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May 11, 2021

When is the Right Time to Move from an LLC to an S-Corp?

As a business owner, you should be on the lookout for ways to maximize profits, reduce expenses, and minimize your tax liabilities.  Taking the subchapter S election and changing your LLC to an S-Corporation brings potential tax savings.  The question is, when is the right time to make the move.

You must pay yourself a reasonable salary as the owner of an S-Corporation.  So, you do not want to add payroll taxes and salary expenses until it makes sense to do so.  And with the timeline restrictions for submitting the Form 2553 Election by a Small Business Corporation, proper planning is important.  Making the election too soon can overburden the company’s operating funds but making the S-election too late may mean missing out on potential tax savings.

An S-Corporation can be formed any time you want.  To qualify for the current tax year, the submittal is due by March 15th.  A newly formed LLC may submit Form 2553 within the first 75 days, and it will be effective for the first year of business. You have the option of applying for relief if you have a valid reason for missing one of these deadlines.

You need to ensure that you have the proper cash flow to continue operations while still paying yourself what the IRS deems a reasonable salary.  In addition to the added expense of your salary, you need to budget for federal and potentially state payroll taxes.  Generally, the recommended guideline is that if your average annual profits are less than $50,000 it is not the right time to transition from an LLC to an S Corporation.  The tax benefits, if any, would be minimal when offset against the cost of the owner’s salary and payroll taxes.

When profits average $50,000 a year, this is sufficient to accommodate a reasonable salary and related payroll taxes.  The tax benefits of being an S-Corporation at this profit level will be rather limited, but still present to some extent.  Remember, as an LLC the profits are subject to federal taxes and self-employment taxes, but with an S-Corporation, only the salary is subject to self-employment taxes.   So, depending on the amount of your salary and whether there are state payroll taxes where you operate, you will start to notice some tax savings in the reduction of self-employment taxes.

 If you expect the business to grow, it is better to have the structure in place to take advantage of future benefits.  You may not be ready to leverage the S-Corporation to its maximum benefit if you wait until the money is pouring in, especially if you miss the filing deadline to make the election.

A few other things to consider when deciding if it is time to switch to an S-Corporation include timing, bookkeeping, cash flow, and setup.  The easiest time to make a major company change is the first day of the new tax year.  This makes the most sense for bookkeeping and tax preparation.

If you take the S-election effective for the beginning of the tax year you will operate the entire year as an S-Corporation and only need to maintain one set of books and file one business tax return.  Changing any other time may require running separate books to track income and expenses for the LLC, which was operating either as a sole proprietorship or partnership, and for the S-Corporation.  It also means you may need to file two separate tax returns, either the 1120-S and 1065, if the LLC was multi-member and taxed as a partnership, or the Schedule C on the personal 1040 and the 1120-S.

With cashflow, in addition to the cost of your salary and payroll taxes, you may need to pay for additional bookkeeping costs, hire a payroll company to process your payroll and keep up with the required payroll filings, and pay additional tax preparation fees, since an S-Corporation must file its own federal corporate tax return, and possibly, a state return.

While becoming an S-Corporation is a matter of submitting the federal Form 2553, additional steps may need to be taken to set up the actual business.  These may include opening a separate business bank account in the company name, registering for new business licenses and permits under the new business formation, and changing or adding an insurance policy.  And, as a salaried employee, you may want to think about opening a retirement account, such as a SOLO 401(k).

Not a Formations Customer Yet?

Finding the balance between minimizing expenses and maximizing tax savings is one of the services we offer here at Formations.  We offer several plans for businesses of multiple income levels and we can help you determine the best time to take the S-Corporation election.  Contact our business consultants today to see which plan will work best for your business. We are here to help.

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