How to change your from a sole proprietor to a corporation.
I say it all the time, “Start your business where you want to be and not where you are.” What I mean is, if you think you want your idea to be big, set it up that way so that proper administrative habits can develop from day one. The process of transitioning a business from one entity type to another is far more complicated than you might think. Let me slide in that I understand that sometimes people need to start where they are. But if you can have enough foresight to dream up the business idea, then I encourage you to have a little more to put yourself as the business owner in the best position possible. Think about it like this, when we put ourselves in the space of operating from lack or deficiency, barely getting by, we are not making room to operate from a space of surplus. This is really the key to financial success in business, knowing what you need and going after it rather than taking what you have and trying to work with it.
I will go out on a limb and say that sole proprietorships are the most popular entity type in the US. I’d assume this because a sole prop is the most simple to set up. All you have to do is file a fictitious business name statement (DBA) with your county of residence, get a business license, a federal tax ID number, and a bank account, and voila, you are a business owner. For clarity, I want to make sure we do not confuse this with being a side hustler; those two are not the same. Usually, a side hustler has not legitimized their entity type, operating using their name, social security number, and personal bank account. Which I think is perfectly fine for testing ideas. However, when it’s time to level up, you will want to make sure that you have your ducks in a row.
Maybe you wonder if it’s so easy to set up why someone wants to transition away from a sole prop? Well, because sole props leave the business owner open to legal and tax liability. For example, if someone were to sue the business, the owner and the owner’s assets would be up for grabs, as is also the case for tax liability. In another example, the business owner does not use ComplYant and has not correctly followed tax requirements. Thus racking up $75,000 in income tax liability, the IRS can seize the personal assets of the owner of a sole prop to recover on the liability. That might not matter if you are just starting, and you haven’t cleared more than a few thousand dollars in sales. But it starts to feel a bit scary as the revenue grows. Another reason someone may consider transitioning away from a sole prop is if the owner takes on a partner. Partnership (no matter how they are structured) cannot be sole proprietorships. The keyword, in this case, is “sole,” meaning only one owner. If you take on a partner, both parts should be sharing the liability. And another reason an owner may want to change their entity type is if the owner wants to take on investors. This is because usually, investment requires the issuance of shares. Sole props cannot issue shares.
How to do it
The simplest way to change from one entity type to another is to close the previous company and start a whole new one. This is because system processing does not usually allow you to just change it all over to a new type. Let’s go through the steps. Start by closing out the fictitious business name statement and the business license. You’ll want to do this because this process tells the county and city where you registered that you will no longer operate the business. Without this, they will assume you are still operating and will expect renewal when the time comes. Next, make sure to file the last Schedule C on your individual income tax return and indicate it on the final return by checking that box on the form. This process tells the IRS you are closing the business. Now you’ll be able to create all-new corporate accounts. Get a new federal tax ID number (FEIN). This step is required by the IRS when you transition from a sole prop to a corporation. File your articles of incorporation with the secretary of state. Set up new tax accounts for sales, property, and employment tax, if applicable. Register for a new business license and get a new bank account. Generally, you won’t be able to transfer these accounts to corporations because they are stand-alone entities. Make sure to transition all auto-debits and deposits to the new bank account. I would suggest leaving the old bank account open long enough to ensure all outstanding checks and payments have cleared. If you use a bookkeeping software like QuickBooks or Xero, you’ll want to set up new accounts for each of those and make sure to transition your chart of accounts over for ease of processing. One last thing, be sure to change your entity type on ComplYant’s platform to see updated tax deadlines and applicable budget estimates for your new entity type. And just a tip, you can manage multiple entities from one dashboard to make the transition process easier to track.
See what I mean, lots of steps to change over. Keep in mind; it is perfectly fine to become a sole proprietor and stay that way forevermore. But if you are considering incorporating, I would suggest looking into that sooner rather than later. I would also recommend closing your old entity at the end of the calendar year. That way, you can start a new year fresh without having to make any mid-year accounting adjustments. As always, work hard, believe harder.
Shiloh Johnson, CPA, works with small business owners and early entrepreneurs to make sure they understand relevant tax rules and requirements. She founded ComplYant in 2019 to fill the gap of streamlined knowledge and support for small business owners trying to self manage the administrative parts of their business. Her motto, “We all have to do it, why not do it better.” Shiloh holds an undergraduate degree in Accounting and a Masters of Taxation and is also a member of several professional organizations, including the American Institute of CPAs, Institute for Professionals in Taxation, and the National Association of Black Accountants.