Should your LLC convert to an S-Corporation?
In the beginning phases of a business getting setup the owner(s) had to make the decision of what type of entity their business would be. They made this decision while setting up the legal entity and while obtaining their Federal ID#. In this article we will discuss those that chose to be an LLC and the fact that they have the option of filing an S-Corporation election in the initial setup or converting to an S-Corporation at a later date.
What is an S-Corporation?
Many people get confused and think that an S-Corporation is an entity type? An S-Corporation is simply how an entity has elected to be treated tax wise. Basically an S-Corporation elects to have all the income pass through to the owners. Therefore the company does not pay income taxes. All the profits are allocated and paid by the owners on their personal returns regardless of whether or not they took the money out of the company or left it in the company. An LLC and a business that is Incorporated both have the option to elect to be treated as an S-Corporation for income tax purposes.
How is the tax treatment for an LLC different than S-Corporation?
Both S-Corporations and LLC’s have their income pass through to the owners. So what is the difference? In S-Corporations the profits are only subject to Federal and State income taxes on the owners personal tax returns. The difference is that in most LLC’s the profits are subject to Federal and State income taxes as well as self-employment taxes (Social Security & Medicare) on the owners personal tax returns. The only Social Security and Medicare taxes that the S-Corporation owners pay is on their salaries out of the S-Corporation.
Why would an LLC want to be an S-Corporation?
Simply put, an LLC would want to be an S-Corporation in order to avoid having all of their profits subject to self-employment taxes. The IRS knows that S-Corporations are set up to reduce self-employment taxes that owners pay. The owners of an S-Corporation must do a “reasonable salary” to themselves to help eliminate the IRS coming in and saying they are totally avoiding Social Security & Medicare taxes. The IRS has been pushing hard over the last few years on making sure that “reasonable salaries” are done in S-Corporations. This just means that the owners will do payroll to themselves out the company and pay the payroll taxes to include Social Security & Medicare on the reasonable salary. Let’s say the company made $40,000 in profits and the reasonable salary is determined to be $30,000. This means that there will be $10,000 of income that will not be subject to Social Security & Medicare. This would equate to $1,330 ($1,530 for years after 2012) in tax savings.
How does an LLC elect to be an S-Corporation?
The LLC needs to file IRS Form 2553 with the IRS. As mentioned before, an LLC has the option of electing to be an S-Corporation once they setup the business or at a later date. If they choose to be an S-Corporation at initial setup of the business they must do this within 2 months and 15 days of forming the new business. If they choose to do it at a later date, they must do it within the first 2 months and 15 days of the year they want to start being treated as an S-Corporation.
If you have any questions on an LLC converting to an S-Corporation, whether your LLC should convert, help determining that “reasonable salary”, or you would like help converting your LLC to an S-Corporation please contact us and we’ll be happy to assist you.