3 Steps to Change Your LLC to an S Corp

If your small business has taken off but is still being taxed as an LLC, a significant portion of your profits might be unreasonably taxed on the combined personal and self-employment tax rates. However, LLCs can mitigate this by converting their tax status.

By electing an S Corp status for taxation via the IRS form 2553, entrepreneurs can efficiently convert an LLC to an S Corp to potentially improve their business’s finances and make it easier to invest in its future. Here’s what you’ll need to know about converting an LLC to an S Corp.

Key Takeaways

• S Corp is a tax classification rather than a business structure and won’t affect how you need to run or manage your business.

• An S Corp must employ its members and provide them with a “reasonable salary.”

• Converting an LLC into S Corp tax status requires filing Form 2553 with the IRS.

• The S Corp tax benefits result from not paying the self-employment tax on the business profits after payroll.

What Is an S Corp?

An S Corp is a corporate tax classification that allows incorporated business entities to pass on the income directly to the shareholders rather than being taxed as an independent corporate entity.[1]

It bypasses the normal double taxation of standard C Corporations. However, the shareholders have to be made into employees of the company and be provided a “reasonable salary” for the work they do for the business.

This differs from the tax status of a traditional C Corporation structure, where the shareholders only receive their dividends based on the company’s profits. The distribution is made after the company pays corporate tax on its income. This structure doesn’t require shareholders to do anything for the company except make initial investments and own its stock.

Since it’s only a tax status rather than a business structure, the IRS (Internal Revenue Service) also allows LLCs to elect this taxation.[2] It translates slightly differently when used by LLCs but can still yield tax savings.

S Corp vs. LLC

The main difference between S Corp vs. LLC structures lies in how the business is taxed. Significantly, an S Corp is a special taxation status rather than a business structure. On the other hand, an LLC doesn’t come with its own taxation status, according to the IRS.

By default, LLCs are treated as partnerships or sole proprietorships by the IRS.[3] As such, the IRS requires owners (members) to file the business’s income tax as part of their personal, self-employment income. The income is based on the distribution of ownership as laid out in the LLC operating agreement.

As such, the company technically doesn’t make any taxable profit, but all of it is passed onto the members. This is why LLCs are often referred to as pass-through entities. 

Technically, the IRS treats a single-member LLC as a disregarded entity, meaning it’s not fiscally separated from its owner. However, if the LLC elects to be taxed as a corporation (whether C Corp or S Corp), the IRS will treat them as such.

Specifically, an LLC taxed as an S Corp still uses pass-through taxation on its income to the owners. However, since it’s now an S Corp, the IRS requires the LLC to employ its owners and pay them a “reasonable salary” for the services provided.

The exact amount for “reasonable” is never stated and usually changes between one year and the next based on the country’s average salary for a similar position. This leads to taxation differences due to how the owner’s personal income is taxed. 

Without an S Corp designation, everything your company earns is transferred automatically to you. These earnings are taxed at the combined self-employment (including Medicare and Social Security) and personal income rates.

However, if you are paid a salary, only that salary is taxed for employment taxes. This means that a potentially significant chunk of your profit can be passed onto you, foregoing the employment tax.

How S Corp Can Save You Money

Let’s use a simplified example where “Mark” owns a single-member LLC and currently has no employees.

If the company made $100,000 in profits in a fiscal year, all of that profit is directly passed onto Mark. Then, Mark pays employment taxes according to the combined 15.3% self-employment rate. This means that he’d need to pay $15,300 in self-employment taxes.

However, suppose Mark elects S Corp status for his LLC and pays himself a $75,000 salary. Since the employment tax is now divided between the employee and the company, the LLC pays 6.65% of the salary in employment taxes, or $5,737.50, and Mark files another $5,737.50 on his personal income tax return. The rest is passed onto Mark as (personal income taxable) dividends.

In the end, Mark pays $3,825 less in employment taxes when his LLC is an S Corp. In both situations, all income would need to be taxed as personal income, which doesn’t affect the equation.

Of course, Mark could save even more if he slashed his salary by $10,000 or even $35,000. However, the IRS keeps track of the reported salary and will notice if it’s below the national average for the industry.

Without a significant discrepancy between the company’s profit and the salary you’d have to take out for yourself, the costs of maintaining payroll and S Corp status can be costlier than remaining as a default LLC. If Mark’s company earned $40,000 and allocated $35,000 to the salary, the $765 employment tax savings would likely get eaten up by other costs.

In general, a multi-member LLC needs to be able to pay out at least $10,000 in dividends after payroll for every member to make the conversion worth it, but even that is a rough estimate. Consult an accountant to get a more precise picture based on your company’s income.

How to Convert an LLC to S Corp

The process is relatively simple if you’re fully intent on changing your LLC to an S Corp and getting some tax savings. You don’t have to file any amendment documentation to the state. Since the S Corp status only affects taxes, the process is completed entirely through the IRS.

1. Determine Your S Corp Eligibility

The IRS has laid out comprehensive requirements for corporations that want to classify as S Corp-taxable. For LLCs, the requirements roughly translate to the following:

• The LLC can have at most 100 members (owners).

• The LLC is registered in the U.S., and all members are either U.S. residents or resident aliens (i.e. have a green card).

• All members have voting rights.

• All members have voted and reached a majority agreement in favor of the S Corp election.

Voting is usually done by properly documenting and filing a company vote for future records. All members need to sign the document.

2. Review S Corp Tax Election Due Dates

The IRS tracks corporate taxes in fiscal or tax years, which are uninterrupted 12-month periods between consecutive tax returns that don’t end on December 31. An LLC is usually taxed based on the calendar year, but you may have outlined a tax year in the LLC’s operating agreement and tax return.

This is important because the IRS imposes election due dates based on a business’s individual tax year. The deadline to elect S Corp status in the current tax year is within 2 months and 15 days (for example, if the tax year starts on February 1, the deadline is April 15).

If the company elects to be taxed as an S Corp after the deadline, the new taxation system is applied in the following year.

Additionally, the IRS might force you to review and change your tax year before changing your tax status. To check whether your current tax year allows you to become an S Corp LLC, review the “General Instructions” section in Instructions for Form 2553.

3. File IRS Form 2553

The final step of the process is to fill out and file the IRS Form 2553. All members need to sign the form physically, so you may need to coordinate if your LLC is primarily a remote business.

Note that you may have to file via mail to the address corresponding to the state where your LLC’s business address is or via fax. The IRS can take up to eight weeks to process the form and send a reply.

Should I Change My LLC to a C Corp?

A C Corporation is an entirely different concept from an S Corp, even though they are usually bundled under “corporation” when discussing business types. An S Corp is a tax status for the IRS, while a C Corp is an organizational system and tax status for the state government.

C Corps can have separated management and ownership structures and issue stocks to obtain capital. In a traditional C Corporation structure, company owners (shareholders) may or may not involved in the company. If a C Corp elects an S Corp status, the shareholders similarly become employed by the company and receive a reasonable salary.

If you want, you can change your LLC to a C Corporation before electing to become an S Corp. However, this conversion process will completely change your management structure and require additional filing with the Secretary of State office and associated departments.

Keep in mind that not all states view the S Corp status according to federal guidelines. It’d be best to contact your Secretary of State office or a corporate law firm for legal advice. Some states may require you to be classified as a C Corp in order to start the process.

FAQs

Can I turn my LLC into an S Corp?

Yes. You can submit Form 2553 to the IRS to elect S Corp tax status.

When should you convert from LLC to S Corp?

The new tax status matters only if your company has significant profit after paying out employee salaries, including the salaries paid to the members.

What are the advantages of converting an LLC to an S Corp?

After paying out salaries to employees and members, the net income isn’t taxed by the employment tax.

Is it better for an LLC to be taxed as an S Corp?

Not necessarily. You’ll need to review your finances and check whether the salary plus payroll requirements cost more than the tax savings.

What happens when you convert an LLC to an S Corp?

Since S Corp is not a business structure, an LLC business that previously processed payroll functions the same as before converting. However, an LLC must pay members a salary, which can create an administrative burden.

What are the tax consequences of converting LLC to S Corp?

The dividends (net profit) that remain after paying out a “reasonable salary” to the members are taxed at a lower rate. Specifically, it doesn’t have to be taxed as self-employment but solely as personal income.

How much does it cost to convert an LLC to an S Corp?

Filing Form 2553 usually doesn’t incur a fee. However, if you plan to change your fiscal year, the IRS may charge you up to $6,200 in fees.

How much can I save by switching to an S Corp?

As an example, a company making $100,000 in profits can save about $9,000 in self-employment taxes by determining a “reasonable salary” of its single owner as $40,000. The savings go up based on business income but get lowered if the salary needs to be higher.

Bibliography

1. U.S. Small Business Administration. “Choose a business structure.” Accessed January 17, 2024.

2. Internal Revenue Service. “Instructions for Form 2553 - Who May Elect.” Accessed January 17, 2024.

3. Internal Revenue Service. “Limited Liability Company.” Accessed January 17, 2024.