Subchapter S of the Internal Revenue Code gives corporations the opportunity to enjoy the financial liability protection of incorporating while avoiding the double taxation inherent in the basic corporate structure. Also known as an S corporation, or S corp, this tax option limits both the number of shareholders and stock classifications, which can make it an attractive choice for sole proprietors considering adopting a corporate business structure. But a business cannot change directly from a sole proprietorship to an S corp: It must close the sole proprietorship and create a new corporation.
Unlike basis corporations, there are restrictions on the types of businesses that can become S corps as well as on where these businesses and their boards are located. Where the company does business, how much it pays its employees and the types of businesses an S corp can own are also subject to federal regulation and monitoring. For example, a business that earns the bulk of its income from exports is ineligible to become an S corp, as is one that has corporate or foreign investors. View the instructions for Internal Revenue Service Form 2553 for a complete list of restrictions.
An existing sole proprietorship must also examine the financial and service ramifications of closing its business to reopen as an S corp. Contact insurance companies to ensure that policies are transferable to the new S corp; some are not. Lines of credit and notes payable may also be nontransferable and you may be required to renegotiate your lease; read your agreements thoroughly before beginning the incorporation process. Additionally, be aware that the S corp cannot assume payroll liability for the sole proprietorship; these must be paid through the business’s closing date.
File Incorporation Papers
File articles of incorporation with the appropriate state agency, usually the secretary of state. The information required and the number of board members that must be named vary by state, as do the filing fees, which can range from $40 to $495. Every state requires that articles of incorporation include the name, location and phone number of the business as well as the name and contact information for the person responsible for receiving and acting on the company’s legal documents. The required forms as well as instructions for their completion are typically available for download on state websites.
Hold a Meeting
Call an initial board meeting; every state requires that all business governing corporate operations be ratified by shareholder vote and that the vote be documented. Conduct the business of officially naming the board of directors, electing officers and ratifying the bylaws. You also need to hold a vote that confirms the corporation's desire to file for the tax option of becoming an S corp.
Download and complete IRS Form 2553, which is the request for S corp status. Every shareholder must sign it; if this is impossible, the IRS allows corporations to substitute a special shareholder consent form. Form 2553 only needs to be filed once, but for the tax option to apply to the current tax year, it must be filed by the 15th day of the third month of the company’s fiscal year.
Finalize Corporate Status
File amended articles of incorporation with the secretary of state’s office that include the S corp’s management structure, bylaws, a description of the type of business to be conducted and the number of stock shares. Include a statement of intent to operate as an S corp and attach a copy of IRS Form 2553. The secretary of state will typically approve the paperwork and issue a certificate of incorporation in four to six weeks.