Many US entrepreneurs set up an LLC in the beginning because it is straightforward and not too expensive. Generally, this is a good approach for the start as LLCs offer liability protection and other advantages. However, entrepreneurs are often not aware that with increasing income, switching from LLC to S-Corp makes financial sense.
Why you should consider switching from LLC to S-Corp
As your income from your LLC increases, so does the self-employment tax. You earn more, you pay more tax, but your ability to contribute to retirement accounts does not change. This is where converting the LLC to S-Corp has advantages.
Self-employment tax savings
One of the biggest and most well-known advantages of an S-Corporation over an LLC is saving on self-employment tax. With an LLC, the income passes through to the owner, who has to pay 15.3% self-employment tax. If the owner resides abroad, the Foreign Earned Income Exclusion can minimize income tax but not self-employment tax.
With an S-Corporation, on the other hand, the owner can take a salary from the profits and apply the Foreign Earned Income Exclusion to minimize income tax.
Tax-preferred retirement savings
Another enormous advantage is that 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, effectively mitigating the tax burden.
The right time to convert your LLC to S-Corp
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.
In general, with around $40,000 net income you should consider converting to S-Corp. Depending on your circumstances the breakeven point could even be as low as $25,000 net income.
Of course, the details depend on a variety of factors, including:
The owner of an S-Corp can take a salary from the profits. What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure.
You may hear the general rule of thumb that salary can be two-thirds of net income. However, take this with a grain of salt. The salary number is very subjective relative to industry standards and should be supportable.
Foreign Earned Income Exclusion (FEIE)
If the owner qualifies for the Foreign Earned Income Exclusion, then he or she can exclude up to $107,600 (2020) of the salary from income tax.
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.
How to convert an LLC to S-Corporation
For federal tax purposes, you can simply make an election for the LLC to be taxed as an S-Corporation. All you need to do is fill out a form and send it to the IRS. Once the LLC is classified for federal tax purposes as a Corporation, it can file Form 2553 to be taxed as an S-Corporation.
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.
Keep in mind though that with this approach you don’t change the actual entity type, only the federal tax classification. Even though the IRS classifies the LLC as S-Corp, it is still an LLC and may be taxed as such by the state where it is formed.
To change the actual entity structure you have to formally change the LLC to a Corporation with the formation state. Some states offer a formal conversion process, while others require a workaround.
Is switching to an S-Corporation right for you?
To see if you should convert your LLC to an S-Corporation, contact us for a consultation. We can also assist you in filing the necessary forms with the IRS and business tax returns.