Choosing the right business structure is one of the most important financial decisions a business owner can make. While an S Corporation (S-Corp) can offer tax savings and long-term growth opportunities, it is not a one-size-fits-all solution. Many businesses transition from a Sole Proprietorship or Single-Member LLC (SMLLC) to an S-Corp to reduce self-employment taxes and gain credibility, but making this change without proper bookkeeping or financial analysis can lead to costly mistakes.
In this guide, we’ll explore why businesses start as sole proprietors, when to transition to an S-Corp, potential drawbacks, and how to file an S-Election.
Why Do Businesses Start as Sole Proprietors or SMLLCs?
Many small businesses begin as Sole Proprietorships or Single-Member LLCs (SMLLCs) because these structures offer:
✅ Easy setup – Minimal paperwork and low administrative costs.
✅ Simple taxation – Business income is reported on the owner's personal tax return (Schedule C).
✅ No payroll requirements – Owners take draws instead of a salary.
For new businesses with low profits, remaining a Sole Proprietor or SMLLC is often the best choice. However, as profits grow, self-employment taxes (15.3% on net earnings) can become a major burden—this is when business owners start considering an S-Corp election.
What Is an S-Corp?
An S-Corp is a tax election, not a separate legal entity. Businesses that elect S-Corp status still operate as LLCs or Corporations, but they are taxed differently.
Key Differences: Sole Proprietor vs. S-Corp
| Feature |
Sole Proprietor / SMLLC |
S-Corp |
| Taxation |
Self-employment tax (15.3%) on all profits |
The owner pays 1/2 of social security and medicare tax and the company pays the other half. |
| Payroll Requirement |
Not allowed to be on payroll |
Owners must pay themselves a reasonable salary based on industry standards and cash flow. |
| Business Growth |
Limited to one owner (for SMLLC) |
Can have multiple shareholders |
| Credibility |
Less credibility with lenders/investors |
More legitimacy in banking and financing |
| Tax Filing |
Schedule C with 1040 |
Form 1120-S (corporate tax return) |
One of the main advantages of an S-Corp is that owners can split income between a reasonable salary (treating like any other employee) and distributions (not subject to self-employment tax).
Important Long-Term Indicators for an S-Corp Election
If your business is experiencing growth and increased profits, an S-Corp election may be beneficial. Here are some signs that transitioning to an S-Corp could be a smart move:
1. You Need to Pay Yourself Through Payroll
An S-Corp requires that owners take a reasonable salary—which means running payroll. If you already run payroll for employees, the cost of adding you (the owner) maybe be minimal.
2. Your Business is Expanding
S-Corps allow for multiple shareholders (up to 100), making it easier to bring in partners or secure investment.
3. You Need Business Credibility for Financing
Banks and lenders often view S-Corps as more legitimate than sole proprietorships. If you plan to apply for business loans or credit lines, transitioning to an S-Corp may be advantageous.
When You Shouldn’t Become an S-Corp
An S-Corp isn’t right for every business. If any of the following apply, sticking with a Sole Proprietorship or C-Corporation may be a better choice:
🚫 Low Net Profit: If your business consistently has a moderate to low annual net profit, the tax savings won’t justify the additional costs of payroll and corporate tax filings.
🚫 You Don’t Want Payroll Obligations: Owners must take a reasonable salary, which means setting up payroll, making timely payroll payroll tax payments, and filing quarterly & annual payroll tax reports.
🚫 Home Office Deductions Claimed on Schedule-C: You can’t claim a home office deduction with an S-Corp. The company has to pay you rent personally, which needs to be claimed on your personal tax return.
How to Elect S-Corp Status (Filing the S-Election)
If transitioning to an S-Corp makes sense for your business, you must file IRS Form 2553 (Election by a Small Business Corporation).
S-Corp Election Process:
1. Ensure your business is eligible (LLC or Corporation, U.S. shareholders only).
2. File Form 2553 with the IRS (within 75 days of starting the business or by March 15 for current businesses).
3. Set up payroll and pay yourself a reasonable salary.
4. File Form 1120-S annually and issue K-1 forms to shareholders to report their share of distributions, and other misc information.
What About a Late S-Corp Election?
If you missed the 75-day deadline for filing Form 2553, you may still be able to elect S-Corp status retroactively under Rev. Proc. 2013-30. This allows businesses to backdate their S-election if they have been operating as an S-Corp in practice (running payroll, tracking equity properly, etc.).
For a more in-depth guide on late S-Corp elections, check out our blog on this topic.
Consult a Tax Professional Before Making the Switch
An S-Corp can offer significant tax savings, but only if the financials justify it. Without accurate bookkeeping and financial reporting, it’s impossible to determine whether an S-Corp election is the best move.
Key Takeaways:
✅ S-Corps help reduce self-employment taxes, but require payroll and additional tax filings.
✅ Consistent profits make the transition more beneficial.
✅ Not ideal for businesses that have low earnings.
✅ S-Election requires IRS Form 2553 and must be filed on time.
✅ Talk to a tax professional before making a decision—bad bookkeeping can cost you thousands in tax savings.
At LedgerFi, we specialize in business tax planning, bookkeeping, and S-Corp guidance. Want to know if an S-Corp is right for you?
Schedule a consultation today and get expert guidance on structuring your business for tax efficiency!
