As an LLC owner, one of the things that you should think about is whether the business should remain an LLC, or whether your business would benefit from changing its corporate structure to something else, such as an S Corp.
If you’re thinking of the disadvantages and advantages of changing the corporate structure of your business, this article is for you.
LLC to S Corp Conversion: The Basics
Obviously, every business grows over time and the business’s priorities can also change over time, depending on what the business is actually doing. In addition, as the business grows from being a startup to an established business, the business owner’s goals also usually change, to focus on achieving goals beyond their survival, and instead, taking advantage of growth opportunities and optimizing its bottom line, for example, by taking advantage of minimization strategies. These are often secondary priorities that only start to grow after the business is proven to be a successful business model that is capable of making good money.
What are the Disadvantages of an LLC?
There can be a few disadvantages to running an LLC.
Extra Taxes at the Entity Level. Obviously, the $800 a year annual payment to the California Franchise Tax Board will not be going anywhere, whether you have an LLC or S Corp. However, California requires successful LLCs to pay an additional layer of taxes, which are assessed based on the LLC’s income. If your LLC is making good money, chances are, you may pay more in taxes, at the entity level, than you might if you will be running an S Corp. instead. By taxes at the entity level, we’re referring to the minimum franchise tax fee assessments by the California Franchise Tax Board. Obviously, LLCs, at a federal income tax level, are pass-through entities and do not pay direct income taxes to the federal government.
No Deductions for Wages. As a member of an LLC, you are prohibited from treating yourself as an employee. This means that whatever you receive in wages cannot be characterized as W-2 or wage type income that is ordinarily offset and deducted against the gross revenues of your company. Instead, you take on what is left over at the end of the month, and none of this is deemed deductible to your entity.
Taxes Owed on Phantom Income. Phantom income refers to net profits that the LLC keeps, and does not distribute to any of the members, which are nonetheless taxable to the members anyway. The concept of retained earnings, i.e., nontaxable earnings that are kept by the business to remain capable of paying its operating expenses, does not exist in LLCs. So, if your LLC has net profits and does not want to distribute to all the members, your share of those net profits is going to be taxable to you, as an individual, even if you never receive that income. Also remember that as an LLC, you have an obligation to withhold estimated taxes, and prepay them four times a year. If you are paying estimated taxes on phantom income, that money is coming out of your pocket, and these estimated taxes must be paid, [even if you] never received the distribution from the LLC. It can be incredibly frustrating to LLC owners to have to reach into their savings accounts and pay estimated taxes on phantom income that the LLC is keeping and not paying to them.
Self-Employment Taxes on Compensation. As an owner of an LLC, you also do not receive what are called dividends. Dividends, in the context of a corporation, refer to nonwage-type compensation that is not subject to payroll taxes or self-employment taxes. In an LLC, however, you will be only permitted to take income in the form of a distribution, which is subject to self-employment taxes. Self-employment taxes refer to federal and state withholdings, such as Medicare, FICA, Social Security, and other withholdings. To make matters worse, self-employment taxes are higher than regular wage/W-2 payroll taxes and are currently 15.3%. This is on top of your federal and state income taxes. So many LLC members feel as though they’re giving up close to half of their income when all is said and done.
How are LLCs Usually Taxed?
When an LLC is first formed, the federal government creates a default method for taxing the LLC, based on the number of members the LLC has. The default classification for a LLC that has a single member is a sole proprietorship. This is a pass-through form of taxation, by which the LLC is classified as a disregarded entity. An LLC with more than one member, which is called a multi-member LLC, is by default classified as a partnership, and handles taxes the way it would be imposed as a partnership.
These default provisions can have an effect on the business, because if the members later would like to change how the entity is taxed, they must file additional forms and make additional modifications to the entity’s operating documents.
Can an LLC be Taxed as an S Corp?
Many businesses find that as their businesses grow, they are paying an incredible amount on taxes and look for alternative operational structures to take advantage of tax minimization strategies – which often includes converting the LLC to an S Corp, or having the LLC change its election and be taxed as an S Corp. An S Corporation can combine some of the most favorable traits of an LLC and an S Corporation and can give the owners a lot of flexibility, while making it possible to minimize unnecessary taxes, both at the corporate level and at the individual level.
LLC Conversion to an S Corp versus LLC Election to be Taxed as an S Corp
Before we go any further, please know that there are two distinct options available for an LLC owner looking to take advantage of the tax-favorable aspects of an S Corp.:
- Updating the LLC’s federal tax election status so it is no longer taxed as a partnership, and that it is instead taxed as an S Corp. (i.e., election to be taxed as a corporation that takes the “S” election)
- Actually converting the LLC to an S Corp at the entity level.
These completely different concepts can have important differences in effect on the business owner and how the business operates.
Would You Save on Taxes Converting Your LLC to an S Corporation?
An S Corporation, like an LLC, is a pass-through entity. It reports income through an information return, the Form 1120S, which reports its gross revenues, business deductions, profits, tax credits, and amounts distributed to shareholders as dividends.
Business Owner Compensation in an LLC versus Compensation in an S Corp. In an LLC, business owners are prohibited from being paid as employees through W-2 wages. They can only be paid as members/owners of the business, through self-employment wages. This can cause frustration to LLC members, because self-employment taxes are higher than payroll taxes on wages. For years, business owners have expressed great frustration that the IRS and U.S. Tax Code essentially penalize small business owners by making them pay more in taxes or self-employment taxes than if they were employees receiving W-2 wages. This problem is easily cured however, through conversion of the LLC to taking an election as an S Corp.
In an S Corp., a business owner has two different relationships with the business: one as an employee, for which the business owner receives wages through payroll, and one as a shareholder, by which the business owner is compensated through dividends. Dividends are not subject to self-employment taxes, and therefore, can save the business owner quite a bit in unnecessary taxes on net profits of the business that the owner is receiving not for providing services, but because of the success of the business.
So, in an S Corp. setting, the owner receives wages which are subject to payroll taxes (FICA/Medicare/Social Security, etc.). 50% of these federal taxes are paid by the business, and 50% by the employee. When combining these two halves together, a 100% of payroll taxes on the same income is less than the taxes that an LLC member would pay if that income were taken as a distribution. Why? Self-employment taxes. Self-employment taxes are at a rate of 15.3%. And this is in addition to regular state and federal income taxes at the individual level.
What Changes are Needed to your LLC’s Operating Agreement Before It Can Elect to be Taxed as an S Corporation?
There is a lot of misinformation on the Internet that indicates that taking an S election as an LLC is as simple as filing a single form with the IRS. This is not necessarily true, especially if your LLC’s operating agreement is not set up for the entity to qualify to be taxed as an S Corp.
Many operating agreements are done on a form basis, using a template, and many of these template forms often reference particular terms that are not workable for the entity to enjoy the benefits of an S Corporation election.
If the necessary changes are not made to your LLC’s operating agreement, and it makes an S election anyway, then the S election can be invalidated by the IRS, including retroactively, and cause the LLC and its members to owe huge amounts to the IRS in back taxes.
One of the common problematic areas involves multimember partnerships, in the allocation of profits and losses. In a multimember LLC, the partners can elect to allocate income and losses any way they like, as long as those allocations reflect the “substantial economic effect” requirements of IRC Section 704(b). However, an S Corporation must allocate all profits and losses on a pro rata basis, depending on each shareholder’s ownership interest in the company. If an LLC cannot show that it has been following these rules during its existence prior to election of S Corporation status, then even if it elects to be taxed as an S Corporation, the IRS can terminate that election retroactively, on the basis that the LLC was never properly set up to take the S Corp. election or convert to an S Corp.
S Corp Guaranteed Payments: Can an LLC Taxed as an S Corp Make Guaranteed Payments to its Members?
Yes and no. The concept of “guaranteed payments” is unique to the partnership business model. There is no such thing as a “guaranteed payment” in the context of corporations. After an LLC converts to an S Corp. or takes an election to be taxed as an S Corp., it will no longer be paying guaranteed payments to its owners. Instead, it will be compensating its owners through wages (W-2) and bonuses for services performed; and it will be compensating its owners, regardless of whether the owners are providing services or not for the success of the business by the payment of net profits through dividends.
Will the S Corp Pay More in “Double Taxation” than an LLC?
One of the concerns the business owners have is whether they will lose whatever savings on self-employment taxes on having to pay taxes at the corporate level. In California, LLCs are taxed at the state level by the California Franchise Tax if revenues are in excess of $250,000. Distributions of net profits to LLC members are taxable as self-employment income, while an S Corp. can take advantage of the tax deductibility of compensation to shareholders made through payroll, which assists in “zeroing out” the net profits of Corporation, so as to be able to minimize corporate taxes as low as possible.
Taking an S Corp Election as an LLC
The process of converting an LLC to an S Corp. involves preparing the necessary paperwork with the LLC, its managers and members, which authorize the transaction to take place; and preparing and filing the necessary paperwork with the IRS. This includes IRS Form 2553.
When You Should Not Convert an LLC to an S Corp
With all that being said, converting an LLC to an S Corp. is not right for everyone, and there can be a variety of hidden dangers. The best way to know whether your company should convert status to being in S Corp. is to simply speak with the business attorney who can assist you in determining what is right your company’s circumstances.
What are the Restrictions on Ownership in an S Corp?
For example, there are certain restrictions on who can own an S Corp.
- An S Corp. can have no more than 100 shareholders.
- All of the Shareholders of the S Corp must be citizens of the United States [or] legal permanent residents (green card). If there is any member of your LLC that is a nonresident alien, foreign citizen, etc., you will not be able to convert your LLC to an S Corp.
- One Class of Stock. If you envision taking passive investments from outsider investors who [you want to receive only a right to receive income?], with participation in the management of business, it generally is not a good idea to convert your LLC to an S Corp. An S Corp can only have one class of stock, meaning that it will not be possible to distinguish between active members of the LLC who are managing the business, versus passive members or investors who have a right to receive a portion of net income but are otherwise “silent” partners.
- No Corporate Ownership. If you have a sophisticated business involving multiple business structures, an S Corp may not be right for you. It is not possible for an S Corp to be owned by any one other than natural persons, meaning that no corporations or corporate shareholders or partnerships are permitted. The S Corp must be owned only by natural persons.
How Difficult Is it to Convert an LLC to an S Corp?
The process of converting LLC to S Corp. does not need to be particularly painful, expensive, or difficult. Although the process itself is relatively straightforward, the bigger and more important question is whether it is right for your company. There are many horror stories in the business world about companies who are unaware of the tax and other consequences that a conversion from an LLC to an S Corp might have on them, their capital counts, their tax basis in their units, and their overall tax liabilities. Many times, this does not occur because of any shortcoming fault of the business owner – our tax system is just so astonishingly complicated that it can be very easy to miss important consequences simply because of not having the knowledge or expertise as to those hidden dangers. Most business owners have no interest in taking tax law as a hobby, so, if you’re thinking about whether your company could benefit from converting from an LLC to an S Corp, you could have peace of mind by simply speaking to an attorney beforehand.
What Actually Happens when an LLC Elects to be Classified as an S Corporation
When an LLC looks to be taxed as an S Corporation, the LLC is essentially electing to transfer all of its assets and liabilities of the corporation in exchange for the corporation stock, and distribute stock to owners in a complete liquidation.
What is the LLC S Corp Election Deadline?
When an LLC seeks to elect to be taxed as an S Corp., it should take the “Check the Box” election at the time of its formation, and then request S Election status no later than 75 days after the start of the tax year in which it seeks to have S Corp status.
LLC Taxed as S Corp Distributions: How do Distributions Work?
For LLCs taxed as S Corps, distributions become the equivalent of dividends in the corporation structure. So, in the same way that an LLC would distribute its excess profits to the members on a quarterly, annual, or other basis, the S Corp can achieve the same result.
LLC S Corp Election Form with IRS: What is Form 8832 Used for?
An IRS Form 8832 is used for the situation when an LLC does not initially elect to be taxed as a corporation, and wants to do this later on. If an LLC elects to be taxed as an S Corporation at the beginning of its existence, it will file an IRS 2553 form. If the LLC fails to do this at that time, then it can no longer use the Form 2553 form, and it must use the IRS 8832 Form. This means that, if an LLC correctly elects S Corp status at the beginning, it will never need to file an IRS 8832 Form.
What Date Should be Listed on the IRS 8832 Form: What is the Effective Date of the S Corp Classification of our LLC?
According to IRS regulations, the Effective Date of the S Corp. election for an LLC has a very specific window of time. It cannot be more than 75 days before the date the election is actually filed, and it cannot be more than 12 months after the election is actually filed. So the maximum retroactive date of an election by the LLC to be taxed as an S Corp. is 75 days prior to the date of actual filing of the election.
Is an S Corporation an LLC?
An S Corporation is not the same thing as an LLC. It is important to note that an “S Corp” is a corporation that elects to be taxed as a partnership, taking the S election, under a specific code section of the Internal Revenue Code. There is no such legal entity called an “S Corp” – it refers to a corporation that makes a specific tax election. An LLC, however, has the same right, and can take the same election and be taxed as an S Corp.
About Axis Legal Counsel
AXIS Legal Counsel’s Business Practice provides legal advice to numerous small businesses with a variety of legal matters, including business formations, contracts, deals, and transactions, business administration, corporate governance, operations, risk management / insurance, labor/employment matters, intellectual property, healthcare, crisis management, directors/officers, private/data security, technology, statutory/legal compliance, and business litigation. AXIS represents businesses, corporations, LLCs, LLPS, partnerships, and startups in need of a corporate lawyer, for business legal matters as well as business litigation, such as disagreements, non-solicit agreements, non-competes, trade secrets, and other disputes with businesses. We are also experienced in providing assistance to business clients concerning business contracts, corporate formation matters, contracts and transactions, business litigation, business legal advice for Corporations, LLPs, LLCs, Partnerships, Small Business, Startups, and others involving corporate law.
If you are seeking a business lawyer, or for information on retaining AXIS Legal Counsel to represent your business in connection with any legal matter, contact firstname.lastname@example.org or call (213) 403-0130 for a confidential consultation.
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