How To Do Taxes When You Switch to an S Corp Mid-Year

Navigating the S-Corp Election as a High Earner

If your small business generates substantial income, electing S-Corp status can provide major tax savings. By taking distributions rather than high salaries, S-Corps enable business owners to avoid thousands in employment taxes.

However, when is the optimal time to make the S election? And how do you handle taxes and record-keeping if you transition mid-year? This guide breaks it down for high earning small business owners.

Knowing When to Make the Switch

Many small business owners opt for a January 1st S-Corp effective date for simplicity's sake. This enables closing out sole proprietorship books on December 31st and starting fresh on January 1st.

However, for high income earners, the tax incentives may warrant a mid-year transition. While switching mid-year involves extra work, the potential five-figure tax savings make it worthwhile.

If it’s already November, waiting until January 1st of the next year is recommended. But if you are earning over $120k annually, a mid-year switch can lead to substantial extra money in your pocket after you file taxes.

Handling the Mid-Year Changeover

If you decide to transition to an S-Corp mid-year, you’ll need to take a few important steps to set up your business properly in the eyes of the IRS.

Filing for S-Corp Status

Before the IRS allows S-Corp tax treatment, you must establish a formal business structure like an LLC or corporation. Sole proprietorships don’t qualify. Once you create your formal business entity, file IRS Form 2553 to elect S-Corp taxation.

Getting a Business Bank Account

As a sole proprietor, you may currently use personal accounts for business financials. With a formal structure established, open dedicated business checking/savings accounts under your company's name and EIN. Update customers to pay into the new business account and restrict expenses to this account. This enables cleaner bookkeeping.

If possible, using another bank from your personal finances enables easier record separation. If convenience outweighs separation, your current bank can simply open a new business account.

Handling Bookkeeping

For tax compliance, you must adjust financial record-keeping once electing S-Corp status. Essentially, you will have one set of books tracking sole proprietorship finances up until the date you establish your formal business structure. A second set of books will then track S-Corp financials from that date through year-end.

Come tax time, sole proprietorship book data populate certain forms while S-Corp data populate others. While this involves added documentation, the tax savings for high income business owners warrant the extra effort.

Filing Taxes as a Sole Proprietor

As a sole proprietor, your business income flows through to your personal tax return. You pay income tax on all earnings at your personal rate up to 37%. Additionally, you owe full 15.3% self-employment taxes on your entire profit. This tax covers Social Security and Medicare.

When filing as a sole proprietor, your taxes include:

- IRS Form 1040

- Schedule C

- Schedule SE

Filing Taxes as an S-Corporation

Unlike sole proprietorships, S-Corps have their own tax filing requirements. First and foremost, S-Corps must submit taxes by March 15th rather than April 15th. Required filings include:

- IRS Form 1120S

- Schedule K-1

You must also file state forms depending on your locality. For instance, California requires Form 100S and Massachusetts requires Form 355S. Double check requirements based on where your business operates.

Additionally, S-Corps must furnish W-2s to owners receiving wages. These detail income and withholdings, which then flow through to your 1040. Unlike sole proprietorship income, only “reasonable wages” are subject to full payroll taxes. The remaining income distributes to owners and avoids self-employment taxes. This enables major tax savings for high earning business owners.

After satisfying S-Corp filing requirements, owners can submit personal returns. Your 1040 will then include W-2 wage income. Use Schedule E to report K-1 distribution income. You may also need to file 1040-ES if you paid quarterly estimated taxes.

Mid-Year Switch Example

To understand how a mid-year S conversion impacts taxes, consider this scenario:

Martha is a marketing consultant earning $300,000 annually while operating as a sole proprietor. On July 1st, she transitions to an S-Corp structure.

Based on her industry and location, reasonable wages would equal $150,000. This means under S-Corp rules, Martha takes $150,000 salary and distributes the other $150,000 to herself as the owner.

Here is how Martha handles her filings:

1. Before March 15th, Martha files S-Corp Form 1120S with Schedule K-1. She also issues herself a W-2 covering the $150,000 salary.

2. By April 15th, Martha files Form 1040 reporting the $150,000 of W-2 wage income. On Schedule E, she includes the $150,000 distribution.

3. Since Martha operated half the year as a sole proprietor, she must also file Schedule C and Schedule SE covering January 1st through June 30th earnings.

While the dual business structures in 2022 create extra paperwork, Martha saves $22,950 in self-employment taxes on the S-Corp distributions. For high earners, the mid-year transition is well worth the effort!

Maximizing Savings by Switching

As this example illustrates, transitioning to an S-Corp mid-year requires filing additional forms to handle the dual business structures. However, for solopreneurs earning over $120,000 annually, the self-employment tax savings easily justify the extra workload.

By taking distributions rather than salaries, high earning S-Corp owners can save five-figures in unnecessary payroll taxes every year. For independent consultants, attorneys, physicians and other solo operators generating high profits, the switch to an S-Corp is almost always recommended.

Speak to one of our business tax specialists at InstaTax Advisors to assess whether electing S-Corp status could benefit your bottom line. We can also help ensure you handle the transition and ongoing compliance smoothly while maximizing advantages as a high income business owner. Contact us today to review your situation with no obligation.

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