Switching from a sole proprietor to an S Corp feels like going from Princess Adora to She-Ra. It’s not like life is terrible for Adora, but as She-Ra, she gets a red cape, fancy sword, and a pegasus unicorn.
Your S Corp might not come with a flying horse, but it does include significant tax and legal benefits.
If you’ve already decided to form an S Corp, you’re probably wondering when the best time is to switch. Should you change right away or wait until the end of the year?
Just like Adora knew precisely when to raise her sword and declare, “For the honor of Greyskull!” you too should know when to transform your sole proprietorship into an S Corp. Doing it at the right time will save you from accounting and tax headaches.
There are four things to consider when making the switch to an S Corp, and you’ll need to weigh the pros and cons of each before deciding when is right for you.
When it comes to accounting, the easiest time to switch is January 1st.
Forming your S Corp at the beginning of the tax year makes record keeping and tax preparation easier because you’ll need to track your S Corp finances separately from your sole proprietor finances.
If you already use a digital bookkeeping program like QuickBooks Online, you’ll create a new file.
If you’ve been tracking your finances manually, you’ll set up a second tracking method just for your S Corp.
Maintaining two sets of records throughout the year can be complicated, especially if you don’t keep up with your bookkeeping. If you’re the type that does everything right before taxes are due, combing through two business’s worth of transactions will be a Red Wedding level catastrophe. #WorstWeekendEver
Switching to an S Corp mid-year also impacts your tax preparation. You’ll need to report your income and expenses for the period you were a sole proprietor plus your income and expenses as an S Corp.
This means, in addition to filing a Schedule C: Profit or Loss From Business for your sole proprietorship, you also file Form 1120S: U.S. Income Tax Return for an S Corporation and a Schedule K-1 for your S Corp.
And let’s not forget about your 1040: U.S. Individual Income Tax Return. That’s a lot of forms to file, and each one increases your tax preparation time and cost.
You’re probably switching to an S Corp to enjoy the sweet tax benefits, mainly no self-employment tax on your profits. Which means the sooner you switch, the more you save on taxes.
So shouldn’t I switch as soon as possible to save the most money?
Not exactly. If it’s November, you’ll only operate as an S Corp for two months. Will the tax savings outweigh the extra accounting time and costs? Probably not.
But, if it’s April and you just got whacked with a killer tax bill, then the tax savings could outweigh the extra costs.
Generally speaking, if it’s later in the year, wait to form your S Corp until the following year, unless you expect a significant spike in income.
If it’s earlier in the year, talk to your tax preparer about how much you could save by switching mid-year and see if it’s worth it.
You can also use Collective’s tax savings calculator to get an estimate of your tax savings before shelling out the dough to talk to an accountant.
While you pay less in taxes as an S Corp, you do pay more in expenses.
S Corp expenses include payroll taxes, payroll service fees, bookkeeping, and tax preparation fees. Plus, you’ll need to pay yourself as an employee of your business, which means regular payroll runs.
Before switching to an S Corp, ask yourself two questions:
- Can your business afford the additional costs of being an S Corp?
- Do you have the cash flow to pay for the additional costs?
Affording something and having the money to pay for it are two different things. Sure, on paper, it looks like your business can afford the costs, but if your bank balance hovers around zero every month, you probably don’t have the cash flow.
Cash flow is the money that goes in and out of your business in a given period. Unlike profit, which just accounts for your income and expenses, cash flow is everything that goes out, including:
- Owner draws
- Credit card payments
- Business loan payments
- Tax payments
Let’s say you have $5,000 in profit at the end of the month. But you have $1,000 in business debt payments plus you need $4,000 to live off of personally. Right now you have just enough, but as an S Corp, things look a bit different.
When you pay yourself as an employee, your take-home paycheck is less than an owner draw. After payroll taxes, your paycheck goes from $4,000 to $3,500 because you’re paying your taxes in real-time. Plus your business pays payroll taxes on top of your salary.
Now, that $5,000 in profit isn’t enough to cover your debt payments, paycheck, and payroll taxes.
The biggest mistake I see businesses make is starting an S Corp before they have steady cash flow. Then, they struggle to run payroll, and their personal finances take a hit. Don’t switch to an S Corp until you have consistent and reliable cash flow to cover the additional costs.
One of the benefits of being a sole proprietor is that your business is easy to set up and maintain. It’s like The Dude of legal entities- super chill and laid back.
Setting up your S Corp is anything but chill. Besides going through the legal process of forming the business, you’ll also complete post-formation tasks like:
- Open a business bank account
- Switch your recurring transaction to your new bank account
- Update your payment processors with your new business name, tax id number and bank account
- Update contract templates with your new business name
- Change your business insurance coverage to the new entity
- Obtain a seller’s permit under the new business
- Register for a new business license and permits under the new business
That’s a lot to do on top of maintaining your regular business activities. Which means forming an S Corp during your busy time of year will seriously cramp your style.
Instead, switch your business to an S Corp when you have the time to complete these tasks. Even if it means waiting for a month or two, your inner Lebowski will thank you.
There’s no one size fits all time to switch from a sole proprietor to an S Corp. It’s up to you to figure out how each of these considerations impacts your business, time, and finances.
Eventually, you’ll know when it’s time to switch and you can channel your inner She-Ra as you make the change, pegasus unicorn and all.
Andi Smiles, small business financial consultant and coach, teaches rad business owners to take control of their finances so they can step into their personal power.
She’s helped hundreds of self-employed folx organize and understand their business finances, while also uncovering their emotional relationship with money. Andi’s core belief is that when business owners are engaged with their finances, their personal awareness around money deepens, creating more sustainable and authentic businesses. She loves helping business owners connect with and feel good about their finances- no matter how many dollars are in their bank account.