There comes a time when it could very well make sense to elect S Corporation status for your Limited Liability Company (LLC). An LLC, if it meets IRS eligibility requirements, has the flexibility to be taxed as an S Corporation. This can potentially lower the business shareholders’ personal tax burden as only their wages and salaries (not their profit distributions) are subject to Social Security and Medicare taxes. Consider these signs for when it could be time to change an LLC to an S Corporation.
Financial and Tax Indicators
- You want to bring on investors. You’re ready to take the company to the next level and to do that, you need financial support from other sources. Sometimes investors are more willing to back an S Corporation than an LLC as they feel more confident in the company’s viability and legitimacy.
- Your net business profit (after taxes; before owner draws) is consistently at or above the range where your self-employment tax obligations (Social Security and Medicare taxes) start to exceed what you’d pay if splitting your business income into a salary and distributions. The range can vary but generally the threshold is when net profit reaches around $40,000 to $50,000 or above.
- You actively work in the business and could pay yourself a reasonable W-2 wage or salary for your role. Additional profits would be paid as distributions, subject to income tax but not Social Security and Medicare taxes.
- Your company’s financial projections indicate your business will have ongoing profitability. A trajectory that can justify the initial costs of S Corporation set up and ongoing compliance and payroll costs.
Compliance Considerations
- You feel prepared to manage payroll (or hire an accountant, bookkeeper, or payroll services provider), i.e., handle reporting and making payroll tax deposits, issuing W‑2s, and filing an annual S Corporation tax return (Form 1120‑S).
- You can justify and document your rationale for your “reasonable compensation” salary based on responsibilities, hours, industry pay for comparable positions, and business performance. The IRS has been known to scrutinize shareholder-employee wages and salaries, and anything that may represent underpayment in an attempt to game the system to disproportionately minimize Social Security and Medicare tax liability.
- Your LLC meets the IRS’s requirements for S Corporations. It must have fewer than 100 members because an S Corporation may have no more than 100 shareholders. Also, your LLC may not have any members ineligible to be S Corporation shareholders (such as nonresident alien owners, partnerships, or corporations).
Timing Food for Thought
- You are prepared to file Form 2553 for the S Corporation election for the current tax year by the applicable deadline. For existing LLCs, this is typically within 2 months and 15 days after the start of the tax year (which is mid‑March for a calendar‑year business). Newly formed LLCs must file within 2 months and 15 days of their entity’s formation effective date.
- You want to lower your audit risk associated with Schedule C reporting. Various sources indicate that S Corporations are less likely to undergo IRS audits than LLCs, Partnerships, and Sole Proprietorships.
Learn More About Why and How to Switch to an S Corporation
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