How Converting Your LLC to an S-Corp Can Save You Money on Taxes

How Converting Your LLC to an S-Corp Can Save You Money on Taxes

If you're running your business as an LLC, you might be missing out on valuable tax savings by not considering the S-Corporation election. Converting your LLC to an S-corp could help you reduce your tax burden, especially when it comes to self-employment taxes. Here’s how making the switch can save you money:

1. Save on Self-Employment Taxes

As an LLC taxed as a sole proprietorship or partnership, all of your business profits are subject to self-employment taxes (Social Security and Medicare) at a rate of 15.3%. This applies whether you take the money as a distribution or reinvest it back into the business.

When you convert to an S-Corp, the game changes. As an S-Corp owner, you are required to pay yourself a reasonable salary for the work you do. You’ll pay payroll taxes on this salary, just like any other employee. However, the remaining profits after paying yourself can be taken as distributions, which are not subject to self-employment taxes.

Example: Let’s say your business makes $100,000 in profit.

• If you are an LLC, the entire $100,000 is subject to self-employment taxes, costing you $15,300.
• As an S-Corp, if you pay yourself a reasonable salary of $50,000, only that $50,000 will be subject to payroll taxes, costing you $7,650. The remaining $50,000 can be taken as a distribution with no additional self-employment taxes, saving you $7,650.‍

2. What’s a “Reasonable Salary”?

The IRS requires that you pay yourself a reasonable salary based on what someone in your industry and with your experience would typically earn. This ensures that you don’t avoid paying payroll taxes altogether by taking all profits as distributions. It’s important to be honest and ensure that the salary you pay yourself is fair for the work you’re doing. If the IRS finds your salary too low, they may reclassify your distributions as wages and impose penalties for unpaid payroll taxes.

3. The Qualified Business Income Deduction

Both LLCs and S-corps can take advantage of the Qualified Business Income (QBI) deduction, which allows you to deduct up to 20% of your qualified business income from your taxable income. This is a valuable tax break that applies to many small business owners, helping further reduce your tax liability.

4. Consider the Additional Costs

While the tax savings can be significant, converting to an S-corp does come with some additional administrative costs. You’ll need to run payroll, which might require hiring a payroll service or dedicating time to managing it yourself. Additionally, S-corps must follow certain corporate formalities, such as holding annual meetings, maintaining meeting minutes, and filing annual reports.

5. How to Convert Your LLC to an S-Corp

If you’re ready to take advantage of the tax savings, converting your LLC to an S-corp is relatively straightforward. You can make the switch by filing Form 2553 with the IRS. This must be done no later than two months and 15 days after the start of the tax year in which you want the election to take effect.

Is Converting to an S-Corp Right for You?

An S-corp election makes the most sense if your business is earning consistent profits and you’re able to pay yourself a reasonable salary while leaving additional profits to be taken as distributions. For smaller businesses or those just starting, the tax benefits may not be as significant until you’re generating enough profit.

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Converting your LLC to an S-corp can be a smart move to reduce your tax liability, but it’s important to weigh the pros and cons for your specific situation. If you’re wondering whether this strategy is right for your business, it’s always a good idea to consult with a tax professional to ensure you’re making the most of the available tax benefits.

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