LLC VS S-Corp – What Profit Level Does it Make Financial Sense to Convert to an S-Corp?

Posted October 10, 2023

Many small businesses and startups initially incorporate their business entity company structure as an LLC due to their simplicity and low set up cost, which is a suitable approach when a new business is just starting out because LLCs offer liability protection and other benefits for fledgling ventures. However, entrepreneurs may not be aware that as their company revenue grows, converting from an LLC to an S-Corp often has financial and tax benefits.

While appropriate in early stages, retaining LLC status indefinitely risks leaving tax efficiencies on the table. Founders and small business owners should regularly reevaluate their corporate structure and consider converting to an S-Corp once their business scales. With some upfront legal work, significant tax reductions make the switch worthwhile.

Keep in mind that an S-corp is a tax classification. You can elect to have your LLC taxed as an S-corp, and many companies choose this option for tax advantages, but it’s important to know when and how these advantages apply. An LLC, or limited liability company, is a legal business structure that protects the owner’s personal assets from the company’s debts. An LLC is considered a distinct entity, which means that there is a financial barrier between the company and the owner. Unlike partnerships and corporations, LLCs don’t have their own IRS tax category. Instead, they’re usually taxed in the same way as sole proprietorships or partnerships, depending on whether the LLC has one owner or multiple owners. However, an LLC can also elect to be taxed as an S corporation (if it qualifies) or a C corporation (C-corp).

What are the benefits of converting an LLC to an S Corp?

As an LLC’s income rises, so do self-employment taxes, scaling infinitely with earnings. You make more, you pay more taxes, while retirement contribution limits remain static. Here, transitioning from an LLC to an S-Corp unlocks advantages. In a Forbes article on the subject, “in an S-corp, the owners can be company employees. They must be paid a reasonable salary, and they will pay payroll taxes on that salary. However, additional company profits won’t be subject to payroll taxes, only income taxes.”

Self-employment tax savings

One of the reasons businesses convert from an LLC to an S Corp is to eliminate self employment taxes, which consist of two separate taxes: Social Security tax and Medicare tax (the same Social Security and Medicare taxes that employees and employers pay). Self-employment taxes are the payroll taxes that fund Medicare and Social Security. With an LLC, the income passes through to the owner, who has to pay 15.3% self-employment tax. A key thing to understand about S Corps is that you don’t pay employment tax on distributions from the business. A distribution is earnings and profits that pass through the corporation to you, the owner. Basically it’s what you earn outside of your employee wages. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation. A reasonable characterization of distributions as salary or dividends can help the owner-operator reduce self-employment tax liability, while still generating business-expense and wages-paid deductions for the corporation.

Cash Method of Accounting

C Corporations must use the accrual method of accounting unless they are considered to be “small corporations” and meet the IRS’ gross receipts test. S corporations, however, usually don’t have to use the accrual method unless they have inventory.

Straightforward transfer of ownership

An article in Wolters Kluwer, on this subject explains that interests in an S corporation can be freely transferred without triggering adverse tax consequences. The S corporation does not need to make adjustments to property basis or comply with complicated accounting rules when an ownership interest is transferred.

Tax-preferred retirement savings

Another major S-Corp advantage is the ability to establish a Solo 401k, enabling substantially higher retirement contributions.

Typically, those earning under $120,000 can contribute up to $5,500 to a Roth IRA/401k. However, with a Solo 401k, you can contribute up to $18,000 to a Roth account if your salary reaches that amount. Contributions cannot exceed salary.

In addition, you can contribute up to another $36,000 to a traditional Solo 401k, again based on salary, for total possible contributions of $54,000.

Older entrepreneurs can further limit taxes and maximize contributions through a defined benefit profit-sharing plan. In some cases, hundreds of thousands of dollars can be socked away based on actuarial tables, effectively reducing taxable income.

The Solo 401k flexibility provides an immense tax advantage for S-Corp shareholders that LLC members cannot access.

Protected Assets

An S corporation protects the personal assets of its shareholders. Absent an express personal guarantee, a shareholder is not personally responsible for the business debts and liabilities. Creditors cannot pursue the personal assets (house, bank accounts, etc.) of the shareholders to pay business debts.

At what income level does it make sense to become S Corp?

According to an article published by Online Taxman , which states that “from a tax perspective, it makes sense to convert an LLC into an S-Corp, when the self-employment tax exceeds the tax burden faced by the S-Corp.” In general, you’ll want to consider electing S-corp tax status for your LLC if your business is generating sufficient profits to pay a reasonable salary to the members and annual distributions.

You need to earn at least $40,000 in profit for an S Corp to make sense, though. Otherwise, the costs of forming and running it exceeds its benefits.

Of course, the details depend on a variety of factors, including:

Salary amount: the owner of an S-Corp can take a salary from the profits. What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure. You may hear the general rule of thumb that salary can be two-thirds of net income, but, if you pay yourself too little in wages, the IRS can allocate part of your shareholder distribution as wages and require that you pay employment taxes on that.

Which State Incorporated: Some states tax at the S-Corp level and the individual shareholder level, for example, California and New York. New York also taxes the S-Corp on behalf of the individual if the individual does not have NY residence.

If you are incorporated in one of those states, the tax savings for switching from LLC to S Corp diminishes. It is generally still worthwhile to convert to save taxes as well as retirement savings options.

Confirm Your Business Is Eligible To Operate as an S-corp

To be eligible to elect S-corp taxation for your business, you’ll need to meet certain requirements:

Be a United States business
Have no more than 100 members and shareholders
Have only one class of stock
Shareholders may be individuals and certain trusts and estates
Shareholders cannot be partnerships, corporations or nonresident aliens

Are There Any Cons or Disadvantages to Switching To a S Corp?

Some potential cons that also warrant consideration when evaluating an LLC to S-Corp conversion. Tax savings may be partially offset by added administrative work and complexity. To operate as an S corporation, you must first incorporate your business by filing Articles of Incorporation with your desired state of incorporation, obtaining a registered agent for your company, and paying the appropriate fees. Adopting payroll for shareholder salaries could necessitate payroll processing and workers’ compensation insurance.

Additionally, C-corp structures better suit businesses looking to raise a seed or Series A round from outside investors or retain significant profits within the company bank account. An S corporation can have only one class of stock, although it can have both voting and non-voting shares. Therefore, there can’t be different classes of investors who are entitled to different dividends or distribution rights. Also, there cannot be more than 100 shareholders. Meaning you can’t go public in an IPO. Can increase IRS scrutiny, because amounts distributed to a shareholder can be dividends or salary, the IRS scrutinizes payments to make sure the characterization conforms to reality.

How to Convert an LLC to S-Corporation

To convert to an S-corp, you will need to file IRS Form 2553. For the tax election to have effect for the full year, the form may be filed anytime in the previous year until March 15 of the year in which you want the tax election to take effect.

If you have just launched your LLC, you can file IRS Form 2553 within 75 days of formation to be taxed as an S-corp.

If the S-Corp election deadline is missed, late relief may be requested with a valid reason.

However, this only changes federal tax classification, not the entity itself. Despite IRS S-Corp designation, states may still tax the business as an LLC.

To formally convert the structure, entities must incorporate in their formation state. Some states offer streamlined conversion processes, while others need workarounds. Before pursuing S-Corp tax status, ensure state requirements are met to avoid potential issues.

Conclusion

As mentioned earlier, one of major tax advantages 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. An LLC owner might want to become an S-corp for the tax advantages while avoiding dealing with the state law formalities of corporations, which would require having officers, directors, board meetings and board minutes. If you are a startup trying to raise outside investor money than a C-Corp might be a more suitable option.

You should review your specific situation with a tax advisor before making the switch to ensure you understand compliance and tax implications. Feel free to reach out to Huckabee CPA with any questions and request a free consultation about your specific situation.