Your LLC is thriving, with consistent profit growth over time, yet your self-employment tax bill seems to follow suit. It’s time to reevaluate your business structure and possibly make a transition. Could shifting from LLC to S corp be the answer?
What is an S Corp?
An S corp is a type of business entity that operates similarly to an LLC but with unique tax benefits. An LLC’s profits and losses are directly taxed as the owner’s personal income. On the other hand, S corp earnings are separately taxed. As an S corp, you can become an employee, draw a reasonable salary, and only pay payroll taxes on your income.
How to Change an LLC to S Corp
To initiate the transformation from an LLC to an S corp, you need to submit Form 2553 (Election by a Small Business Corporation) to the IRS. This form calls for comprehensive information about your business, including basic data like address and EIN, the tax year in question, particulars confirming your company’s eligibility to be an S corp, and information about each shareholder in the newly established Subchapter S corporation.
Timeframes are vital when submitting Form 2553. You can file it at any point during the current tax year for the transition to take effect the following tax year. Alternatively, you can apply to transition during the current tax year, but this requires filing within ten weeks and five days of the year’s start.
One key condition to transition from an LLC to an S corp is having no more than 100 owners or members. The IRS allows a workaround: treat individual family members as one family ‘shareholder’. This permits you, your spouse, and your estates to count as one shareholder for the eligibility test. Your company must be US-based, and all shareholders must not be ‘nonresident aliens’.
Once you have submitted the necessary forms, the next step involves transferring the LLC’s assets to the newly created S corp. Following this, you need to apply for pertinent state and local business permits, update your LLC Operating Agreement (if any), and modify your LLC’s existing contracts with suppliers and customers. Finally, file Form 8832 (Entity Classification Election), to notify the IRS that the transition is complete.
Convert LLC to S Corp – Advantages
One major benefit of transitioning from an LLC to an S corp is the tax treatment of profits. As an LLC member, the entirety of your earnings, say $200,000, is subject to self-employment tax. However, as an S corp employee, only your reasonable salary, say $120,000, incurs payroll taxes. The remaining $80,000 is subject to income tax but not Social Security.
- Retirement Perks
As an S corp employee, you have greater retirement planning opportunities and can contribute more towards those plans. However, ensure your contributions do not exceed your S corp salary. As an S corp employee, you can contribute to both a 401K and Sep-IRA, while as an LLC owner or member, you are limited to a Sep-IRA.
- Shareholder Status
Transitioning from an LLC to an S corp implies all LLC members will acquire shares in the new entity. This facilitates raising capital and transferring ownership. Moreover, it boosts credibility with potential investors, suppliers, and customers.
Transitioning from LLC to S Corp – Drawbacks
- Intricacy and Cost
The transition to an S corp is a complex, time-consuming, and potentially costly process. You might face legal expenses while amending all existing LLC contracts. Also, ensure none of your members are ineligible institutions, such as banks. If your LLC has many members, the administrative cost of transition can be substantial.
- State-Specific Variations
Subchapter S corporations are treated differently across states, which can significantly affect the benefits of transitioning from an LLC to an S corp. For instance, in Florida, S corp profits are exempt from state income tax. However, in New York, S and C corps are treated similarly, which significantly reduces the tax benefits and the incentive to transition.
- Reduced Flexibility, Increased Formality
As an S corp member, you and your fellow shareholders will have more obligations and requirements. You’ll need to hold regular director and shareholder meetings and maintain corporate records. There’s also less flexibility in profit sharing: profits and losses must be shared with shareholders proportionally to their company ownership, which may not suit everyone’s circumstances.
Before You Convert from LLC to S Corp…
Business startup tax and accounting matters can be complex to navigate independently. It’s advisable to consult a corporate law specialist. If you’re a client of Trivium Point Advisory, we can assist in filing the paperwork on time. If not, ensure a tax expert is available to help with tax filings. Our financial specialists are always ready to discuss your tax needs and determine how we can assist.
At Trivium Point Advisory, our aim is to assist businesses like yours in understanding tax obligations and saving resources by preparing year-round. Schedule a call with our team today to learn more.