Business owners who wish to enjoy the benefits of limited liability opt for the LLC business structure because it is simple and easy to manage. However, as the business grows, an LLC is not the most convenient structure from a taxation standpoint, as it entails more taxes. This is why many owners elect an S Corporation. The key question is when to make the shift. Also, what is the process involved? This guide provides a detailed explanation of LLCs and S Corps, as well as the steps for converting an LLC to an S Corp.
What Is an S Corporation?
An S Corporation is a tax classification that offers certain benefits to business owners. At the same time, it also entails certain obligations that the business owner must fulfill.
Definition and IRS Tax Classification
According to the IRS, “S corporations are corporations that elect to pass corporate income, losses, deductions, and credits through to their shareholders for federal tax purposes.” The income of this entity is taxed under Subchapter S of the IRS Code and avoids double taxation by passing the income directly to shareholders.
How It Differs from a Standard LLC or C Corp
The S Corp is unique, as it allows business owners to take a reasonable salary, and the remaining is distributed as profits. This means there are no self-employment taxes, which are required under the LLC structure.
A C Corp, on the other hand, has to pay corporate tax, and the shareholders have to pay personal taxes, resulting in double taxation for business owners. An S Corp avoids this by allowing profits to flow directly to business owners.
Who Should Consider the S Corp Election?
Generally, LLCs with a net profit of more than $60,000 per year can find the tax benefits of an S Corporation worthwhile. For businesses that earn less than that, an S Corp may be too much effort for the gains. It is also suited for small and medium-sized businesses that can handle payroll processing and filing with minimal resources.
Why Convert an LLC to an S Corp?
One of the primary reasons to convert from an LLC to an S Corp is the taxation benefits, especially when the business reaches a certain threshold. Below are the key reasons for making this election.
Self-Employment Tax Savings
Members of an LLC have to pay self-employment taxes on their entire earnings. At the current rate of 15.3%, this can be substantial. As an S Corp member, you have to pay self-employment taxes only on the part that is taken home as salary. This tax does not apply to the profit distributions, resulting in substantial savings.
Reasonable Salary + Profit Distribution Model
As mentioned earlier, the earnings can be divided into salary and profit distributions. The salary portion must be reasonable and along the lines earned by others in a similar role. The remaining can be treated as profits. This model can lead to substantial tax savings for owners.
QBI Deduction and Other Tax Advantages
Another advantage is that owners can claim up to 20% as Qualified Business Income (QBI). This means that taxes are paid only on 80% of S Corp earnings, resulting in more savings.
Common Scenarios That Trigger the Switch
Many businesses elect S Corp status when the net income exceeds $60,000. In general, professional services firms and small agencies benefit from this switch over.
S Corporation Requirements
There are certain requirements that must be met in order for an LLC to be elected as an S Corp. Some of these key requirements are as follows.
Must Be a Domestic Entity
One of the primary rules is that the LLC must be a domestic company that is registered in the United States. Companies that have foreign registrations are not eligible for this election.
100 Shareholders or Fewer
The option to switch over to an S Corp is available only for small businesses that have fewer than 100 employees. For this rule, owners who are married and file jointly are considered as a single shareholder.
One Class of Stock Only
The company that is electing to become an S Corp must offer only one class of stock. This means all owners have equal voting rights and profit share.
Eligible Shareholders (U.S. Persons Only)
Lastly, all shareholders must be U.S. citizens or residents only. Other corporations and non-resident aliens are not considered eligible shareholders.
LLC vs. S Corp: Key Differences at a Glance
The choice between an LLC and an S Corp often comes down to three factors: tax, payroll compliance, and IRS filings.
Taxation Comparison Table
The primary difference is the salary and profit model in S Corps and only the profit model in LLCs, which results in substantial tax benefits. Below is a quick comparison of the differences.
Feature |
LLC |
S Corp |
| Self-employment taxes | On the entire profits. | Only on the salary part of the profits. |
| Tax structure | Only profits | Profits and salary |
| Taxation rate | Based on individual tax brackets. | Based on individual tax brackets. |
Payroll & Compliance Requirements
An advantage of an LLC is that it has less paperwork and filing requirements. More importantly, there’s no payroll processing for the owners. S Corps, on the other hand, must process payroll, file taxes quarterly, and maintain shareholder records.
IRS Filings & Deadlines
S Corps must file Form 1120-S annually and send Form K-1 to every shareholder. Also, the salary component must be processed, and W-2 Forms must be sent out. LLCs don’t have to do any of these.
Ideal Revenue Range for Each Structure
LLCs are ideal for businesses that earn under $60,000 because the tax savings are not significant until this level. When your business starts earning more than $60,000, the tax savings become more substantial.
Step-by-Step: How to Convert an LLC to an S Corp
The process of converting from an LLC to an S Corp is straightforward, provided you meet the IRS eligibility requirements. Here is the step-by-step process involved.
Step 1: Verify Eligibility (Entity Type, Ownership, etc.)
The first step is to see if your LLC meets the IRS rules. It must be a domestic company having fewer than 100 shareholders, all of whom are U.S. citizens or residents.
Step 2: Obtain an EIN (If Not Already Issued)
Next, your LLC must have an Employer Identification Number (EIN). This is free and can be obtained from the IRS by filling out forms and following the procedures. If you need help, Manay CPA can get this EIN for you.
Step 3: File IRS Form 2553 (S Corp Election)
Once you decide to elect to an S Corp, you must file Form 2553 with the IRS within two months and 15 days of the start of the tax year. Only when you file this form within the deadline can you convert the LLC to an S Corp.
Step 4: Adjust Your Operating Agreement (if needed)
Make sure to change the shareholder or operating agreement to reflect the S Corp status.
Step 5: Set Up Payroll for Owners
Set up payroll processing, as you will have to pay the owners a reasonable amount as salary. Often, small firms prefer to outsource this processing to firms like Manay CPA, so they can focus on their business.
Step 6: Update Accounting & Bookkeeping Practices
Lastly, maintain records of all transactions. Understand the forms that must be filed with the IRS and complete them before the deadline.
With these steps, your LLC can be elected to an S Corp.
When to File Form 2553 to Elect S Corp Status
An LLC is officially elected as an S Corp only when you file Form 2553 with the IRS. The following aspects must be kept in mind to make this election successful.
Deadlines: 2 Months + 15 Days Rule
For the tax rates to take effect, you must file Form 2553 within two months and 15 days after the start of the tax year. This roughly falls around mid-March, so make sure to keep this date in mind.
Retroactive Election Options
In case you miss the deadline, the IRS may provide the option for a retroactive election if you meet certain conditions and can provide a valid reason for late filing.
Late Filing Relief Under IRS Rev. Proc. 2013-30
This rule consolidates the late filing relief provided that the business has acted in good faith. If you meet the conditions, you can get relief for delayed filing.
How Converting Impacts Taxes and Payroll
As mentioned before, electing to an S Corp provides tax benefits, provided the income exceeds $60,000. Let’s see why this can lead to savings.
Owner Compensation Rules
The owner must take a reasonable salary that is commensurate with the salary levels of others having similar job responsibilities. Note that underpayment can increase the chances of an IRS audit.
Employment Taxes (FICA, FUTA)
Only the salary part of the compensation is subject to FICA and FUTA taxes. This is where an S Corp offers significant tax benefits, as the taxes will be lower because they are calculated only on the salary component.
Filing Requirements (1120-S, W-2s, K-1s)
There are increased filing requirements for S Corps, as they must file Form 1120-S with the IRS and send Form K-1 to shareholders for the profit component. Additionally, Form W-2 must be sent for the salary components. Based on this income, the individual shareholders will file their taxes.
Quarterly Payroll Reporting (Form 941)
S Corps must also report their quarterly payroll through Form 941 and remit the appropriate federal income taxes for each quarter.
Compliance Considerations After Converting
After converting to an S Corp, you must continue to meet the compliance requirements. Otherwise, there’s a chance that your status can become invalid.
State-Level Notifications
Once you elect to become an S Corp, you must notify the state. Depending on your location, some states have annual fees that must be paid to operate in that state.
Annual Reports & Franchise Taxes
The state-wise requirements vary, but some states require you to file annual reports and pay franchise taxes if you meet the conditions laid down by that respective state.
Shareholder Agreements and Distributions
While not mandatory, it’s good to rewrite shareholder agreements that lay down the exact contribution percentages. This written agreement helps avoid disputes later.
Audit Risk with Improper Salary Practices
One of the key areas that can attract IRS audits is the “reasonable” salary. There’s always a chance that owners can take low salaries to avoid self-employment taxes. Anything too low when compared to the market levels can attract IRS audits.
Staying on top of these compliance requirements can help you make the most of S Corp conversions.
Common Mistakes to Avoid
As business owners, it’s important to know the pitfalls. Here are a few common ones to avoid.
Missing the 2553 Deadline
One of the most common mistakes is to miss the deadline as you get caught up in running the business. This can attract penalties in some cases. But largely, there’s a chance that you can’t avail the S Corp benefits in the current tax year.
Not Running Payroll or Misreporting Salary
Another common mistake is to take a lower salary or not run the payroll processing according to the IRS rules. These actions can attract IRS audits.
Mixing Personal and Business Expenses
When you are the owner, there is always a possibility of commingling your personal and business expenses. However, this can increase the chances of audits and the resulting penalties.
Assuming S Corp Is Always Better (It’s Not!)
Finally, it’s important to note that the S Corp structure is not for everyone. Businesses with low incomes may be better off with an LLC structure, as there’s less processing.
Can a Foreign Owner Choose S Corp Status?
There are ownership restrictions for an S Corp status, as the owner must be a U.S. resident or citizen.
Non-U.S. Citizens or Residents = Not Eligible
Anyone who is not a U.S. citizen or a resident as per the IRS regulations is not eligible to own shares in an S Corp. Similarly, foreign-owned entities are also not eligible.
Alternative Strategies (LLC + Partnership or C Corp)
Non-residents and foreign-born owners who are not eligible to own shares in an S Corp can choose an LLC, partnership, or C Corp structure, depending on their business goals and eligibility requirements.
Manay CPA Support for International Founders
Manay CPA works closely with foreign entrepreneurs to help them select the appropriate business structures. These experts ensure that you are compliant with U.S. regulations while enjoying the benefits of U.S. business ownership.
Manay CPA Can Help You Convert to an S Corp the Right Way
Working with an experienced firm like Manay CPA helps you select the right structure that offers the maximum benefits. Some key services that they offer are:
Entity Structure Review and Tax Impact Simulation
Manay CPA experts can analyze the current entity structure and recommend the tax entity that can meet your goals. They even simulate savings across multiple structures, allowing you to make an informed decision.
EIN + Form 2553 Filing
They stay on top of deadlines and can file Form 2553 on your behalf. Also, if you don’t have an EIN, they can get it for you.
Payroll Setup and Ongoing Bookkeeping
Another key pain point for many S Corp owners is payroll processing and bookkeeping. Manay CPA can take care of these aspects, so you can focus on growing your business.
IRS & State Compliance Monitoring
IRS and state taxes are subject to change from time to time. Manay CPA stays on top of these changes and helps your business adapt to them.
Book a Free Consultation (CTA)
To know more about how Manay CPA can help you convert from an LLC to an S Corp and run your operations in a smooth and compliant way, book a free consultation today.
