Are you considering a change from LLC to S Corp?
Maybe, like many entrepreneurs, you founded your business as an LLC (Limited Liability Corporation). Many founders go this route, and it generally makes sense when starting out. Especially those with a single owner or small number of partners, it’s the optimal default legal structure. Creating an LLC is fairly straightforward and the setup is relatively inexpensive.
There are other advantages as well for starting as an LLC. The structure offers substantial legal protections for the owners and protects their personal assets. Business losses are then limited to the assets of the business.
An LLC also offers a high level of flexibility when it comes to taxes. The organization can decide how it’s taxed – as a partnership, corporation or an S-corporation.
Normally business income is treated as owner income, meaning profits and losses subject to taxes are passed directly to the owners. This arrangement avoids double-taxation (both the business entity and the owners paying tax on the profits of the business).
Why Change from LLC to S Corp?
With the benefits of tax and simplicity of business structure on your side, why bother changing from an LLC to anything else?
Although on one hand an LLC has various tax benefits, the reasons for changing are also mainly tax-related. Especially with increasing income, switching to an S-Corp can make financial sense.
The major difference is the self-employment tax savings. While an LLC’s business income isn’t subject to double taxation, the owners need to pay the 15.3% self-employment tax when receiving income from the business.
In other words, after switching to an S-corporation, the owner can take a “reasonable” salary from the profits of the business. A reasonable salary is heavily dependent on location and industry.
The other major tax advantage is related to retirement savings contributions. Unlike LLC members, shareholders of the corporation can set up Roth Solo 401k and Solo 401k accounts. The company is then able to contribute higher amounts on your behalf.
It’s important to note that an S-corporation isn’t a business, but rather a tax classification. According to the IRS, an S-corp is a corporation that elects to pass corporate income, losses, deductions, credits through to their shareholders for federal tax purposes. In this way, it’s similar to an LLC.
As such, there are essentially two ways to convert your business from an LLC to an S-corporation. You can simply change the tax election from partnership to corporation and then to S-corporation by filing a few forms with the IRS. Or, you can convert the legal form of the business from LLC to a corporation.
What Issues Can Arise?
In order to be considered an S-corp, the business needs to meet certain requirements:
- It must be a domestic company, meaning a foreign LLC can’t be converted to an S-corp.
- Only certain types of shareholders are allowed, i.e. individuals, some trusts, and estates. Partnerships, corporations or non-resident aliens may not be shareholders.
- 100 or fewer shareholders
- Only one class of stock. This means there is an equal distribution of equity and liquidation preferences among the shareholders.
- It may not be an ineligible corporation. For example, some financial institutions, insurance companies, and domestic international sales corporations are not eligible.
There are also a few additional drawbacks to consider when deciding to convert from an LLC to an S-corp. What you can save in terms of taxation may be offset by increased paperwork and hassle. Because the shareholders are paid a salary, the corporation may need to implement a payroll system and file for workers compensation insurance.
Furthermore, if you’re considering bringing on outside investors, or are interested in retaining profits in a company bank account, a C-corp might be a better choice.
When Should You Change?
The general rule of thumb is that switching to a corporation makes sense when the self-employment tax becomes greater than the additional burden of an S-corp would be. This normally happens around the $40k profit mark, but depending on the circumstances it can be as low as $25k.
However, it’s important to check with your state laws. Some states, like California and New York, may tax both the S-corporation and the shareholders.
If you decide to change your business’ tax status, the LLC simply chooses to be taxed as an S-corporation. This can be done by filing IRS form 8832, informing the IRS you’d like to be taxed as a corporation. Afterward, it’s necessary to file form 2553, electing to be taxed as an S-Corp.
The deadlines are quite strict. These filings must be completed by March 15th of the year in which the change should take effect. Although, with a valid cause for delay you can apply for relief in case of late election.
Conversion Instead of Tax Election?
If you choose, it’s generally possible to actually change the business setup. This means, instead of simply selecting to be taxed as an S-corp, the business itself is converted to a corporation. There are three types of conversion.
This is the simplest methodology, but it’s not allowed in all states. Conversion occurs simply by filing a few forms with the secretary of state’s office.
This is slightly more complicated. Essentially, you form a new corporation, of which the LLC members are now corporate stockholders. Then, the LLC members/corporate shareholders approve the merger from both roles.
A non-statutory merger is the most expensive and most complex. After forming a new corporation, you formally transfer all asset liabilities from the LLC to the corporation. Then you formally exchange the LLC membership interests for corporate shares.
Changing from an LLC to an S-corp
Many businesses start out as LLCs. The structure is attractive to owners because of the flexibility, ease of set-up and initial tax benefits. But as the business and its profits grow, it may eventually make sense to either convert to, or elect to be taxed as, an S-corporation.
However, this decision shouldn’t be made lightly. Converting can have serious tax implications. It’s important to consult with a qualified accounting service, like Founders, to ensure you understand compliance and tax implications. Then, you’ll be ready to make the best decision for you and the business.