You’ve recently been considering changing your business structure from an LLC to an S-corp.
When you factor in the liability protections and tax benefits that accompany an S-corp, making the switch just makes sense.
But how do you know if your business qualifies to make the transition, and what’s the process of changing your status?
In this article, we cover what it takes to make a move from LLC to S-corp, the steps you’ll need to follow, and answer the most frequently asked questions about how to go from LLC to S-corp.
What Is an S-Corp?
An S-corporation is a type of corporation in which all …
- Taxable income
- Credits; and
… are passed directly through the business and on to the shareholders.
S-corps are known as pass-through entities, a title that makes them stand out from their primary alternative, C-corps.
S-Corp vs. C-Corp
The main difference between an S-corp and a C-corp is how they are viewed by the Internal Revenue Service.
- Has its profits and losses stay within the business.
- Files its own tax returns.
- Pays a 21% flat tax on profit.
With a C-corp, if the business owner decides to pull a salary from the company, they experience double taxation.
Because they’re taxed at both the personal and corporate levels.
Since S-corps are not eligible for double taxation, they are a desirable business structure for business owners who are want to receive the optimal benefits from their corporate structure without the added costs of double taxation.
Can I Convert an LLC to an S-Corp?
Yes, you can convert your LLC to an S-corp —- but you must meet certain qualifications relating to your:
- Type of corporation
- Shareholders; and
What Does It Take To Become an S-Corp?
Only some businesses are eligible to make the switch from an LLC to an S-corp.
To qualify as an S-corp, a business must:
- Be a domestic corporation.
- Have no more than 100 shareholders.
- Have only one class of stock.
- Only have individuals, estates, and/or certain trusts as shareholders.
- Not have non-resident aliens, partnerships, or corporations as shareholders. (This excludes insurance companies, domestic international sales companies, and certain financial institutions.)
5 Advantages of Converting to an S-Corp
#1: Shareholders Are Only Taxed Once
S-corps are known as pass-through (or flow-through) entities, meaning that in most states, they don’t pay federal taxes at the corporate level. Any income or loss incurred by the business is "passed through" to the shareholders, who then report it on their personal income tax returns.
Because of this, any losses the business incurs can offset other income on the shareholders’ tax returns.
#2: They Provide Liability Limitation
Just like LLCs, S-corps offer liability limitations.
This means that should debts be called in, or the business were to be sued, the owners of S-corps don’t have to worry about losing their personal assets, homes, vehicles, or personal bank accounts.
#3: Business Owners Can Categorize Themselves as Employees
In an S-corp, a portion of the business owner’s income can be taken as salary and an additional portion as business distributions.
By choosing to do this, an S-corp owner can save a large chunk of money on the self-employment taxes paid by LLCs. This is because the owner only would have to pay social security and medicare taxes on the salary amount they paid to themselves. An LLC owner (sole proprietor), on the other hand, has to pay tax on the entire amount of business income they owe.
#4: You Can Use the Cash Method of Accounting
The cash method of accounting means that transactions are reported as soon as they are paid or received.
Since income and expenses are recorded when the money actually changes hands, record keeping is simple and straightforward.
#5: They Can Help Improve Your Business’s Reputation
In many people's eyes, S-corps are viewed as larger, more impressive, and more sustainable entities than LLCs.
Transitioning from LLC to S-corp can boost your image and up your credibility in both the corporate and public eyes.
How To Go From LLC to S-Corp in 5 Steps
Now that you know the benefits of going from LLC to S-corp, let's take a look at a strategy you can implement to make the transition as smooth and easy as possible.
#1: Meet the Filing Deadline
If you plan to submit paperwork to change your business status, it must be received by March 15 to be counted as an S-corp on that year’s taxes.
In some cases, you may be able to file a “late S-corp election,” but you’ll need to register a valid reason why you did not meet the March 15 deadline. In the absence of a valid reason for late filing, the IRS is unlikely to approve the switch, and you’ll have to wait an additional year — which means you’ll be paying more taxes.
#2: Check Eligibility
As we mentioned earlier, not every LLC is eligible to become an S-corp.
If your business …
- Is not based in the U.S.
- Has more than one class of stock; or
- Has over 100 shareholders
… you don’t qualify to transition from an LLC to an S-corp.
#3: Complete Form 2553
IRS Form 2553, Election by a Small Business Corporation, is the document that lets the IRS know you’re changing the structure of your business from an LLC to an S-corp.
This form must be filled out fully and precisely — otherwise, you risk being stuck as an LLC for another year and missing out on the benefits of S-corp status.
Obtain Shareholder Signatures
The next step in going from an LLC to an S-corp is to have all of your shareholders sign IRS Form 2553.
To properly complete this form, you must obtain the signature of investors, even another business owner who’s also a shareholder (including a spouse).
File Form 2553 By the Deadline
Once Form 2553 is fully filled out and signed by all shareholders, it’s time to file with the IRS — by the March 15th deadline.
Upon completing this step, the IRS will accept the changes, your business structure will be changed from LLC to S-corp, and you’ll receive a CP261 Notice. This notification lets you know that the IRS has approved your business’s conversion and accepts that you will now be taxed as an S-corp.
Be sure to keep your CP261 Notice in your personal records should you ever need it in the case of an audit or lawsuit.
Late S Election
If, for some reason, you're unable to file Form 2553 with all the required signatures by the March 15th deadline, don’t panic.
In this case, you’ll simply file a late S Election form.
To do this, you will need to obtain IRS Form 2553 as you normally would. Fill it out as specified, but at the top of the form you will handwrite, “Filed pursuant to Rev. Proc. 2013-30.” By including these words, you’re letting the IRS know you desire to switch your LLC to an S-corp, even though you missed the March 15th cutoff.
Simply including those words at the top of the form doesn't mean you are guaranteed S-corp status. You will also need to have a valid reason why you missed the deadline.
If the IRS believes you're simply filing a late form due to a lack of organization, you will likely be denied and have to wait until the following year to file. However, it is not unusual for the IRS to grant a change in business status if the excuse for late filing is that you were unaware of the deadline.
The Important Thing To Remember When Going From an LLC to an S-Corp
If you decide that switching from an LLC to an S-corp is the best move for your business, there's one critical factor that you won't want to miss:
Don’t set your salary too low.
This is a common mistake made by many new S-corp business owners. If you set your salary unreasonably low, you may be flagged for a Reasonable Compensation Audit by the IRS. If they determine that your salary is lower than a reasonable amount for your industry, they may force you to raise your salary and retroactively pay self-employment tax — plus any penalties or fines on the difference.
The generally recommended salary is at least 30% of your business’s net income.
FAQs About Going From LLC to S-Corp
When Should I Transition LLC to S-Corp?
There is no one right answer.
You can make the switch from LLC to S-corp whenever you feel it's right for your business. However, there is a point where making the move just makes sense due to the tax implications. Generally, when your business is generating around $40,000 net income, it’s probably a good idea to make the switch.
Once your business hits this income marker, It's logical to have an S-corp from a financial and tax perspective. You’ll save money by switching to an S-corp and avoid paying the bulk of self-employment taxes.
And the more money you make, the more you’ll save by changing to S-corp status.
How Much Can I Save By Changing From an LLC to an S-Corp?
Imagine your LLC is making $150,000 a year. You're currently paying self-employment taxes of 15.3% which comes to $22,950 per year.
Now say you decide to make the move to convert your LLC to an S-corp. If after you do this you take 40% of your income ($60,000) as a salary and the rest as distribution (a.k.a. owner’s draw), your only tax obligation would be to pay 15.3% on $60,000 — or $9,180 — a far cry from $22,950.
That’s a savings of $13,770 just by switching to an S-corp. And remember, the more money you make, the greater the savings.
While you'll still be paying federal and state (if relevant) taxes on the remaining profit, you’ll be spared having to pay self-employment taxes on that amount.
How Does Filing Taxes as an S-Corp Differ From an LLC?
Filing taxes as an S-corp differs slightly from filing as an LLC.
Rather than reporting your income on a Schedule C as you do with an LLC, you’ll have a new filing requirement — IRS Form 1120-S (U.S. Income Tax Return for an S-corporation).
Are There Any Other Important Differences Between LLC and S-Corp?
Yes. Bookkeeping and payroll look a bit different for S-corps.
They are required to:
- Formulate and adopt bylaws.
- Issue shares of stock.
- Hold annual shareholder meetings.
- Keep minutes and records of annual meetings.
- Maintain a profit and loss statement and balance sheet.
S-corps also have a number of different reporting and remittance requirements, including filing forms:
- W-2 for yourself and your employees; and
- W4 and I-9 for new hires
Are There Times When It’s Best To Remain an LLC?
For most business owners, the answer is no. Once you’re meeting the income threshold, it just makes sense to become an S-corp.
However, for a few business owners, it won’t make sense to switch. If you’re an LLC that …
- Is investing in passive real estate
- Has non-resident alien shareholders
- Already has numerous shareholders or is planning to add a large number of shareholders down the road, since if you have over 100 shareholders you’ll be unable to be approved as an S-corp owner
… then it will likely be best to stick with LLC status.