Starting a business? There are a multitude of options available to entrepreneurs when considering entity selection. Two of the most common types are Limited Liability Companies (LLCs) and S-Corporations. While discussing the pros and cons of each is outside of the scope of this article, if you have already started an LLC, the following discusses some of the benefits of converting from an LLC to an S-Corp.
First, why would one want to convert? Self-Employment (SE) taxes. The ability to avoid, reduce, or eliminate SE tax is the most popular reason for considering a conversion from an LLC to and S-Corp.
If you are the owner of a business as a sole proprietor or as a single-member LLC (one owner) your business income will be included on your personal return on Schedule C. This income is subject to SE tax AND ordinary income. Since these rates are 15.3 percent and upwards of 25% you could, in theory, being paying an average of 40% in taxes on your net business income. A keen mind would notice that you are being taxed twice. Once as Self-Employment tax, and again as ordinary income tax.
Now that you have some grasp of the possible savings, a quick example of the real-world savings will help cement the concept. Before you were a business owner, or contemplating heading down the entrepreneur route, you were likely a W2 employee. Let us say for a moment that you were paid $100,000. Your employer at the time would have withheld your portion of Social Security and Medicare taxes on your behalf. Your employer would have also had to pay their portion of Social Security and Medicare (7.65%). It logically follows then that your employer’s total wage expense related to you was $107,650. ($100,000 in wages plus the employer portion of taxes, $7,650) It is the same for sole proprietors and LLCs:
Please make note of the $14,130 or 14.3% of $100,000. This is your effective rate of tax as a self-employed person. Now, if you elect to be treated as an S-Corporation for tax purposes, you will file a corporate tax return, Form 1120-S, and pay yourself as an officer. This amount should be adjusted to adhere to certain rules, as well as optimization. For purposes of example, out of the Net Income of $100,000, let us say you will pay yourself a salary of $40,000:
Payroll tax consists of Social Security and Medicare taxes, which are referred to as FICA taxes. You may have come to the obvious conclusion that when filing as an S-Corporation you will need to fulfill certain additional compliance obligations that you would not have as a sole proprietor or single member LLC. Things such as:
- Filing a corporate return,
- Utilizing a third-party payroll provider or doing payroll yourself,
- Maintaining more robust account records.
These are all things that can be discussed during a consult should you be interested in exploring the possibility of saving on tax. And we know that most people are interested in paying less in tax!
Some considerations about a possible conversion are the rules surrounding the actual conversion process. First, you must have and LLC, partnership, or C-Corp already in place. Second, you must be domestic. Third, can only have 100 or fewer shareholders and shareholders must be individuals, estates, or exempt organizations, and not have any non-resident alien shareholders. Finally, S-Corporations can only have one class of stock. Again, these concepts can be quite complex, and a consultation is recommended in you desire to explore this opportunity.
If you have an existing LLC, you can convert to an S-Corp by completing IRS Form 2553. This form can be faxed or emailed to the IRS. It will usually take 6–8 weeks to get a confirmation letter back from the IRS. You are not officially an S-Corp until you receive the confirmation letter. Additionally, you should save your fax receipt or send the form by certified mail with return receipt requested so you have proof of filing with the IRS.
S-Corp your LLC can manage all these complex issues and can make the process easy.
Click here here to use our calculator to see how much you could be saving.