If you are a small business owner, switching to an S Corp can make sense for many reasons. A primary benefit is that you may be able to save money on taxes by taking some of your company’s profits as distributions rather than wages.
But how can you do your taxes if you switch to an S Corp in the middle of the fiscal year? We break down what you need to know.
When to make the switch
When you switch to an S Corp, also known as a Subchapter S, you can choose the date the S Corp election takes effect.
From a taxpayer perspective, switching on January 1st is popular for simplicity’s sake. With this date selected, you can close last year’s books for your sole proprietorship and start new ones for your LLC taxed as an S Corp using the full year for tax purposes. A mid-year switch means a bit more work, but it’s manageable and sometimes worth the effort.
If you’re considering switching to an S Corp and it’s already November or December, you might want to wait. However, early in the year, an immediate switch won’t cause too many headaches and will be worth the savings.
If you do choose to opt for a mid-year switch to an S Corp, there are a few things you’ll need to do.
Set up a legal structure and file the S-election
Before you can elect for S Corp taxation, you need to have a legal structure in place. This could be an LLC or a corporation. A sole proprietorship cannot elect for S Corp taxation, so this is an important step in the process.
Once your legal structure is established, you’ll then file Form 2553, which requests that the IRS taxes your business as an S Corp.
Get a new bank account
If you’re running a sole proprietorship, you might be using your personal bank account to manage your business finances. Once your legal entity is established, you’ll need to open a new bank account under the business’s name and EIN.
Open a new business bank account and update all your business transactions, including payments from your customers and expenses your business pays, to go through this new account. You might also want to open a business credit card.
When opening your business bank account, using a different financial institution can help you keep your personal and business funds separate. However, you could also use your current bank and simply open a new account. It’s up to you to decide which is easier.
For income tax purposes, you’ll need to change your bookkeeping once you make the switch to abide by internal revenue codes. You can do this by starting new books and separating your company’s finances from your personal ones.
This means that you’ll have one set of records that tracks your sole proprietorship’s finances up to the date your new entity formation and a second set of records that track your S Corp’s finances from that day until the end of the year.
When it comes time to file your taxes, you’ll put the information in the sole proprietorship’s books on some forms and information from the S Corp’s books on others.
Filing taxes as a sole proprietor
When you file your taxes as a sole proprietor, you must pay regular income taxes and self-employment taxes. This means filing Form 1040 for your individual income taxes, Schedule C for your profit or loss from your business and Schedule SE for your self-employment taxes.
Sole proprietorships are a pass-through entity. This means that all income for sole proprietors flows through to your personal income tax return, so you’ll report all your earnings on your personal income taxes.
You’ll also pay a higher tax rate since you are responsible for the 15.3% self-employment (SE) tax on all your earnings as a sole proprietor. The self-employment tax includes Social Security and Medicare taxes, sometimes called payroll taxes.
Filing taxes as an S Corp
Unlike sole proprietorships, S Corps have their own corporate tax filing requirements.
When you file taxes for your new business entity, you’ll file Form 1120-S and Schedule K-1 to detail distributions made to your S Corporation shareholders. There may also be state filing requirements. For example, Massachusetts uses Form 355S, Schedule S and Schedule SK-1 for S Corporations.
It’s important to look up any requirements your state has by reviewing your state’s tax website. If you aren’t sure whether you are looking at your state’s tax website, make sure the URL ends in .gov.
One key consideration for S Corps is that they have a different business tax filing due date than individuals. Typically, S Corps must file taxes with the Internal Revenue Service (IRS) by March 15th if the S Corp is a calendar year taxpayer, one month before the individual tax filing deadline.
Your S Corp also has to issue tax forms such as W-2s, which report the wages you received from your S Corp and the taxes withheld from your paychecks. You’ll include the information from your W-2 when filing your personal income taxes.
Once you file your S Corp taxes, you can focus on filing your individual tax return. Like with a sole proprietorship, you’ll file Form 1040 for your income. You’ll also file Schedule E (with information from Form K-1) for supplemental income and loss, and you may file Form 1040-ES if you paid estimated taxes.
John Smith is a marketing consultant and operates as a sole proprietor. He decides to switch to an S Corp halfway through the year and opts to have July 1st be the effective date for the switch.
John consistently earns $10,000 per month. This means that at the end of the year, he made a total of $60,000 while operating as a sole proprietor and $60,000 while operating as an S Corp. He follows tax law by taking $30,000 as a reasonable salary, then takes $30,000 as distributions.
Step 1: File S Corp tax return
When preparing his taxes, John must first handle his new S Corp to meet the required tax deadlines. This means issuing a W-2 for the wages he paid to himself. He must file his S Corp’s forms by the March 15th deadline. This includes Form 1120-S and Schedule K-1. He’ll also file any state tax forms.
Step 2: Report S Corp earnings on personal tax return
Once John finishes his S Corp taxes, he can file his personal tax return by April 15th. He’ll fill out Form 1040 detailing his earnings for the year, including the $30,000 in wages he paid himself and that his S Corp reported on his W-2. He’ll also fill out Schedule E, which details supplemental income and loss that describes the $30,000 in distributions he received from this S Corp.
Remember that the $30,000 in distributions won’t be subject to the 15.3% self-employment tax, saving John $4,590 when he goes to pay taxes. This reduction in his tax liability is worth the extra effort.
Step 3: Report sole proprietor earnings on personal tax return
Since he also operated as a sole proprietor for part of the year, John will also file Schedule C and Schedule SE. These forms will report the $60,000 in taxable income he earned as a sole proprietor and the self-employment taxes he must pay.
Ultimately, this means John files standard income tax forms, income tax forms for self-employed people that operate as sole proprietors and income tax forms for an S Corporation all in the same year. However, in future years, John will not be required to file any sole proprietor tax forms.
Switching from a sole proprietorship to S Corporation status mid-year does mean slightly more tax filing requirements at the end of the year. You’ll need to file forms for your new business entity and sole proprietorship, but you’ll only have to do this for the current tax year. You won’t have a sole proprietorship to file for in future years, meaning you can focus on S Corp forms.
Despite the additional work, the savings and benefits an S Corp provides are worth it when you pay your federal income taxes. Don’t be afraid to switch your business structure mid-year.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should engage a qualified tax professional or accountant to evaluate your business and help determine applicable tax obligations.
TJ Porter is a freelance writer based in Boston, Massachusetts. He began covering finance while earning a degree in business at Northeastern University in Boston, Massachusetts and enjoys writing about credit, investing, real estate topics. When he’s not writing, TJ enjoys cooking, sports, and games of the video and board varieties. You can contact him at find more of his work at TJPorterWriting.com