One of the most common questions CPAs get asked is, “When should I change my tax election from a sole, or partnership, LLC to an S-Corp?” The follow-up question is usually, “Why should I make the tax election move?” Let’s first explain the difference between an LLC and an S-Corp.
An LLC or Limited Liability Company is a legal structure for a business that separates your personal and business assets and protects your personal assets from business liabilities.
An S Corp or S Corporation is a tax election – not a legal structure – for a business that determines how it is taxed at the federal and state levels. Therefore, when a company assumes an S-Corp tax election, it does not lose its LLC structure.
Now, let’s look at the two questions above.
When Should I Change My Tax Election To an S-Corp?
It is beneficial for any small business with annual net profits of approximately $45,000 or more to strongly consider changing its business entity from a sole or partnership LLC to an S-Corp. Switching your business’ tax election requires meeting IRS requirements for making the change and then, if all the requirements are met, filing Form 2553, Election by a Small Business Corporation with the IRS. If you file paperwork and complete the process within two months and 15 days after the beginning of the current tax year, you may be able to claim S-Corp status for the current tax year. If your election falls after this, it will be valid for the following year.
Why Should I Make the Tax Election Move?
The main reason for electing an S-Corp tax classification is to avoid being double-taxed by the IRS. A 15.3% self-employment tax levied on sole and partnership LLC’s profits versus a 7.65% (+ FUTA) rate of S-Corps. An S-Corp also allows its owner(s) to contribute more money to retirement plans.
Though tax savings is a major reason for a business deciding to elect an S-Corp status, it is not the only reason. To learn about other reasons contact your CPA.
Some Important Things to Note About S-Corp
There are a few important changes to a business that occur when the tax election moves to the S-Corp classification, namely:
- Active or hands-on owner(s) become employees of the business and must draw a reasonable regular salary.
- The owner(s) can take withdrawals from the business. However, since the IRS does not define “reasonable” salary, most companies apply a 50-50 or 60-40 rule. That is, 50% (or 60%) of self-pay is through monthly salary, and 50% (or 40%) is through drawings throughout the year. This is an industry-standard rule, not an IRS-established rule.
- The S-Corp needs to have a board of directors.
- Check with your state’s Department of Revenue on how the S-Corp election is treated for tax filing purposes. For Missouri income tax purposes, the S-Corp income tax return is filed for informational purposes only. The tax is paid by the shareholder on his Missouri individual income tax return at the time of filing.
If you are unsure if you should apply for the S-Corp tax election or if you have any further questions about S-Corps, please contact your CPA.