Switch from Sole proprietor to S-Corp mid year

[kizfaka]

I had a specific question for those who transition from Sole Proprietor to LLC with S-Corp election mid year.  For example, if I start running earn income through an S-Corp beginning 08/2023, it would seem to me that the savings on payroll taxes would be diminished since a bulk of my income was already earned as a sole proprietor prior to forming the S-Corp.  Is that correct?

Is there a way to reclassify the income earned as a sole proprietor as a distribution to save on payroll taxes?

[Mike9241]

income earned while a sole proprietorship goes on schedule C. income earned by the S-Corp goes on the S-corp return.  to change from single-member LLC to an S-Corp you need to file form 2553. The IRS will notify you via form CP261 of the acceptance of the S-Corp election and the effective date. It would seem form 8832 is not needed.

Do not file this form (8832) for an eligible entity that is:

• Electing to be classified as an S corporation. An eligible entity that timely files Form 2553 to elect classification as an S corporation and meets all other requirements to qualify as an S corporation is deemed to have made an election under Regulations section 301.7701-3(c)(v) to be classified as an association taxable as a corporation.

the issue is whether you can elect S-corp status effective mid-year. 

see form 2553 part I section F

https://www.irs.gov/pub/irs-pdf/f2553.pdf 

There is not enough info to determine if you can use a fiscal year (if not the CP261 will likely state your S-election is effective 1/1/2024) or you may qualify for late election relief which would mean the S-election would be effective 1/1/2023 possibly solving your payroll tax issue. consult with a tax pro who can review the facts and circumstances in your situation. 

[kizfaka]

I'm sole proprietor now  and just created an LLC.  I have not yet submitted for S-Corp election.

So are you saying that if the S-Corp election starts for this calendar year then my income made as a sole proprietor can effectively be classified as a distribution be free of payroll tax?

[Rick19744]

I will add a few additional comments:

• To address your specific question, you could be correct.  However, there are many factors that need to be considered, with additional questions, and this forum is not the best place to do the analysis.
• While an S corporation may save you some payroll taxes, there are a couple of factors to keep in mind:
  • An S corporation should be paying out a "reasonable salary".  What this is, we can't tell you at this point.  The salary component, obviously is no different than what you would be paying as a sole proprietor given the same income level; you are still paying in both sides of SS, just from a different pocket.
  • Also keep in mind, that all of the income earned as a sole proprietor is being reported to the SS administration.  As an S corporation, only your wages get reported to the SS administration.  So in the long run, upon retirement, where are you better off?
• Just to clarify a technical formality, your facts state that you are a sole proprietor, not a single-member LLC (SMLLC).  So this means you would need to create a SMLLC first and then make the S election.  Creating the SMLLC needs to happen at the state level. [edit - you responded as I was typing my response].
• I believe you should meet with a tax professional and discuss your long-term goals before making this decision.  There are many nuances with an S corporation and the tax complexity increases.  Just makes sense to understand the pros and cons before going down this path.  

[Rick19744]

To address your follow-up question:

• No.
• Your tax year would be split between Schedule C (sole proprietor / SMLLC), and
• then an 1120-S for the remainder of the year.
• You would not avoid SE tax on the sole proprietor earnings

[kizfaka]

Thanks Rick.  That was my main point of interest.  

I understand the pros and cons of S-Corp.  I sounds like the income is classified to one entity or another and if it was earned while a sole proprietor in 2023 then it shall stay that way; that income will not be subject to payroll tax.  

In that case, it would make more sense for my to elect s-corp status for the calendar year of 2024.  

[Critter-3]

When making the S-Corp election the IRS only allows you to backdate  a short while ... I think a couple of months.  So you cannot wait until Dec 2023 to make the S-Corp election for Jan 2023 it will not be allowed. 

[kizfaka]

A colleague of mine transitioned from sole practioner to llc s-corp mid year and told me that his accountant was  able to recognize all of the year’s income in the S-corp.  So the amounts earned from 1.1.23 until the S-corp is set up will be shown as Nominee income (earned by me on behalf of the s-corp).

Have you or anyone else heard about this?

[Mike9241]

yes, he applied for a late election which the IRS granted.  

[kizfaka]

Oh, that's what that is; sweet!  So the income originally earned as a sole proprietor in a sense can be reclassified as s-corp and not subject to payroll (medicare and SS).  Nice. 

[ee-ea]

Most states also have an ongoing mandatory fee – usually paid every 1 or 2 years – which keeps your LLC in compliance and in good standing.

https://www.llcuniversity.com/llc-filing-fees-by-state/

[AmeliesUncle]

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@kizfaka wrote:

I'm sole proprietor now  and just created an LLC.  I have not yet submitted for S-Corp election.

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You JUST created the LLC?   You can not file a late election for before the LLC existed.  And you can't file the late election unless you meet the other requirements, which you don't seem to meet them (such as "reasonable cause" for not filing the election on time).

You REALLY should sit down with a GOOD tax professional that is experienced with analyzing the pros and cons of various ways to be taxed.  Many people like the idea of a S-corporation, but in MANY cases it is NOT in their best interest and they don't realize everything that is required.

Besides the extra work and expense of a corporation, one thing that most people (even many tax professionals) neglect to consider is that paying less Social Security Tax means that your eventual Social Security (or Disability) benefits will usually be reduced.  So you need to factor that into the decision.

[Mike9241]

you must follow the late election procedures as outlined on page 2 of the form 2553 instructions. 

SEE THE SECTION Relief for a Late S Corporation Election Filed By an Entity Eligible To Elect To Be Treated as a Corporation

The IRS will make the determination and send you a form that will tell you the year the election is effective. SEE THE SECTION Acceptance or Nonacceptance of Election

Instructions for Form 2553 (Rev. December 2020) (irs.gov)

some but not all payroll taxes can be avoided. taxed as an S-corp you must take reasonable salary