LLC vs. S Corp: When to consider switching (Part 2)
Disclaimer: This article is intended for general informational purposes and does not constitute individualized tax or legal advice. Tax treatment depends on the specific facts and circumstances of each taxpayer and business.
When does an S Corp election start making sense?
There is not one specific profit level at which every business should become an S Corporation (S Corp).
At relatively low levels of profit, the potential self-employment tax (payroll taxes) savings may not justify the additional cost and administrative burden. As profits increase beyond what would constitute reasonable compensation for the owner, the economics often become more attractive.
Example
Consider an owner generating $60,000 of annual business profit who would reasonably need to receive most of that amount as compensation. There may be relatively little economic benefit to an S Corp election after considering payroll and compliance costs. An owner generating $200,000 or $300,000 while requiring a reasonable salary substantially below total business profit may have a much stronger case.
This is why I generally recommend running an S Corp tax projection before making the election.
The additional costs of an S Corp
Tax savings are not the only consideration.
An S Corp generally creates additional responsibilities, including:
running payroll for owner-employees
filing quarterly and annual payroll tax returns
issuing W-2s
filing a separate federal S Corp income tax return (Form 1120-S)
maintaining appropriate accounting records
tracking shareholder basis
properly distinguishing wages, distributions, contributions, and reimbursements
maintaining state-level registrations and filings when applicable
Depending on the state, additional franchise, excise, income, or other business taxes may also apply.
Those costs should be incorporated into the analysis. Saving $2,000 of tax while creating $3,000 of additional annual compliance costs is not particularly useful.
What about multiple-member LLCs?
An LLC with multiple owners is generally taxed as a partnership unless it makes another tax election.
A qualifying multi-member LLC may also elect S Corp taxation, but the analysis becomes more complicated. S Corps have specific eligibility and ownership requirements. They also generally require distributions and allocations to follow shareholders' respective ownership interests.
Partnership taxation can provide considerably more flexibility in allocating income, losses, and distributions among owners.
Therefore, a partnership should not elect S Corp status solely because the owners have heard that an S Corp saves payroll taxes. The economics, ownership structure, compensation arrangements, and long-term plans for the business should all be reviewed first.
Don't forget about retirement planning
An S Corp election can also affect retirement plan contributions.
For an S Corp shareholder-employee, retirement plan contributions are generally based on W-2 compensation, not S Corp distributions. This creates another reason that salary should not be determined solely by asking, "What's the lowest salary I can legally pay myself?"
The appropriate compensation level may need to consider reasonable compensation, payroll taxes, retirement contributions, cash flow, and the owner's broader tax strategy.
When an S Corp may not be worth it
An S Corp election is not automatically beneficial.
It may not make sense when:
business profits are relatively low
most of the profit would reasonably need to be paid as wages
income is inconsistent or unpredictable
the additional accounting and payroll costs eliminate most of the tax savings
the ownership structure is not compatible with S Corp requirements
partnership tax flexibility is important
state taxes significantly reduce the expected benefit
the owner does not want the additional administrative burden
In some cases, remaining a sole proprietorship or partnership is both simpler and more economical.
Don't make the decision based on a “rule of thumb”
You may often hear statements like: "Once you make $50,000, you should become an S Corp." However, two businesses earning the exact same amount can have completely different tax situations.
The better question is: How much tax would the business owner pay under the current structure compared with an S Corp after accounting for reasonable compensation, payroll taxes, state taxes, retirement planning, and additional compliance costs?
That is a calculation — not a rule of thumb.
Considering an S Corp election?
If your LLC has become consistently profitable, it may be worth evaluating whether an S Corp election could reduce your overall tax burden.
At Jon Acevedo, CPA, LLC, we help business owners evaluate their current tax structure, estimate potential S Corp tax savings, determine an appropriate compensation strategy, and implement the election when it makes financial sense.
Before making the change, we recommend reviewing:
current and projected business profit
reasonable owner compensation
estimated payroll-tax savings
state tax implications
payroll and compliance costs
retirement plan opportunities
long-term business and ownership plans
An S Corp can be an excellent tax-planning tool, but the goal is not simply to become an S Corp.
The goal is to choose the tax structure that makes the most sense for your business.
If you would like to discuss more about this topic with us, please reach out using the contact form. We look forward to hearing from you!
Thank you for reading our blog! Here are some helpful deadlines and notes:
Key tax deadlines
Individuals
April 15 – Federal individual income tax return due (Form 1040)
October 15 – Extended individual filing deadline
Estimated tax payments
April 15 – 1st Quarter payment due
June 15 – 2nd Quarter payment due
September 15 – 3rd Quarter payment due
January 15 – 4th Quarter payment due (following year)
Businesses
March 15 – Partnerships (Form 1065) and S-Corporations (Form 1120-S) due
April 15 – C-Corporations (Form 1120) due
September 15 – Extended deadline for Partnerships and S-Corporations
October 15 – Extended deadline for C-Corporations
Important reminder
An extension provides additional time to file a tax return, but not additional time to pay. Any expected tax liability should generally be paid by the original due date to minimize penalties and interest.
Current clients
Please upload tax documents through the secure client portal whenever possible. Additionally, please do not send Social Security numbers, tax returns, or other sensitive information by email. If you received an IRS or state notice, please upload the complete notice, including all pages.
Submission of documents does not constitute completion of a tax return. We will contact you if additional information is needed.
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