Is It Time for Your Single Owner LLC to Become an S-Corp? A Comprehensive Guide
How to decide whether you should become an S-Corp and How to Transition from LLC to S Corp Status
If you are a solopreneur or small business owner, chances are you have heard about S-Corporations (S-Corps) as a way to minimize taxes and protect your personal assets. But with so much information out there, it can be hard to know if it is the right move for your business and when to make the transition. In this comprehensive guide, we will discuss what S-Corps are, their benefits and drawbacks, and how to decide if becoming an S-Corp is the right move for your single owner LLC. We will also walk you through the process of becoming an S-Corp, from filing your taxes to creating an employee benefit plan.
What is an S-Corp?
Similar to a single owner LLC implementing pass-through taxation, an S-Corp is a business structure that allows owners to avoid the double taxation issue of traditional corporations (C-Corps) while providing similar liability protections. Unlike a traditional corporation, an S-Corp is not taxed on its profits. Instead, the profits are passed through to the shareholders, who report them on their individual tax returns.
A single member LLC and a single owner S-Corp are of the same family. If you are a solopreneur, you are going to be a single owner S-Corp, which is a tax status associated with a single member LLC. As a single owner S-Corp, you are the single shareholder- the owner of the corporation and operator of the S-Corp.
Benefits of an S-Corp vs an LLC
One major benefit of an S-Corp is tax savings for the business. As the profits are passed through to you, your personal tax rate is applied to the profits instead of the corporate tax rate. This can amount to significant savings, especially for small businesses.
In a single-member LLC, the owner is not considered an employee and does not receive a traditional salary. Instead, they take money out of the company's profits as needed, which is known as an "owner's draw". This is essentially a withdrawal of capital from the business for personal use. The owner's draw is not a deductible business expense, so it does not reduce the business's income for tax purposes. However, the owner must pay self-employment taxes (Social Security and Medicare) on the entire net income of the business.
In contrast, a single shareholder of an S Corporation can be treated as an employee and receives a salary, which is a deductible business expense. This means that the corporation's income can be reduced by the amount of the salary for tax purposes, potentially resulting in lower taxes. The shareholder-employee's salary is subject to employment taxes (Social Security and Medicare), but any additional profit distributions to the shareholder are not subject to these taxes. This can provide a significant tax advantage if the S Corporation is profitable and the shareholder receives substantial distributions in addition to their salary.
It's important to note that if you become an S-Corp, you will now have to use a payroll service. Since you become a W-2 employee of your business, taxes must be regularly withheld and paid. Lastly, the salary you pay yourself as an S Corp owner must be "reasonable", i.e., what you would pay for the same job in the open market. This stipulation is one of the primary things to consider when examining your businesses profitability and if you can reasonable and responsibly become an S-Corp. Note, this salary can't be a one off- you must be able to sustain the salary.
Another benefit when it comes to S-Corp status and payroll is that you can also implement a company benefit policy, such as retirement matches to your personal tax-advantaged retirement account. These matches would be part of your total compensation package.
The main difference between these two methods of owner compensation lies in the taxation. A single-member LLC owner pays self-employment taxes on all business profits, while an S Corporation shareholder pays employment taxes only on their salary, not on profit distributions. It's worth noting that reducing your wages to pay out profits through profit distribution could potentially limit your ability to make substantial contributions to a retirement plan, as these can only be made from compensation
(Not sure how to get to the place of having a salary account? No worries! MM Strategic Advising regularly works with business owners to get their business financials to a place where 6-18 months of salary are in a salary account at any given time!)
Drawbacks of an S-Corp
For S Corps with multiple shareholders, a major drawback of an S-Corp is the restrictions on ownership and types of stock. An S-Corp can only have up to 100 shareholders, and all of them must be US citizens or residents. Additionally, only one class of stock is allowed, which means that all shareholders must receive the same distribution of profits.
Another potential drawback is the extra paperwork and filing requirements. As an S-Corp, you will have to file additional tax forms beyond the standard annual income tax return. You will also be required to hold annual meetings and keep detailed records of business decisions.
How to decide if becoming an S-Corp is the right move
Deciding whether to become an S-Corp is a big decision that should be made after careful consideration. Here are some key factors to consider:
Your business income: As we mentioned earlier, one of the main benefits of an S-Corp is tax savings. However, if your business is not generating significant profits, becoming an S-Corp may not make sense.
Your business structure: Becoming an S-Corp may not be the best move if you plan to grow your business to the point where you need additional funding. In that case, you may want to consider a different business structure.
Your goals for the business: Consider your long-term goals for the business and whether becoming an S-Corp aligns with those goals. If you plan to sell the business or eventually take it public, becoming an S-Corp may not be the best move.
How to become an S-Corp
If you have decided to become an S-Corp, here are the steps you will need to take:
File Form 2553 with the IRS: This form notifies the IRS that your business is electing to become an S-Corp.
Create an employee benefit plan: As an S-Corp, you will be required to have an employee benefit plan in place.
File additional tax forms: As we mentioned earlier, you will have to file additional tax forms beyond the standard annual income tax return.
Hold annual meetings: As an S-Corp, you will be required to hold annual meetings with other shareholders, if relevant. You will need to keep detailed records of business decisions.
Molly's Final Thoughts:
Becoming an S-Corp can be a smart move for solopreneurs and single owner LLCs looking to save on taxes and protect their personal assets. However, it is important to carefully consider your individual business's performance before making the decision to transition. If you do decide to become an S-Corp, the process can be relatively simple, but it is important to follow all of the necessary steps to ensure compliance with regulations.
Please Note: It's always advisable to consult with a tax professional or CPA to understand which business structure might be most advantageous for your specific circumstances.
Meet Molly, a Financial Advisor who specializes in working with artists, creative entrepreneurs, and small business owners!
Talking about money is hard. I make it easier.
After 20 years working in, managing, and eventually leading multi-million dollar arts organizations, AND the start-up of my own two successful businesses, I decided my passion was found in helping other creatives not only gain financial control, but thrive in the creative arts.
I want to help YOU have the freedom to live a creative life with a solid financial footing so that you can create your best work.
My goal is to help 300 individuals and creative business owners get solid when it comes to money and building the lives they want.
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