Can sole proprietors become S corporations?

Okay, the quick answer to this question is "yes."

One-person businesses can often operate as S corporations. And, in fact, many of the do-it-yourself kits I sell here seem to be purchased by self-employed individuals converting their sole proprietorships to subchapter S corporations.

Why a sole proprietor might use an S corporation

The rationale for converting a sole proprietorship to an S corporation works pretty simply.

A one-person sole proprietorship making, for example, $100,000 a year in profits probably pays about $13,000 in self-employment taxes. If this person operates as an S corporation and can fairly pay a salary of $50,000 and then make a $50,000 distribution to its shareholder, the business owner cuts his or her payroll taxes in half--from around $13,000 annually to about $6,500 annually.

So that's the good news, so to speak.

When an S corporation doesn't make sense

A handful of issues need to be considered if you're a sole proprietor contemplating the S corporation option. First, an S corporation will require more paperwork. You'll have to file an annual income tax return with both the federal and probably the state government, for example. And you'll need to prepare payroll checks and payroll tax returns (even if the only employee is the business owner). This paperwork isn't that difficult. But it is extra work.

Another issue to consider is that there probably are some incremental costs you'll pay as an S corporation. For example, you'll pay an extra payroll tax called the federal unemployment tax (or FUTA) that adds about $400 or $500 to your annual tax bill--just because you've become an employee. You'll probably also need to step up and start using a real tax accountant--even if you've been very capable, thank you, of going the TurboTax route in the past.

A danger zone for sole proprietors

One other issue: You do need to set your S corporation compensation to some reasonable amount. You can't lowball your salary. And in fact, some IRS agents take the position that in a one-man business all of the profits should be reported as salary. (Let me say that most tax accountants would disagree with this IRS position.)

A final quick comment: If you're interested in comparing the features of sole proprietors and subchapter S corporations--in other words, if you're looking for s-corp vs. sole proprietor information--look at the articles available at this web site that discuss the advantages and disadvantages of S corporations. They provide comparisons of the S corporation and sole proprietor forms.

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