Changing a Business From Incorporated to a Sole Proprietorship

by John Cromwell

Choosing the right entity when you start your business is important, but it does not have to bind you to that organizational form forever. Being incorporated may be helpful if you are looking to gain investors and protect yourself from liability, but it can be costly in terms of taxation and filing fees. Prior to switching a business from a corporation to a sole proprietorship, consider the implications of the change. While a sole proprietorship is cheaper to maintain and pays fewer taxes, it does not protect its owner from business liabilities.

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Dissolution

The first step in switching from a corporation is dissolving it. Corporations are organized subject to state law, so the process for disincorporation varies based on where the business originally organized. In Illinois, a business owner would need to file articles of dissolution with the Secretary of State. These articles require you to state how the shareholders authorized the corporate dissolution, how much stock was outstanding and the value of the shareholders' investment in the business as of the dissolution vote.

Contracts and Leases

The former corporation and new sole proprietorship are distinct legal entities. The sole proprietorship cannot automatically step into the corporation's role in existing contracts with vendors and landlords. Before finalizing the corporate dissolution, the business must settle all contracts and claims. However, it can negotiate with its vendors and landlords so that the sole proprietorship can undertake the former corporation's obligations.

Licenses

While a sole proprietorship does not need to file with the state to organize, it may need to register with the state so it can operate in a specific industry. States require licenses to operate in certain industries -- like real estate brokers and child care services -- regardless of whether the business is a corporation or sole proprietorship.

Doing Business As

A converted sole proprietorship may want to register a “doing business as” name. The legal title of a sole proprietorship is the name of its owner. To capitalize on the brand recognition generated by the corporation, the sole proprietor may want to use a version of the corporate name. A sole proprietorship will need to register its DBA with the county clerk where its business is headquartered or with the state government, depending on its home state.

Last Tax Return

Many corporations are separately taxed entities, while the proceeds from sole proprietorships are included on the owner’s personal tax return. The corporate tax return is Form 1120. The corporation will need to file one last tax return after it dissolves, containing all of the financial activity from the beginning of the corporation’s last tax year to the day it formally dissolved. The tax preparer should check the “final return” box in item E of the tax return.

Employer Identification Number

The new sole proprietorship needs a new Employer Identification Number, since it cannot use the corporation’s EIN. You need to close the corporation’s EIN account by writing a letter to the Internal Revenue Service. The sole proprietorship can then apply for a new EIN either through the IRS’s website, by phone, fax or mail.

New Records

Since the corporation was a distinct legal entity that no longer exists, all of its accounts and financial records should be closed shortly after dissolution. All of the assets and resources that were in the corporation should be transferred into new sole proprietorship accounts and financial records.