Single Member LLC to S-Corp Conversion: What You Need to Know , Pt. 2

  • Why would I convert my single member LLC to an S-Corp?
  • What are the benefits of an S-Corp?
  • What should I be aware of? Are there restrictions?
  • How do I do it? What are the requirements?
  • Can you show me an example of how tax is different between an S-Corp and a Single-Member LLC?

As a CPA, I hear these questions a lot in my field. S-Corps are a popular business structure, and for good reason. That’s why I’ve put together a comprehensive, two-part series for you. If you missed the first post, here’s the link to read it.

In this final post, I’ll cover the benefits and drawbacks of converting your single member LLC to an S-Corp. Plus, I’m giving you a hypothetical example showing the tax differences between the two. Ready? Let’s begin!

Benefits of S-Corp Tax Election

When you file an S-Election, your LLC remains intact – but you’re taxed as an S-Corp. One of the biggest benefits? Reduced SE tax! Keep in mind that payroll is needed and MUST pass as “reasonable”. You must have good bookkeeping records in order to file a separate business tax return.

Payroll taxes (aka Self -employment taxes) are paid on compensation only – not on the full net profit of the biz as in the LLC option. A separate return is filed, but all income flows to your personal tax return and is taxed for income taxes only – not SE tax.

Distributions/draws are allowed once reasonable compensation is obtained and there is basis to do so. This is NON-deductible by the company and NON-taxable by the individual.

Be sure to research “reasonable compensation” for your business type and geographic area you are in.

As a summary, here are some key reasons why small business owners choose to be taxed as an S-Corp:

  • Unlike a sole proprietorship or partnership, an S-Corporation offers asset protection, which is obviously a substantial benefit. S-corps allow you to protect your personal assets from liability from corporate debts. 
  • With an S corporation, business income or loss essentially “passes through” to shareholders and is then reported on their personal income tax returns. Therefore, your business losses can offset other income when you file your tax return.
  • Shareholders can be employees and take a salary, as well as receive dividends and distributions. As explained before, these must be reasonable – but the major benefit is lower SE tax liability. To be clear, “the S corporation and its owner will only pay these taxes on the owner’s salary. The remaining profits are not subject to these taxes,” explains a Legalzoom article on the topic.
  • Transfer ownership without unfavorable tax repercussions – a welcome difference from partnerships and LLCs, where a transfer of greater than 50% interest can prompt termination of the entity.
  • S corporations can choose the cash method of accounting instead of the accrual method (unless they have inventory); traditional corporations generally must use the accrual method unless they’re considered a small corporation.

What Should I Know About Before Converting My LLC to an S-Corp?

Knowledge is power: before you make the decision to convert your single member LLC to an S-Corp, be sure to consult with a qualified tax professional so you can understand how the benefits and drawbacks impact your unique business circumstances. As with other corporations, maintaining S-Corp status can be complex and feel overwhelming for small business owners.

That said, here are some common areas to be aware of:

  • If you’re looking for simplicity, an S-Corp might not be for you. Not only are there costs associated with electing S-Corp status, but your state may also require ongoing fees associated with annual reporting and/or franchise tax fees.
  • Although not overly common, your S-corp status could be terminated if you overlook certain legal filing requirements or other tax obligations. S-corps also tend to be the subject of greater IRS examination, particularly because shareholder distributions can be dividends or salary if you don’t carefully consider the differences and basis calculations.
  • S-corps have restrictions on stock ownership, and foreign stock ownership isn’t allowed at all. Just one class of stock is permitted, and there cannot be more than 100 shareholders.

Single Member LLC to S-Corp: An Example

Wondering what the numbers look like?

Here’s a sample example, where I’m comparing the same company and the tax consequences under both scenarios:

Have more questions? Not sure if converting your single member LLC to an S-Corp is right for you? Let’s chat! Reach me at 207-522-1014 or Tracy@TracyCassidy.com to see how I can help you achieve your business goals.

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