Convert Sole Proprietorship to S Corp

Step 1: Form the entity

Form a single-member LLC (simpler, more flexible state law) or a corporation. Most converters choose LLC. File articles of organization with your state Secretary of State. Cost ranges from $40 (Kentucky) to $500 (Massachusetts). California adds the $800 minimum franchise tax in year one (with limited exceptions for some new entities; verify with the FTB).

Operating agreement for the LLC must not create multiple classes of stock economically (voting differences are permitted under IRC Section 1361(c)(4)). For a single-member LLC, a simple member-managed operating agreement is enough.

Step 2: New EIN required

File Form SS-4 (or online via IRS.gov) to get a new EIN. Even if you had an EIN as a sole prop with employees, the new entity needs its own EIN under IRS guidance on change of business structure.

Use the new EIN on Form 2553. Use it for all post-conversion payroll, vendor payments, and 1099s. The sole prop SSN-based EIN should be retained for closing-period tax filings, then retired.

Source: IRS Do You Need a New EIN

Step 3: IRC Section 351 asset transfer

Transfer business assets (cash, equipment, inventory, intangibles) from yourself personally to the new entity. Under IRC Section 351, this is a tax-free exchange if the transferor (you) is in control of the entity immediately after (80 percent or more of vote and value) and receives only stock in exchange. For a single-member LLC that elects S corp treatment, the membership interest is the equivalent of stock.

Document the transfer with a bill of sale or contribution agreement listing each asset and its fair market value. Carry tax basis from sole prop to the entity (no step-up). For assets with mortgages or other liabilities exceeding basis, IRC Section 357(c) may trigger gain; consult a CPA for any property with mortgage debt.

If you are converting an existing sole prop, the transferred assets typically include accounts receivable, inventory, equipment, intangibles. The new entity opens a new bank account and starts billing in its own name from the conversion date.

Source: 26 U.S.C. Section 351; 26 U.S.C. Section 357(c)

Step 4: File Form 2553

For a new entity wanting S corp treatment from inception: file Form 2553 within 75 days (two months and 15 days) of formation. Election effective date is the formation date.

For mid-year conversion of an existing entity: by March 15 for calendar-year treatment in the current year, or as a late election under Rev Proc 2013-30 within 3 years and 75 days of the desired effective date.

See LLC to S corp for the Form 2553 walkthrough.

Step 5: Payroll and the closing Schedule C

Once the S corp is effective, the owner must take a reasonable salary via W-2 (no more "owner draws" reported on Schedule C). Register with state employment agencies, set up payroll through a service (Gusto, ADP, Quickbooks Payroll, etc), withhold federal income tax, FICA, state income tax, and remit through Form 941 quarterly.

For the year of conversion: file a final Schedule C reporting income from January 1 to the conversion date. Then file the new S corp's Form 1120-S for the period from conversion date to year-end, with a short-year designation if necessary. The K-1 reports your share of S corp income (often 100 percent for sole owner).