Tax Trap #1: Waiting to Incorporate: What A Difference A Date Can Make

NOTE: This is the first in a series of 5 articles:
"Small Business Tax Traps and How To Avoid Them"

If you're a sole proprietor, perhaps you've considered
incorporating your small business or self-employment
activity.

And so maybe you've been wondering,
"When is the best time to incorporate?"

From a legal standpoint, any time is the best time.
The sooner you incorporate, the sooner you make the move
from the world of unlimited liability to the world of
limited liability.

From a tax savings standpoint, any time is the best time.
The sooner you incorporate, the sooner you will start
putting more money in your own pocket and less in
Uncle Sam's.

(For more about the potential tax savings of a
corporation, see the second article in this series --
"Tax Trap #2: Double Taxation -- Isn't Once Enough?"
http://www.YouSaveOnTaxes.com/tax-trap-2.html)

But from a **tax reporting** standpoint, there is one time
of year that stands out as best: January 1st.

Why is that?

Assuming you have a sole proprietorship (or other entity,
such as a partnership) that is up and running as of
January 1, and assuming you then incorporate that
existing entity on any date other than January 1,
you face the possibility of filing not one but
two business income tax returns for that year.

Here's an example to clarify this important point . . .

Let's say you've been operating your sole proprietorship
for a few years, and in early 2005 you decide to
incorporate. In January you get around to starting
the paperwork, but life gets in the way and
you finally get it done in late February. By the time
your state processes the Articles of Incorporation,
the start date of your new corporation is March 1.

For 2005, you must file a Schedule C for the period
of January 1 through February 28, when your business
was still a Sole Proprietorship. And you must also
file a corporate income tax return for March 1 through
December 31.

Maybe that's no big deal. Maybe you enjoy filing
one business income tax return so much, filing
a second one doesn't bother you. And it may be
that the inconvenience of filing two tax returns
in 2005 is far outweighed by the legal and tax
advantages of incorporating.

Keep in mind, too, that 2005 will be the only year
you have to do this "double duty". In 2006 you
will only have to file the corporate income tax return.

But if you are thinking about incorporating, the
best time to do it, from a tax paperwork standpoint,
is as of January 1. Only then do you have a "clean break"
from the old sole proprietorship to the new
corporation.

This timing issue can also be relevant if you
decide to make the switch late in the year. If
the effective date of the incorporation is November 15,
you will have to file a Schedule C for January 1
through November 14, and a corporate return for
November 15 through December 31. In that scenario,
you should ask yourself, "Do the benefits of
incorporating outweigh the convenience of waiting
until January 1?"

So before you decide when to incorporate, take a moment
to reflect on the tax reporting consequences of
incorporating on January 1 vs. any other date.

Sometimes it may make sense to wait a few weeks
(as in the second example), and sometimes it makes sense
to "do it now", especially when January 1 is nearby.