When Is the Best Time to Convert to an S-Corp?
Starting a business involves making several decisions that might impact its functioning drastically in the long run. When it comes to taxation, taking the right call can save you a lot of money and make tax filing easier, especially when it comes to the question of when is the best time to convert to an S-corp?
Most professional businesses are taxed as corporations, be it an S-corp or C-corp. On the other hand, businesses owned and operated by one person are known as sole proprietorship enterprises. Here, the owner and the business entity are regarded as the same for tax purposes.
Under the United States federal income tax law, a C corporation is a for-profit business that is taxed separately from its owner. In contrast, an S corporation or small business corporation is not taxed at the corporate level. Hence, there are quite a few benefits of converting your business to an S-corp if you are eligible.
Small business owners generally prefer to register as a pass-through entity like an S-corp for tax reasons. Since you can avoid double-taxation and significantly reduce self-employment tax. For a quick estimate on exactly how much you can save check out our S-corp tax calculator.
Before you decide whether to convert your business to an S-corp, you must know what it is and how to legally qualify for it.
What Is an S-Corp?
Your business cannot be registered as an S-corp if:
- It is unincorporated and not separated from its owner.
- It has more than 100 shareholders.
- It has more than one class of stock (apart from voting and non-voting stock).
- It has any ineligible shareholders.
In the first instance, you are a sole proprietor, and in the next three, you need to be a C-corp legally.
However, if you are in the process of setting up a business or changing the enterprise registration type, there are certain time frames and conditions where it is suitable to convert to an S-corp.
How Is an S-Corp Different From a C-Corp?
Converting from a C-corp to an S-corp involves several legal steps and cannot be undone as easily. Hence, you need to be fully informed about how you will be taxed differently in the following areas:
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Some other specifications for S-corps include:
- Claiming the pass-through deduction, as they are eligible for business income deduction while C-corps are not.
- Having ownership limitations, as only US citizens can own S-corps, not foreign citizens or other businesses.
- Limitations in size, as it cannot have more than 100 owners or shareholders.
- Limitations in stock type, with only one kind of stock allowed.
For more information and other taxable components for S-corps, you can consult the IRS website.
Converting Your Business to an S-Corp
While choosing a suitable time and opportunity to convert your business to an S-corp, you need to consider the following:
Accounting is an important aspect of any financial decision in your business. From the accounting perspective, the ideal time to switch your business to an S-corp is January 1st. This is because converting at the beginning of the tax year makes record keeping and tax filing much easier.
This way, you can also track your business finances separate from your personal or sole proprietor finances. And if you were earlier in a C-corp, it would also help you escape the perils of corporate taxes.
This way, you do not have to maintain two different tax records and switch to one in the middle of the financial year. As an S-corp, you need to file your income and expense records as part of the S-corp and also for the time before.
Hence, if you were a sole proprietor, you would have to file a Schedule C: Profit or Loss from Business, Form 1120-S: US Income Tax Return for an S Corporation, Schedule K-1, and 1040: US Individual Income Tax Return.
Most businesses switch to an S-corp to avail tax benefits, as there is no corporate or self-employment tax on your profits. However, this does not mean you should switch any time of the year.
From the tax savings perspective, converting to an S-corp towards the beginning of the year makes more sense than October. This way, your tax savings will outweigh the extra costs of conversion. So, wait until the following year to make the conversion if you do not expect a huge hike in your income.
In all scenarios, it is best to consult your tax preparer or accountant before making any decisions.
You must remember that an S-corp has to pay more expenses than a sole proprietorship or C-corp. The costs for an S-corp include payroll taxes and service fees, tax preparation fees, owner’s salary, and bookkeeping. For a more detailed list of S-corp expenses visit our S-corp calculator page.
You should only convert to an S-corp if your business profits outweigh the extra expenses and you have the cash flow to ensure smooth operations. Consider all cash flow avenues, including loans, tax payments, savings, credit card payments, and so on. Switching to an S-corp is advisable only when you have a steady cash flow to cover these costs.
Time for Setup
A sole proprietorship can be easily set up and run, whereas an S-corp needs a lot more active work. Some of the important tasks involved include the following:
- Open a business account and move all your recurring transactions to that account.
- Update your info, like business name, tax ID, etc., with all payment processors.
- Update contract templates, change business insurance coverage and obtain a new seller’s permit.
- Apply for a new business license and permits for the new S-corp.
All this has to be done along with regular tasks. So, make sure you have enough time and resources to focus on these. If that means waiting for a while, so be it.
The best time to convert to an S-corp is subjective to the individual business and the owners. The answer may not be entirely clear to you due to the complexities and unknowns such as your future income. However there are several factors that can be used to quantify the tax savings from converting to an Scorp. For more a more detailed look at the cost and benefits of converting to an S-Corp visit our S-Corp Tax Savings Calculator. If you still need clarification feel free to schedule a free call with one of our CPA’s.
Bryan Kesler is a renowned CPA exam mentor and founder of CPA Exam Guide. He aims to provide affordable mentoring and tutoring solutions to smart accountants to pass the CPA exam. You can connect with Bryan on Linkedin and follow him on Twitter.