Converting an LLC to an S Corp
Many small business owners form limited liability companies (LLCs) rather than corporations because an LLC is flexible and has minimal state reporting requirements. Many US entrepreneurs set up an LLC in the beginning, because it is relatively easy and relatively cheap. Generally, this is a good approach for the start as LLCs offer liability protection and other advantages.
Here's more on LLCs - https://www.mooresrowland.tax/2018/12/the-pros-and-cons-of-llcs.html
- Reasons include -
- As your income from your LLC increases, so does the self-employment tax.
- The ability to contribute to retirement accounts does not change. This is where converting the LLC to S Corp has advantages.
- Offering shares in your company to outside investors.
- Enjoying the foreign earned income exclusion while working abroad
Let's talk about #1. From a tax perspective, it makes sense to convert an LLC into an S Corp, when the self-employment tax exceeds the tax burden faced by the S Corp. Some states tax at the S Corp level and the individual shareholder level, for example California and New York. New York also taxes the S Corp on behalf of the individual if the individual does not have NY residence. If you are incorporated in one of those states, the tax savings for switching from LLC to S Corp diminishes. It is generally still worthwhile to convert to save taxes as well as retirement savings options.
Lets talk more about #2. You can contribute more to retirement accounts because with an S Corp you can set up a Solo 401k. Usually only people with an income of less than $120,000 can contribute up to $5,500 to a Roth IRA/401k. With a Solo 401k however, you can contribute up to $18,000 to a Roth Solo 401k, as long as your salary is at least $18,000. You cannot contribute more than your salary.
In addition to the Roth contribution, you can contribute up to another $36,000 to a traditional Solo 401k, again depending on the salary, to a total contribution of $54,000. With a defined benefit profit sharing plan, older entrepreneurs can limit their tax liability further and contribute even more. Based on actuarial tables, in some cases hundreds of thousands of dollars can be put away for retirement.
- It is possible to change an LLC to a corporation, and it’s a simple process in many states.
- But if you only want to become a corporation for its tax advantages, you can also remain an LLC and elect to be to be taxed as an S corporation.
LLC vs. S Corporation
LLCs and corporations are types of business entities. “S corporation” and “C corporation” refer to the way a corporation is classified for income tax purposes. Both LLCs and corporations limit their owners’ personal liability for business obligations, but they differ in their ownership and management structure.
- Corporations have a standard management structure that includes a board of directors and officers. LLCs can be managed in any way the owners choose.
- Corporations generally have more recordkeeping and reporting requirements than LLCs, and they’re required to hold annual shareholders’ meetings.
- Corporate shares are easy to transfer from one owner to another, making corporations popular with outside investors. An LLC’s membership interests are more difficult to transfer.
It is important to note that one must convert to an S Corp by March 15 in order to be applicable for the following year, or within 75 days of opening the LLC to be applicable for the year of opening. If you miss this deadline, you may apply for late election relief if you have a valid reason for missing the deadline.
How to Convert LLC to S Corporation
If you believe your business structure should be changed from LLC to corporation, the LLC to S corporation process requires two steps: converting your LLC to a corporation and then electing S corporation status with the IRS.
The first step in an LLC to S corp. conversion is to determine whether your LLC qualifies for S corp. status.
If your LLC meets the S corporation requirements, then in many states you can use a process known as a “statutory conversion” to make the LLC/S corp. change. In a statutory conversion, the LLC’s assets and liabilities automatically transfer into a corporation. There’s no need to form a new corporation and dissolve the LLC.
The statutory conversion process is relatively simple: you file a certificate of conversion and other required documents with the state and pay a filing fee. Information, forms and filing fees are typically available on the website of your state’s business filing agency.
If your LLC was formed in a state that doesn’t allow statutory conversions, you will probably have to undertake a more complicated change procedure known as a statutory merger. In a statutory merger, you form a corporation with your LLC’s members as shareholders. The shareholders then approve a plan of merger and swap their membership interests in the LLC for shares in the corporation. To complete the statutory merger, you must file a certificate of merger and any other required documents with your state. You may also be required to file documents formally dissolving the LLC. A statutory merger can be complicated, so it’s a good idea to seek advice from an attorney.
Once you have completed the process of converting the LLC to a corporation, you must file Form 2553, Election by a Small Business Corporation, with the IRS to elect S corporation tax status.
How Can an LLC Be an S Corporation for Tax Purposes Only?
To be taxed as an S corporation while still being organized as an LLC, an LLC must meet the same requirements as a corporation regarding number and type of owners.
The LLC must then file IRS Form 8832, Entity Classification Election. Once that is done, the LLC can elect LLC as S corp. taxation by filing Form 2553, Election by a Small Business Corporation.