Many entrepreneurs start with a Limited Liability Company (LLC) due to its simplicity and flexibility. However, as your business evolves, you might consider converting your LLC to an S Corporation (S Corp). This article will explore when and why you should consider making the switch from LLC to S Corp, and guide you through the process.
Too Long; Didn’t Read
- An S Corp is a tax classification that can be made by an eligible corporation or LLC
- Unless you have deliberately elected S Corp taxation for your LLC, it is likely being taxed as a sole-proprietorship or a partnership
- While there are benefits to filing as an S Corp, there are some drawbacks as well
What is an S Corp?
An S Corporation is a tax classification available to qualifying corporations and LLCs. It’s named after Subchapter S of the Internal Revenue Code. Unlike a traditional C Corporation, an S Corp allows profits and losses to pass through directly to the owners’ personal income tax returns, avoiding double taxation.
Key features of an S Corp include:
- Limited liability protection for owners
- Pass-through taxation
- Potential tax savings on self-employment taxes (FICA: Social Security and Medicare Income Tax)
- Stricter operational requirements than an LLC
It’s important to note that an S Corp is not a distinct legal entity like an LLC or C Corp. Instead, it’s a tax election that can be made by an eligible corporation or LLC.
How to Know if My LLC is an S Corp
Many business owners are unclear about whether their LLC is already taxed as an S Corp. Here’s how you can determine your LLC’s current tax status:
- Check your tax returns: If you’re filing Form 1120S, your LLC is already taxed as an S Corp.
- Review your LLC’s operating agreement: This document may specify the tax treatment of your LLC.
- Look for Form 2553: If you or your accountant filed this form with the IRS, your LLC is likely taxed as an S Corp.
- Consult your accountant or tax professional: They can confirm your LLC’s current tax status and advise on potential changes.
If you haven’t taken any specific actions when starting your business to elect S Corp taxation, your LLC is likely taxed as a sole proprietorship (for single-member LLCs) or a partnership (for multi-member LLCs).
How is an S Corp Taxed?
Pass-Through Taxation
Like an LLC, an S Corp is a pass-through entity for tax purposes. This means that the company itself doesn’t pay federal income taxes. Instead, profits and losses “pass through” to the shareholders, who report them on their personal tax returns.
Reasonable Compensation Requirement
S Corp owners who are also employees must receive reasonable compensation for their services. This salary is subject to payroll taxes (Social Security and Medicare taxes).
Savings on Self-Employment Taxes
One of the primary tax advantages of an S Corp is the potential savings on self-employment taxes. In an LLC, all profits are typically subject to self-employment taxes. In an S Corp, only the owner’s salary is subject to these taxes, while additional profits can be distributed as dividends, which aren’t subject to self-employment taxes. In 2024, self-employment taxes are a flat tax of 15.3% of all earned income up to $168,600 in taxable wages. That being said, S Corps can potentially save 15.3% of your profit!
When to Consider Changing from LLC to S Corp
Your Business is Profitable
If your LLC is generating significant profits, especially those exceeding what you’d consider a reasonable salary for your role, an S Corp election could lead to tax savings.
You’re Paying High Self-Employment Taxes
As an LLC owner, all your business profits are subject to self-employment taxes. If these taxes are becoming a substantial burden, an S Corp could help reduce this tax liability.
You Want to Attract Investors
While an LLC can have multiple members, an S Corp’s ability to issue stock can make it more attractive to potential investors.
You’re Planning for Future Growth
If you anticipate rapid growth or the possibility of going public in the future, starting with an S Corp structure can make future transitions smoother.
You Need More Credibility
In some industries, operating as a corporation (even an S Corp) may lend more credibility to your business than an LLC.
You Want More Defined Roles and Structure
S Corps require more formal management structures, which can be beneficial as your company grows and roles become more specialized.
However, it’s important to consider potential drawbacks as well:
- Increased paperwork and compliance requirements
- Stricter operational rules
- Limitations on ownership
- Potential scrutiny from the IRS regarding reasonable compensation
How to Change LLC to S Corp
Ensure Your LLC Qualifies for S Corp Status
To be eligible for S Corp election, your LLC must meet these criteria:
- Be a domestic corporation
- Have only allowable shareholders (individuals, certain trusts, and estates)
- Have no more than 100 shareholders
- Have only one class of stock
- Not be an ineligible corporation (e.g., certain financial institutions, insurance companies)
Obtain Consent from All LLC Members
All members of your LLC must agree to the S Corp election. Document this consent in writing.
File Form 2553 with the IRS
Complete and submit Form 2553, “Election by a Small Business Corporation,” to the IRS. This form must be filed:
- No more than two months and 15 days after the beginning of the tax year the election is to take effect, or
- At any time during the tax year preceding the tax year it is to take effect
Adjust Your Operating Agreement
Update your LLC’s operating agreement to reflect the new tax status and any changes in management structure or profit distribution.
Comply with S Corp Requirements
Once your election is approved, ensure you’re following all S Corp rules, including:
- Holding regular board meetings and keeping minutes
- Maintaining accurate financial records
- Issuing stock to owners
- Paying yourself a reasonable salary if you’re an owner-employee
Update Your Accounting Practices
Work with your accountant to adjust your bookkeeping and tax preparation processes to align with S Corp requirements.
Final Thoughts
Changing from an LLC to an S Corp can offer significant benefits for many businesses, particularly in terms of potential tax savings and structural advantages. However, it’s not the right choice for every company.
Carefully consider your business’s current situation and future goals, and consult with legal and tax professionals before making the switch. By understanding the pros and cons of both LLC and S Corp structures, you can make an informed decision that sets your business up for long-term success.
