When it comes to small businesses, many entrepreneurs and business owners start by creating an LLC, or Limited Liability Company, because of the ease of setting one up and the flexibility an LLC offers. However, as the business and its revenues grow, some entrepreneurs consider converting their LLC to an S Corp.
Does this sound familiar? If it does, you probably set up your business as an LLC because it was the easiest option. Now that your business is growing and becoming more stable, you want to know your options for paying your taxes. A friend might have told you that converting your LLC to an S Corp is the way to go, but you’re not sure exactly what that means or how to do it.
Don’t worry! I’m here to ensure you know everything you need to know about LLCs, S Corps, and everything in between.
As a professional tax advisor with 20 + years of experience, I want to help you think through this and make an informed decision. Let’s get started!
LLC versus S Corp
There are certain advantages an S Corp has over an LLC. I’ll discuss the differences between the two entities and the tax consequences of converting an LLC into an S Corp.
First, let’s review the main differences between an LLC and an S Corp.
1) LLC (Limited Liability Company)
Many small businesses begin as LLC because there are fewer legal requirements to set one up. LLCs are taxed the same way as a sole proprietorship. This means LLCs typically have a “pass-through” tax structure, which means the income and expenses, or business profits and losses, of the LLC are reported on the owner’s individual tax returns.
The main difference between an LLC and a sole proprietorship is that the LLC status offers liability protection to the owner, similar to an S Corp. Sole proprietorships do not have this liability protection. Another key feature of an LLC is that it doesn’t pay federal income tax.
2) S Corp (S Corporation)
An S Corp is more well-known as a tax designation rather than a business structure. Like an LLC, an S Corp has a “pass-through” tax structure. It passes income and taxes to the shareholders’ personal tax returns.
However, S Corp shareholders can divide their incomes from the business into salary and dividends. The shareholders do not need to pay self-employment taxes on the dividends they receive. Only their compensation is subject to self-employment tax. This can provide shareholders with favorable tax benefits.
Remember that the S Corp tax designation is only available to the following types of small businesses:
- Incorporated in the U.S. (domestic)
- Have 100 or fewer shareholders
- Only one class of stock
- Shareholders are individuals, trusts, estates or certain tax-exempt organizations. Other corporations, partnerships, or non-resident aliens cannot be shareholders.
Now that we’ve reviewed the key differences between the two, let’s look at why you would want to convert your LLC into an S Corp.
Why Convert Your LLC to an S Corp?
The most common reason to convert an LLC to an S Corp is to gain tax savings by saving money on self-employment taxes.
When an LLC is set up, it is automatically taxed like a sole proprietorship or partnership. This means that LLC owners are considered self-employed. They must pay Social Security and Medicare taxes on all their business profits until federal limits.
However, when a business owner converts their LLC to an S Corp for taxation purposes, the owner can become a company employee. They’ll be able to pay themselves a salary and then pay Medicare and Social Security taxes on this declared salary only. They won’t need to pay these types of taxes on all business profits.
Also, owners (now also employees) of an S Corp can put more money in tax-deferred retirement accounts such as a Roth Solo 401K. This means that older business owners can decrease their tax liabilities and put hundreds of thousands of dollars away for retirement. Doing this is only possible with an S Corp.
However, switching to an S corp also means additional paperwork and expenses, especially if you don’t already have other employees.
If you convert to an S Corp, you’ll have more administrative tasks on your plate. These include running a payroll and having to enroll in state workers’ compensation and unemployment programs. You may also have more tax forms to file.
Before you take the leap and convert your LLC, let’s take a closer look at the specific tax consequences of converting your LLC into an S Corp.
Switching from LLC to S Corp Tax Consequences
We’ve already established that converting your LLC to an S Corp has tax implications. While we use the term “tax consequences,” some might consider the following more as “tax benefits” rather than consequences.
Here’s where you’ll see the tax consequences clearly:
1) Self-Employment Tax
This is arguably the most popular reason people convert their LLC to an S Corp. As mentioned earlier, S Corp shareholders can divide their earnings from the business into salary and dividends. Only the salary portion is subject to self-employment tax, and dividends are not. This could result in significant tax savings. You must balance savings and dividends to maximize tax benefits while complying with IRS regulations and guidelines. On the other hand, LLCs must pay taxes on all business profits.
2) Built-In Gains Tax
When a business becomes an S Corp it may be subject to a Built-In-Gain (BIG) tax under certain conditions. The BIG tax is typically triggered when a C Corp becomes an S Corp, not when an LLC becomes an S Corp.
However, being aware of the BIG tax is still a good idea. BIG often refers to appreciated assets held by the company at the time of its conversion to S Corp. If these assets are sold or liquidated within a specific period, the S Corp may be subject to corporate-level taxes.
3) Reasonable Compensation
Again, when a business becomes taxed like an S Corp, owners can become company employees and pay themselves a salary. To avoid any scrutiny from the IRS, ensure you pay yourself a reasonable salary.
While there is no set amount for reasonable compensation, and it leaves a lot of room for interpretation, take into account the nature of your business and industry standards. Paying yourself an unreasonably low salary and distributing the rest as dividends can trigger IRS audits and penalties, which you certainly don’t want.
A good rule of thumb is to research average salaries of similar positions in your area and industry and pay yourself within the same range. If your business is making tens of millions a year and you pay yourself $20,000 annually, this will definitely be a red flag for the IRS.
- Complex Reporting
If you decide to convert your LLC into a corporation, note that an S Corp requires more paperwork and reporting than an LLC. S Corps must file 1120S annually and provide shareholders with Schedule K-1, which documents each shareholder’s share of income, deductions, and credits. Corporations also have a more complex management structure, have regular shareholder meetings, and can transfer shares to each other. Keep in mind these requirements apply to LLCs that convert themselves into a corporation as a business structure, not to LLCs that apply for an S Corp tax designation.
5) State Considerations
Each state has its own regulations, so state tax implications can vary widely. It’s essential to consider state-specific rules and regulations when converting your LLC to an S Corp.
For example, New York taxes the S Corp on behalf of the individual if the person does not have a valid New York residence. So, the tax savings you receive may be less than you initially thought. However, even if your S Corp is affected by this New York tax regulation, you’ll probably still save on taxes.
These are the general tax consequences you’ll face once you decide to convert your LLC to an S Corp.
Convert your LLC to an S Corp
Now that you’re aware of the tax consequences of converting an LLC to an S Corp, here are a few more important details to remember.
When you convert your LLC into an S Corp, you don’t need to change your business structure to a corporation. You can elect your LLC as an S corp only as a tax designation. This transition only affects how you handle income and how you file and pay taxes. Your business structure can remain the same.
When Should You Switch your LLC to an S Corp
The question of when you convert your LLC to an S Corp has more than one answer. Typically, business owners convert their LLC to an S Corp when their self-employment tax is higher than the taxes they would need to pay as an S Corp. This point varies from business to business, so ensure that you do your homework and determine what point this is for your business.
If you decide to convert your single-member LLC to an S Corp, file an IRS Form 2553. The shareholders and a company officer must sign the form. If you want your conversion effective for the entire tax year, file your form by March 15 of the year you want to take it effect or anytime during the prior tax year.
If you have a new LLC, you can file the IRS Form 2553 within two months and 15 days of when the business starts its first tax year.
Of course, it’s best to consult a tax expert (like myself) when considering and completing this process. You want to ensure your requirements are in order and you don’t miss out on anything. This is where I can help.
Simply put, converting your LLC to an S Corp is recommended for small businesses. They offer additional tax advantages while providing limited liability protections, both beneficial to you. With an S Corp tax designation, you can gain tax savings without changing your business structure. Even with a growing business, an S Corp is easier to maintain and run than a C Corp. Essentially, you get the best of both worlds when it comes to an S Corp.