Convert LLC to S Corp: a Step-by-Step Guide

Everything You Need to Know About S Corp Election

A Limited Liability Company (LLC) is a great choice for many self-employed professionals. LLCs have straightforward management and protections against legal burdens, making them highly attractive for most businesses.

From a taxation perspective, LLCs provide appealing simplicity. Single-owner LLC owners report their business income on their personal tax returns, similar to sole proprietors.

You may have heard of colleagues or peers in your network running their solo business as an S Corporation (S Corp). Electing to be taxed as an S corporation does not restructure your LLC. Instead, it changes your tax strategy and the financial outcomes of your business—a savvy move for those seeking to reduce their self-employment tax liability without altering the benefits of their LLC.

Let's explore why and how an LLC can switch to S Corp taxation and the benefits it can bring.

The Basics of an S Corporation

The S Corp structure is appealing for self-employed professionals because it avoids the double taxation seen in corporations and over-taxation typically seen in sole proprietorships or LLCs. In an S Corp, profit and losses pass directly to the owner's personal income, bypassing corporate tax rates.

The primary advantage of an S Corp for self-employed individuals is the potential for tax savings. Unlike sole proprietorships or LLCs, where the entire income is subject to self-employment taxes (including Social Security and Medicare), an S Corp treats the owner’s income differently.

In this structure, the business owner receives a reasonable salary, which is subject to employment taxes. However, any additional income (profits) from the business passes through to the owner without being subject to these taxes. This distinction can lead to significant tax savings, especially for higher-earning individuals.

However, S Corps require adherence to certain formalities like maintaining corporate bylaws and holding annual meetings. Before moving forward, it’s important to balance the tax benefits against the administrative obligations.

Benefits of an S Corp Election

Beyond tax savings, electing S Corp status also brings a higher degree of separation between personal and business finances, particularly for federal tax purposes. This separation is beneficial for financial record-keeping and can enhance the credibility and professionalism of the business. It simplifies personal tax returns by distinguishing personal income from business income, which is advantageous during tax filings and audits.

It also opens the door to a suite of other corporate benefits, such as 401(k) matching, more robust write-offs for benefits, and a payroll system in place should you wish to pay family members through your S-Corporation.

Moreover, this election can also influence the perception of the business in the eyes of potential investors, financial institutions, and clients, as it demonstrates a commitment to formal business structures and financial responsibility.

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Eligibility Requirements to Elect S Corp Status

To be eligible for S Corporation status as a self-employed individual, there are several key criteria set by the IRS that must be met.

These requirements ensure that only certain types of businesses and ownership structures qualify for the tax advantages that an S Corp can provide.

1. Type of Entity: First and foremost, your business must be a domestic corporation or a domestic entity eligible to elect to be treated as a corporation. This means that your business should be organized under the laws of the United States, a state, or a territory. If you’re currently operating as a sole proprietor or a general partnership, you would need to incorporate your business as a corporation or an LLC (Limited Liability Company) before you can elect S Corp status.
2. Number of Shareholders: S Corps are limited to 100 shareholders. This is to ensure that the S Corp status is used primarily by small to mid-sized businesses.
3. Type of Shareholders: Shareholders must be individuals, certain trusts, and estates. They cannot be partnerships, corporations, or non-resident alien shareholders. This requirement is in place to maintain the closely held nature of the business.
4. One Class of Stock: S Corps can only have one class of stock, although they can have differences in voting rights among shareholders. This means the corporation cannot issue preferred and common stock with different rights and privileges.
5. Consent: All shareholders must consent to the corporation electing S Corp status. This is done by signing and filing Form 2553 with the IRS.
6. Tax Year: Generally, an S Corp must adopt a calendar year as its tax year unless it can establish a business purpose for having a different tax year.

Steps to Convert Your LLC to an S Corp

1. Ensure Eligibility: Confirm that your current LLC structure and operations align with the requirements and advantages of an S Corp and that you meet all of the eligibility requirements listed above.
2. Consult with Professionals: Before making any changes, it's wise to consult with a tax advisor or attorney. They can help you understand any state-specific or industry-related implications or nuances.
3. File IRS Form 2553: To elect S Corp status, file Form 2553, "Election by a Small Business Corporation," with the IRS. This form must be signed by all LLC members. It's crucial to file this form in a timely manner - generally by March 15th of the tax year in which you want the election to be effective.
4. State Notification: Notify your state's taxing authority of your election to be treated as an S Corp. Some states automatically recognize the federal S Corp election, while others require a separate state-level election.
5. Adopt Corporate Formalities: Once your S Corp election is approved, adopt the necessary corporate formalities. This includes holding and documenting annual shareholder and director meetings, maintaining separate financial records, and ensuring proper financial management in line with S Corp requirements.
6. Adjust Payroll: Because of your reasonable salary, you'll need to start issuing payroll for yourself as an employee of the S Corp. Payroll taxes must be withheld and paid on this salary.
7. Revise Tax Reporting: Prepare to file your taxes as an S Corp. This includes filing an 1120S tax return and issuing Schedule K-1 forms to all shareholders, reporting their share of the corporation’s income or loss.
8. Maintain Compliance: Stay compliant with ongoing S Corp requirements, including yearly filings, maintaining proper records, and adhering to corporate governance practices.

Remember, each step is crucial for a successful transition from LLC to S Corp, and the process may vary slightly depending on the specifics of your business and state laws. Always seek professional advice to ensure compliance and optimize the benefits of your S Corp election.

The Tax Implications

When you transition your LLC to an S Corp your income tax structure will change. Instead of all of your income being subject to self-employment tax, only the reasonable salary you pay yourself will be subject to those taxes.

The remaining income (profit) will pass through to your personal tax return and will not be subject to self-employment taxes. This can reduce the overall tax burden, especially if the business is profitable enough to pay the owner a reasonable salary and still distribute profits.

On the business side, you will now need to file a corporate tax return (Form 1120s). But rest assured, you won't be paying taxes at the corporate level for your S Corp. Profits and losses will be reported on Form 1120s and passed through to shareholders (you) on a Schedule K-1. Each shareholder then reports this income on their personal tax return.

How to Maintain S Corp Status

Maintaining S Corp status as a self-employed professional involves adhering to specific regulatory requirements and business practices.

Here are the key steps to ensure you retain your S Corp status:

1. Compliance with Ownership Rules: S Corps are restricted to a maximum of 100 shareholders, and these shareholders must be individuals, certain trusts, or estates. Shareholders cannot be partnerships, corporations, or non-resident aliens. Continuously ensure your shareholder structure adheres to these rules.
2. Maintain One Class of Stock: S Corps can only have one class of stock, though they can have differences in voting rights. Any action that can be interpreted as creating a second class of stock (such as special distributions or differing rights to assets) could jeopardize your S Corp status.
3. Meet Filing Deadlines: File your corporate tax returns on time using Form 1120S. This form must be filed every year by the 15th day of the third month after the end of your tax year. Late filings or consistent errors can lead to scrutiny and potential revocation of S Corp status.
4. Accurate and Separate Record Keeping: Keep accurate financial records that clearly separate the corporation's finances from your personal ones. This includes maintaining separate bank accounts and credit cards for business transactions.
5. Pay Reasonable Compensation: If you work in your S Corp, you must pay yourself a reasonable salary for the services you provide. This salary should be in line with industry standards. The IRS closely monitors this to ensure that S Corps are not evading payroll taxes by distributing profits in lieu of a reasonable salary.
6. Adhere to Corporate Formalities: Even as a self-employed individual, you must respect the formalities of a corporation. This includes holding annual shareholder and board of directors meetings, keeping meeting minutes, and maintaining an updated corporate record book.
7. State Compliance: Apart from federal requirements, ensure you comply with any state-specific regulations regarding S Corps. Some states have recognition and tax rules that differ from federal rules.
8. Ongoing Tax Planning and Review: Regularly consult with a tax advisor to ensure your business practices and financial planning align with S Corp requirements and to take full advantage of the tax benefits.

By diligently following these guidelines, you can maintain your S Corp status, thus benefiting from its tax advantages and legal protections.

Conclusion

Transitioning from an LLC to an S Corp is a strategic decision. It requires understanding the nuances of various business entities and their tax implications.

But for solopreneurs, this shift can herald significant tax savings and more efficient tax management. S Corps offer amazing tax benefits while maintaining the necessary liability protection and flexibility that comes with an LLC. And those are just a few of the reasons why S-Corps are better than LLCs.

At Formations, we specialize in guiding self-employed professionals through the complexities of business entity selection and tax strategies. Our team of experienced advisors is well-versed in the intricacies of the s corp election process and is dedicated to ensuring that you have all the information you need to make an informed decision.

If you're considering an S Corp election, Formations is here to provide expert advice tailored to your unique situation. Schedule a meeting with one of our advisors today to see if an S Corp is right for you and your business.