Your profits have increased steadily over the years, and you’ve heard you can save money on taxes if you convert your LLC to S Corp or C Corp. However, the process seems complicated, and you’re unsure whether you’ll even reduce your tax bill.
What should you do?
In this article, we’ll discuss the potential tax outcomes of converting your business entity and provide the step-by-step procedure.
Table of Contents
What is an S Corp?
An S corp and an LLC are both business designations and in many ways, they are pretty similar. They provide limited liability protection to owners and are pass-through entities, where profits and losses shift to owners as individual income. However, they’re treated differently for tax purposes.
An S Corp is sometimes considered superior to an LLC because business owners can avoid a portion of payroll tax by taking profit as a dividend rather than traditional income.
You can choose to be an employee of the S Corp, receive a reasonable salary, and receive the rest of the profits as a FICA-tax-free dividend.
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Tax Consequences of Converting LLC to S Corp
The math is complicated, but in the best-case scenario, any individual owner could save 15.3% on their payroll taxes by converting from an LLC to an S Corp. However, there’s a catch: If your LLC’s liabilities outweigh assets, the difference is considered taxable income and could raise your tax bill when you make the S Corp election.
Here’s how the payroll tax savings work:
- FICA taxes amount to 15.3% of wages. You’ll pay these on your “employee” salary but not on dividends.
- As an S-Corp, a portion of profit can be distributed as a dividend rather than individual income. Depending on your tax bracket, “qualified” dividends are taxed at 0%, 15%, or 20%, and “non-qualified” dividends at ordinary income tax rates.
- Regardless of tax bracket or dividend type, you’ll pay less tax on a dividend than a salary because FICA taxes are excluded.
For example, the total amount is subject to self-employment tax if you receive $200,000 as an LLC member. If you receive $200,000 as an S corp employee, you’ll only pay payroll taxes on what you decide is a reasonable salary, say $120,000. The remaining $80,000 will be subject to income tax but not FICA taxes.
Remember that the IRS only generally outlines what a “reasonable” salary means, asking: How much would a similar company pay for the same or similar expertise? This vague guideline has been interpreted through various court cases and audits. So, setting your “reasonable” salary with only dividend tax rates in mind would be unwise.
Instead, use market reports to gauge pay ranges and adjust accordingly. Using multiple sources to ensure accuracy and keeping your deviation within 20% of the median salary should keep you relatively safe.
If you’d like help evaluating whether switching to an S Corp is advantageous or deciding on a “reasonable” salary to pay yourself, reach out to indinero’s accounting services team today.
How to Change LLC to S Corp
If you meet the requirements for an S corp election, the process is relatively simple. Submit form 2553 (Election by a Small Business Corporation) to the IRS within two months and fifteen days of the current tax year’s beginning.
The form will ask for a detailed description of your business, including basic information such as address and EIN, the tax year the change will apply to, details that confirm your company meets the requirements to become an S corp and information about each of the individuals/groups who will hold shares in the newly formed S corporation.
Next, you’ll transfer the LLC’s assets into the name of the newly formed S Corp. You’ll also have to re-apply for any relevant state and local business permits under the new legal entity, update your LLC operating agreement, and amend contracts with suppliers or customers.
S Corp Election Criteria
Not every company is eligible to be taxed as an S Corp. Here’s the list of requirements:
- The business must be a domestic corporation or entity.
- The S Corp can have no more than 100 shareholders. Family members, including spouses, can be treated as a single shareholder.
- Shareholders must be U.S. Citizens, resident aliens, or certain types of trusts or estates. Other corporations, partnerships, and non-resident aliens cannot be shareholders.
- The S Corp can only have one class of stock. All shares must confer identical rights to distribution and liquidation proceeds. However, differences in voting rights are generally allowed.
- All shareholders must consent to the S Corp election.
Advantages of Converting from LLC to S Corp
In addition to payroll tax advantages, there are other reasons to organize as an S corp.
Section 199A Qualified Business Income Deduction
The Tax Cuts and Jobs Act created a new deduction for S corp owners, allowing them to take up to 20% of business income as a tax deduction.
The deduction is limited to 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the unadjusted basis of all qualified property. Additionally, it may not exceed taxable income for the year.
Easier Ownership Share Administration
As part of converting your LLC to an S corp, all members of the LLC will be given shares in the new entity. Being able to issue shares makes it easier for members to raise capital. It is also easier for shareholders to transfer ownership stakes. Finally, it can provide higher credibility with potential investors, suppliers, and customers.
Disadvantages of Converting LLC to S Corp
Becoming an S Corp can be an administratively burdensome process without a professional tax accountant in your corner.
You may incur legal costs amending existing contracts associated with the LLC, and you’ll have to make sure no ineligible institutions (for example, banks) are among your owners. For LLCs with many members, converting can be a complex process.
Additionally, subchapter S corporations are treated differently depending on the state. For instance, in states like Florida, you don’t pay state income tax on profits earned through an S corp. However, if you attempt to change from an LLC to S corp in New York, you’ll discover S and C corps are both subject to double taxation, dramatically reducing the benefit and incentive to convert.
S corps are also subject to more duties and requirements. You must hold regular director and shareholder meetings and maintain corporate records. There’s also less flexibility in profit sharing. In an S corp, you must share profits and losses with shareholders according to the amount of the company they own; this may not suit your circumstances.
How to Convert From LLC to C Corp
A C corporation is the standard business structure for corporations where the business is legally separate from its shareholders. The c corp is also subject to double taxation – the company is taxed on its corporate profits while employees are taxed on wages and owners are taxed on dividends they receive.
Converting from an LLC to a C corp is similar to converting an LLC to an S corp. In addition to filing form 8832, where you inform the IRS of your election, you’ll update contracts and transfer assets to the new entity. You’ll also need to obtain a new employer identification number (EIN) and file articles of incorporation with your state.
Advantages of Converting LLC to C Corp
Despite the downside of double taxation, there are many reasons companies choose to be organized as C corps.
Attracting Investment
Accelerators, incubators, and venture capital firms often require participants to incorporate. As a C corp, it’s easier to give out equity to investors through advisory shares in exchange for expertise and network access.
Remember, investors are investing in founders as much as in business ideas. Successful incorporation indicates to investors that you’re an entrepreneur with a strategy, one who is capable of handling organizational challenges.
Diverse Equity Options
C Corps have more flexibility than LLCs and S Corps when extending equity to investors. From common and preferred stock, which carry different voting rights, to convertible debt instruments and class A and class B stocks, C corp owners can tailor their offerings to meet many different investor preferences and individual circumstances.
Employee Equity
In a corporation, reserving shares you can later distribute to employees is easy. In an LLC, partners own 100% of a company; if you want to give a non-partner employee equity, you must make them a partner. Depending on your circumstances, this may or may not be preferable.
Separate Legal Existence
In contrast to LLCs, a C corp will remain in operation regardless of how often the company changes ownership.
For example, LLC owners are advised to write and maintain an operating agreement that details management and decision-making procedures. Without one, their business might resemble a sole proprietorship, and, in a worst-case scenario, their personal assets might be at risk to cover business losses.
Unfortunately, many LLC owners don’t take this step. If the owner dies without detailing procedures for such an event, the company may have to dissolve to resolve the legal consequences of losing a member.
Disadvantages of Converting from LLC to C Corp
A C corp has considerably more flexibility in equity administration and, as a result, is often more attractive to investors than an LLC. However, there are also downsides to consider.
Double Taxation
Unlike an LLC, a C corp has to pay taxes. When the company distributes its income to founders, investors, and employees, each person must pay taxes on those funds. This can feel like a big shift if your company operates as an LLC.
Increased Complexity and Administration
Converting from LLC to C corp can be complicated and depends on the state where you formed your LLC. Some states, such as California, allow for fast-track conversions, while the process can be considerably more complicated in other states. Transferring ownership from your LLC, as well as changing existing contracts with clients and suppliers, can be cumbersome as well.
Extra Tax Payments as Part of the Transfer
You may be able to convert all of your LLC’s assets and liabilities to your new C corp, which is considered a tax-free contribution under IRS Code Section 351. If that’s the case, you won’t have to pay taxes.
However, you must pay taxes if your LLC contributes more liabilities than assets to the new C corp. For example, if your LLC contributes $50,000 in assets and $70,000 in liabilities, your LLC partners have shifted $20,000 of debt from themselves to the C corp. The IRS considers $20,000 as income, and the partners will be responsible for paying income tax.
Additionally, the IRS expects a tax return from the now-dissolved LLC. It’s due within 3.5 months of the dissolution date. Otherwise, each partner is responsible for a $195 monthly penalty for filing taxes late.
Conclusion
Converting from an LLC to an S corp or C corp isn’t a decision to be made lightly. Corporations can have an easier time courting investors, and S corps enjoy potential advantages on payroll taxes. However, if your LLC carries more liabilities than assets when you change legal entities, the difference is considered taxable income to the owners.
Indinero is here to help businesses understand their tax responsibilities and save valuable time and money by streamlining their accounting and bookkeeping processes. To learn more, download your copy of The Entrepreneur’s Business Tax Pack. If you’d like personalized help at affordable prices, contact our business tax services team for a complimentary consultation.
