There’s a trend among small business owners, particularly owners of Limited Liability Corporations (LLCs), that is becoming a problem. LLC owners are changing entity structure or electing to be taxed as S corporations, and they are doing it prematurely. I don’t think that business owners fully understand the potential disadvantage of S corporations with regard to administration and retirement, at least not as much as they seem to understand the benefits. Here’s what you need to know.
Do the tax savings cover the costs?
There are good reasons to change from an LLC to an S corp. The main benefit is tax savings. But there are also several cons:
- More complex tax laws
- Extra tax-related expenses
- Less investment in retirement
If you restructure from an LLC to an S corp too early, it could cost you money and time. I’m not a tax attorney, so I can’t advise on legally restructuring your business. However, I can provide some information you may not be aware of concerning S corps.
An LLC is a flexible and simple legal entity structure.
LLCs are a popular structure for small business owners. In 2021, there were 21.6 million of them in the US.¹
As the name suggests, LLCs offer limited liability protection to their owners, who are referred to as “members” or “managers.” I’m referring to multi-member LLCs here because that’s the comparison that makes sense. So, with two or three members, an LLC is straightforward to set up and not particularly burdensome when it comes to administration and accounting.
Compared to S corps, LLCs are a set-and-forget affair:
- No formal meeting requirements unless stipulated in the partnership agreement
- Fewer ongoing reporting and compliance obligations
- May be managed by the owners or a designated manager
- No limit to the number of members, and members may be entities²
Overall, an LLC is suitable for small businesses looking for a scalable structure that minimizes paperwork and shields them from personal liability. Members decide on a monthly disbursement, so it’s simple for business owners to pay themselves, as well.
S corporations are similar to LLCs.
There are around five million S corps in the US. They are comparatively rare but share similarities with LLCs.
S corps provide limited liability protection, and both are “pass-through entities,” which means that profits and losses pass through to the owners and taxes are paid via individual income tax. No taxes are paid at the business level. This is different than C corporation, for example.³
For LLCs to be taxed as S corps, members must file a Schedule K-1 (Form 1120-S), each reporting his or her share of the income, credits, and deductions. Tax savings may increase depending on income level and other factors. Changing entity structure is a far more complex process. In this case, tax savings come with additional and quite burdensome administrative issues that cost money, like additional payroll tax compliance and more record-keeping requirements.
The biggest plus of an S corporation is payroll tax savings.
Here’s how it works: S corp shareholders can be employees of the business and receive a salary. That way, they can split their income into salaries and dividends. Then, their dividends aren’t subject to self-employment taxes the way salary is.
Here are the main disadvantages of S corporations.
So, while changing to an S corp can produce increased tax savings, the structure comes with a set of issues that take time and money to address. Do the tax savings justify the cost? That’s what we have to look at.
1. Expect to spend more time dealing with administration.
One example is that S corps cannot have more than 100 shareholders. LLCs, by comparison, have no limit to the number of members.
An S corp is also required to have a board of directors that oversees management and annual shareholder meetings.
To be taxed as an S corp, an LLC or other eligible entity must either file Form 2553 or change its legal entity structure under the guidance of an attorney, which is a lengthy and costly process.
2. Complexity comes with additional costs.
I just said an S corp offers tax savings compared to an LLC. While that is true, it doesn’t tell the whole story. That’s because S corps also have several tax-related costs that can add up and cost you more than if you hadn’t switched.
First, S corps are required to give their shareholder-employees reasonable compensation that’s subject to employment taxes, which can cancel out any payroll tax savings. And remember when I said S corps have more intricate rules? That additional complexity leads to increased administrative expenses and tax preparation fees.
3. S corps offer fewer options for investing in retirement.
Since shareholder-employees at S corps have to put down some of their earnings as salary, they have less flexibility to invest their money in other accounts, like retirement.
Get to at least $75K in profit before restructuring.
In addition to profit, we need to see an income of above $100K per year, at the very least. Until you reach those benchmarks, there’s no point in even considering the change.
The disadvantages of S corporations should be taken seriously.
I won’t tell you unequivocally not to restructure. But the bottom line is this: you should not rush to convert an LLC to an S corporation if you aren’t ready for the planning and financial legwork needed to ensure a smooth transition. It’s one of those critical decisions that you should take to a CPA and tax attorney.
Get guidance today.
Regardless of your small business’s structure, I can help you maximize your tax savings and position for growth.
I’m a Fort Worth-based CPA with more than a decade of experience helping businesses like yours succeed. I offer end-to-end financial support and business advisory services anchored by partnerships with business owners.
Schedule a discovery call with me today.
Talk soon,
Jeremy A. Johnson, CPA
References
- How to form an LLC: A guide for new businesses. January 9, 2023. Stripe.com. Retrieved from https://stripe.com/resources/more/how-to-form-an-llc
- Limited Liability Company (LLC). November 13, 2023. Irs.gov. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/limited-liability-company-llc
- S corporations. May 9, 2024. Irs.gov. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations