Converting an S Corporation to a Sole Proprietorship in California

Selecting a legal entity is often one of the first critical decisions you must make when starting a new business. But it is possible to change or convert one type of business entity into another if your needs or circumstances change. If you want to know more about the potential tax and legal implications of such a move, the Silicon Valley corporations attorneys at Structure Law Group are here to help.

The Advantages and Disadvantages of S Corporations in California

Let’s assume you currently have an S corporation, and you want to convert it to a sole proprietorship. What are the advantages or disadvantages of such a conversion? And how would you go about accomplishing it?

First, it is important to understand how an S corporation operates. Essentially, an S corporation is a regular corporation organized under the laws of California (or another state) that elects to be taxed as a “pass-through entity” with the Internal Revenue Service. This means that any income, losses, deductions, and tax credits pass through the corporation to the individual shareholders or members of the corporation. The individual owners must then report these items on their personal income tax returns.

The benefit of an S corporation is that the entity itself does not pay any federal income taxes. But there are some restrictions: the IRS must approve S corporation status, there cannot be more than 100 total shareholders, and there are certain restrictions on who can be a shareholder.

Converting an S Corporation or LLC to a Sole Proprietor in California

While most S corporations are corporations, it is also possible for a limited liability company (LLC) to elect S corporation treatment. An LLC is also a pass-through entity. But LLC owners, referred to as members, must pay self-employment tax on any income they receive through the LLC. By electing S corporation status, however, that same income can pass through as either dividends, which are not subject to self-employment tax, or as salary paid to the member acting as an employee of the business. There can be significant tax savings to operating an LLC as an S corporation.

However, if consider an S corporation with just shareholder, it may not be worth the additional administration and expense of maintaining this special status. It is possible under California law to convert an existing S corporation or LLC to a sole proprietorship. A sole proprietor must report any income or losses from their business on their personal tax return, the same as with an LLC that does not elect S corporation status. And a sole proprietor lacks any legal protection for their personal assets. This is one of many examples, but it is important to consider all of the implications of proceeding with this type of conversion.

Our Silicon Valley Corporations Lawyers Can Help Your Business

Before selecting or converting a legal entity for any business, it is always a good idea to consult with a qualified Silicon Valley business attorney who can walk you through all of your options. Contact SLG today to schedule a consultation.