QUESTION ON How to Change Business From Sole Proprietorship to an S-Corporation
Hi. I am planning to open a retail store next year and have spent some money on researching the idea, location, etc. I plan to form an S Corp when the store opens, but would like to know if it makes sense to file a sole proprietorship in the mean time so I can write off the expenses this tax year. The reason I am waiting on the S Corp is that I don’t wish to pay the CA state taxes/fees for S Corp if the business hasn’t started yet. If I do this, am I converting my sole proprietorship to an S Corp? Or would I be dissolving my sole proprietorship? Any assistance you may provide will be greatly appreciated. – Michelle O., California.
– Michelle O. California
Advice by Chrissie Mould
Sole proprietorships are not “filed”; that is, no formation documents are required to be filed with the Secretary of State in order to form a sole proprietorship.
In fact, a sole proprietorship is not a separate legal entity at all. Rather, the term “sole proprietorship” is used to describe an unincorporated business that is owned and controlled by one individual. Having said that, starting a sole proprietorship probably would not serve your purpose in terms of being able to deduct startup business expenses this tax year.
According to IRS Publication 535, “Business Expenses” http://www.irs.gov/pub/irs-pdf/p535.pdf startup costs include any amounts paid or incurred in connection with creating an active trade or investigating the creation or acquisition of an active trade or business. Startup costs are typically treated as capital expenses which are amortized (written off in increments) over a period of 180 months.
However, current tax laws do allow you to make an election to deduct up to $5,000 of business startup costs paid or incurred after October 22, 2004 in one shot. (Any remaining costs would need to be amortized.) But to make the election, you would claim the deduction on the income tax return for the tax year in which the active trade or business actually begins. This would preclude you from being able to deduct startup costs this tax year if your active business does not begin until next year.
It should also be noted that the $5,000 deduction is reduced by the amount your total startup costs exceed $50,000. So, for example, if you incurred a total of $54,000 in startup costs, the deduction would only be $1,000 ($5,000 – $4,000 = $1,000). A good rule of thumb would be to hold off on incurring startup costs (and, especially, put off purchasing depreciable items for your new business) until the year in which your business actually starts, if you can.
As far as the out-of-pocket expenses you have incurred so far in anticipation of starting the business, you should obviously hold onto the receipts. You could then submit an expense report with the receipts to the S corp after it is formed for reimbursement. Your S corp would in turn deduct the reimbursed expenses in accordance with the rules regarding startup costs.
In any event, sole proprietorships are not “converted” to corporations or S corps, per se. So if you do decide to start a sole proprietorship and then wish to form an S corp for the business later, the sole proprietorship would effectively cease to exist, and the S corp would be a newly formed entity unto itself.
Recommended Resources on How to Form LLC:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- Surprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies
- Form Your Own Limited Liability Company
- What Qualifies for a Home Office Tax Deduction?
- Do You Qualify for Home Business Tax Deductions?
- Choosing the Legal Structure of Your Business
- Non-Traditional Tax Deductions: Successes and Failures
- Forming an LLC and Electing to be Taxed as an “S” Corp