When to Switch From an LLC to an S-Corp

when to switch from an LLC to S-Corp by tax hack accounting

Forming an entity is one of the first steps a growing business should take. Entities help business owners protect their assets and take advantage of tax benefits. Many businesses opt to start with an LLC, thanks to its robust liability protection and simple pass-through tax structure, but S-Corps often prove to be better options for them down the road. But, is it worth it for your business? This guide will help you decide whether you should switch from an LLC to S Corp

Why Should I Switch from LLC to S Corp?

An S Corp might start making sense when you find that your self-employment tax is higher than what you would pay in taxes as an S Corp.

Generally, if your business is making around $40,000 or more in net income, it’s time to think about converting. However, even with a net income of about $25,000, there could be valid reasons to make the switch.

How an S-Corp Can Beat an LLC

The primary advantage of being an LLC is the simplicity of tax filing and the pass-through taxation. However, this also means that as your income increases, so does your self-employment tax.

The LLC structure can incur significantly higher self-employment taxes for business owners as their income increases. Conversely, an S Corp can offer more favorable tax treatment once a business reaches certain income levels.

In an S Corp, the company’s income is viewed as pass-through, which helps avoid double taxation. More importantly, an S Corp allows for a distinction between salary and distributions, which can be a significant tax advantage.

The salary you pay yourself as an owner of an S Corp will be subject to payroll taxes, but distributions above this salary may not be subject to self-employment taxes.

If your business is in a growth phase, expanding operations, and hiring more employees, converting to an S Corp offers additional advantages.

It provides a stronger framework for such expansion, albeit with a cap of 100 shareholders. This structure not only allows for more efficient tax handling but also brings enhanced credibility to your business.

How to Change from LLC to S Corp

Switching from an LLC to an S Corp involves several steps, both at the state and federal levels. First, you need to submit an Articles of Amendment document to the state where your LLC was formed.

You also have to get a new Employer Identification Number (EIN) from the IRS so they can make note of the change in business structure.

If you plan on paying yourself a salary, you’ll also have to set up payroll for your company if you haven’t had employees before. Check out our blog post on setting up payroll to learn more about the process.

Ideally, you should have a tax advisor to facilitate this process. It’s complicated, and a screw-up could cause major problems for your business down the road.

Alternative: Choosing the S Corp Election

If you don’t want to full transition your LLC to an S Corp, you can still take advantage of the favorable tax treatment by filing Form 2553 and electing S-Corp tax treatment for your LLC.

However, it’s crucial to file this form within the prescribed deadlines to ensure the election is effective for the desired tax year.

Benefits and Challenges of an S Corp

An S Corp can provide significant savings on self-employment taxes for businesses with significant incomes. It’s a valuable benefit that can save up to thousands of dollars in savings, but it comes with some downsides.

S Corp compliance requires more rigorous record-keeping and corporate formalities. In addition, filing requirements are more stringent, so your tax preparation costs will likely increase. Lastly, you’ll need a solution to run payroll, and you’ll be required to withhold taxes and submit regular payments to federal, state, and local tax authorities.

Ultimately, the primary downside of the S-Corp structure is increased administration and accounting costs. However, if your net income exceeds $50,000 annually, the tax savings will probably outweigh the added expense. Plus, the increased costs are typically tax-deductible.

When to Stay as an LLC

Despite the notable tax benefits, many businesses often find that remaining an LLC is their best option.

For example, a business with a relatively modest income might determine the tax savings aren’t worth the added costs of managing an S Corp.

LLCs also offer more flexibility in profit distribution and management structure, which can be beneficial for smaller or more dynamic businesses.

Closing Thoughts

Deciding to transition from an LLC to an S Corp is a significant choice that hinges on various factors, including your business’s current financial standing, future growth plans, and personal preferences in managing business operations.

It’s a decision that should not be taken lightly and requires careful consideration of both the immediate and long-term implications for your business.

Tax Hack Accounting specializes in sophisticated tax strategies for growing business that are customized to deliver game-changing tax benefits. Connect with one of our tax pros for a one-on-one strategy session now to see how we can help your business.

Book your session now!