LLC to S-Corp Conversion for Small Business Owners

I’m sure that many of you are aware of the Limited Liability Company (“LLC”) and S-Corporation (“S-Corp”) types of business entities available to US taxpayers, especially if you own a small business.  The most common business entity in today’s US tax landscape is the LLC.  I’m sure many of you may be engaged in a side activity, whether it be consulting, online sales, web development, or real estate, and I’m sure many of you have an LLC formed to source your revenues from that side activity through.  While it doesn’t provide any tax benefits, it does provide sound peace of mind through the liability protection an LLC offers.  For some of you who currently enjoy your side venture and can see it possibly developing into a full-time business, it’s important to understand the benefits of conversion of that part-time side business from an LLC to a S-Corporation.

The S-Corporation structure provides two principal advantages for you as the prospective 100% shareholder.  First and foremost are the payroll tax advantages that you will gain from the S-Corporation.  To gain these advantages, a reasonable salary will need to be paid to you as the 100% shareholder and presumed President of the business.  A reasonable salary is based on a variety of factors, such as employees or contractors working on your behalf, annual revenue, and comparative salaries earned by owners of other businesses in the same industry in which you operate, amongst others.  Any net income earned by the business above and beyond your salary will not be subject to self-employment tax, which will end up saving most small business owners thousands of dollars in payroll taxes annually.

Here is an example.  XYZ Business earns $100,000 in net income per year, before the 100% Shareholder’s salary is taken into account.  In this example, the 100% shareholder receives a $50,000 per year salary, which is based on the reasonableness factors discussed above. Only that $50,000 salary is subject to payroll taxes.  The remaining $50,000 comes to the 100% shareholder free and clear of payroll taxes.  With a combined self-employment tax rate of 15.3% up to certain income levels, the savings in this example is approximately $7,500. In an LLC given the same set of facts, the entire $100,000 of net income would be subject to that 15.3% self-employment tax.

Secondly, the value of being able to pay yourself through a W-2 is immeasurable, particularly for those persons who are looking to obtain credit for a home, vehicle, investment property, and the like.  Most bankers create headaches and trouble for self-employed taxpayers, especially when the self-employed person is trying to purchase real estate and obtain bank financing to do so. It is generally much easier to obtain bank financing for the small business owner with an S-Corp as opposed to an LLC, because there is a W-2 present from the S-Corp.

There are additional administrative expenses and tasks that the S-Corp creates, such as reporting the 100% Shareholder’s wages on quarterly payroll tax returns, adding the 100% shareholder to a Worker’s Comp policy if the business is located in New Jersey, and filing separate federal and state(s) S-Corporation tax returns in addition to your personal income tax returns, but the overall benefit derived from an S-Corp relative to an LLC for the 100% small business owner will almost always outweight the slight increase in the administrative burden.

Please contact me at ryan@curranllp.com with any questions about your current small business structure, LLC or S-Corp formation or conversion, or any tax or accounting related inquiries in general.