Small Business Tax Trap #1: Waiting To Incorporate -- What A Difference A Date Can Make

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 2006 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 2006, 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 2006 is far outweighed by the legal and tax advantages of incorporating.

Keep in mind, too, that 2006 will be the only year you have to do this "double duty". In 2007 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.

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