintaining the flexibility and protection of an LLC.

How doola Helps Small Businesses Transition to S Corporation

At doola, we know that transitioning from a sole proprietorship to an S Corporation can feel like a big leap.

That’s why we offer a full suite of services to make the process as seamless as possible.

1. Entity Formation

Whether you’re forming an LLC or a C Corporation, we handle the paperwork and guide you through the steps.

2. Tax Consultation

Our expert Certified Public Accountants (CPAs) will advise you on the tax benefits of becoming an S Corp and ensure you file all necessary IRS forms.

3. Bookkeeping Services

From managing transactions to tracking salary payments, doola’s bookkeeping services keep your finances organized and IRS-compliant.

Ready to take your business to the next level?

Schedule a free consultation with one of our experts today, and let us make your transition to an S Corporation effortless!

FAQs

Is your business eligible to become an S Corporation?

To qualify for S Corporation status, your business must meet specific IRS criteria.

These include being a domestic corporation, having no more than 100 shareholders, offering only one class of stock, and avoiding classification as an ineligible corporation.

Additionally, different industries, like finance or healthcare, may have regulatory considerations that could affect your eligibility for S Corporation status.

What are the costs of transitioning to an S Corporation?

Converting to an S Corporation comes with both initial and ongoing costs. These can include the IRS filing fee for Form 2553, which varies by state, as well as legal fees for preparing corporate documents like bylaws and stock certificates.

You’ll also face recurring expenses such as state filing fees for annual reports, franchise taxes, and potentially higher accounting costs due to the more complex tax structure of an S Corporation.

How long does it take to transition to an S Corporation?

From drafting corporate bylaws to issuing stock and establishing a board of directors, the entire process can take anywhere from several weeks to a few months, depending on your state’s processing times and the complexity of your business.