When to Switch from an LLC to an S Corporation

If you're running a business through an LLC and you're starting to make real money, I mean real money, you might be wondering, when's the right time to switch to an S corporation? Because here's the truth. Every year I meet entrepreneurs who wait too long and end up paying thousands of dollars more in self employment taxes than they ever needed to. Or they try to clean this up the following year and think, oh, it's okay, I can do a retroactive best election and move money around this way or that way. And guess what? You're opening yourself up for an audit. I'm Marc J. Kohler, CPA attorney and best selling author. And in this video I'm going to show you exactly when to convert your LLC to an S Corp, how much it can save you in taxes and the biggest mistakes to avoid along the way. Stick with me because by the end you'll know the perfect time to make the switch, how to keep more of your profits in your pocket, and how to do it the right way, legally, strategically and with confidence. Let's get started. Well, the first thing we're going to talk about is why do so many small business owners overpay on taxes? They may think an LLC saves them taxes. It does not. Because if you're operating as a single member LLC or sole proprietor, every dollar of profit you make is hit with self employment tax or FICA. That's 15.3% right off the top. Now the purpose of that tax is to cover Social Security and Medicare and that's on top of your federal and state income taxes. It's essentially if you work for someone else, what they withhold from your paycheck and the employer matches. So the net result is if you net $100,000 as an LLC, you could owe over $15,000 in FICA before paying any income tax at all. Frankly, that's your tip to the irs. You're working so hard and then you just hand over to them another 15% for the privilege of being self employed. But once your business starts producing consistent profit, that 15% does not have to be there. We can change the equation. So when do you make the switch? What's that magic profit zone? Well, after 25 years of experience and teaching thousands of small business owners how to properly use an S corporation, I'll tell you, once you're netting or making profit of around 40 to $50,000 in your LLC, it's time to start looking seriously at an S Corp election. Once you hit that zone, the math flips in your favor. Let's take that example earlier of $100,000 of net profit. Let's say you have 150k gross income, 50,000 in expenses with cell phone, dining, marketing, equip equipment, home office, travel, all the goodies and you net $100,000 in profit. As a typical standard LLC, you would pay 15.3% in self employment tax on that 100 grand. Remember that 15% $15,300. But as an S corporation, you pay yourself a reasonable salary. Let's assume $40,000, leaving $60,000 classified as pass through profit, not septica fica. That's a $9,000 savings right there. And guess what? Those savings multiply every year. The more you make, the more you save. So when you start to feel that tax sting of that 15.3% FICA stuff, that's your sign and it's time to graduate. Your business might just move from high school to college and become that S corporation is meant to be. So how does the S Corp actually save you money? Well, the key difference isn't the entity, it's how you're taxed. All that profit and all the expenses and income is going to be reported in an S corporation and you're going to split that profit into two parts. We're going to split part into that salary where you pay yourself as if you were getting a paycheck. And that's the payroll portion. The subject of FICA, the owner, K1, is the rest of the profit that flows through. Now, on a practical basis, every day, every week or month, you're going to take a draw. You just take a draw whenever you want, but on paper, quarterly, your accounting service or payroll service is going to allocate so much to payroll and the rest falls out. The bottom is that K1 profit. Now this structure lets you legally avoid paying way too much in Social Security and medicare on a portion of your profits, saving thousands. And the IRS is fine with this. It's built into the code. They just want to see that your salary is reasonable and you file the paperwork properly. You're not cheating the irs. You're just using the same rules the wealthy business owners use every. Now let's talk about the right way to transition. And we can do this anytime during the year, but we don't want to wait too long. Now the first tip here is don't dissolve your llc. You're going to keep the same ein, the same bank account, the same company name. You're just going to elect to be taxed as an S Corp. Now, using IRS Form 2553, you can backdate this election under RevProc 2013-30, allowing you to make it effective back as far as January 1st for the same years. If you file later in the year, this means you can decide mid year and still capture the tax savings for the whole year. Now, once elected, your LLC will now file as an 1120s tax return instead of Schedule C as in charge. You'll start running this payroll report every quarter through a simple payroll procedure. For all intents and purposes, you are now an S corp, even though the LLC acronym is still at the end of your company name. Because it's not a new company, it's the same LLC with a new tax treatment. So don't overcomplicate this. You're not rebuilding the house, you're just upgrading the electrical system. Now, the cost. Buckle up. It's super expensive to convert to an S Corporation. Our law firm, we charge around 250 bucks. I know, totally expensive, out of control. It is actually very affordable to make this switch and very affordable to maintain. Once you make that election, you're going to set up payroll that could run anywhere from 400 bucks a year to $500 at most. Now remember, you're still going to be doing bookkeeping. The bookkeep doesn't change. But now you're going to do a different tax return. And it's interesting, you're actually going to save the cost of doing a Schedule C. So you might save 3, 4, $500 there, but then you're going to do an S corporation tax return, 1120s, which might cost around $1000 to maybe 1500 at the most. But when you do the net difference, you're really only going to be paying about 500 to $1,000 more to save thousands of dollars. Once you're saving 5 to $10,000 in FICA annually. Those costs protection and savings. It's no longer a cost, it's an investment in your tax plan. Now, a few common mistakes to avoid switching too early. If you're netting under $30,000, I might just say stay as a simple LLC until we start making more money again. Keep it lean and mean. There's no need to convert to the S Corporation. The next huge mistake is overpaying yourself this reasonable salary. Now, the guidelines for this are very subjective. In my opinion. You're going to be anywhere from 20 to 50% in payroll all allocation. And the more money you make, that payroll allocation percentage actually goes down. You might make 400 grand and take $100,000 salary or make 50 grand and take a $25,000 salary. See how it went from a 25% allocation up to a 50% allocation. Now that's just a subjective analysis. There's a lot of companies and tax advisors out there that will try to overcomplicate it to charge more for this analysis. In over 25 years, I've never had a client get audited for staying in those general ranges and just being strategic and wise about their allocation. But at the end of the day, you're going to work with your tax advisor to nail it based on your situation. And another mistake people make is making an S election on an LLC that has rental property in it or some sort of asset that's creating passive income. Make sure you get those assets out of the LLC before you make the selection. We don't want to commingle asset passive income with operational income. Now maybe another mistake not as often is putting your family members on payroll that could even be your spouse. We don't want to indiscriminately put people on here and give them a W2 just because we think it's the right thing to do for my spouse to get Medicare or Social Security. And with your kids, unless they're acting like an employee and look like an employee with all the rest of your rank and file employees, we're not going to W2 them either. The payroll function is for you, the primary business owner, materially participating in the business. But of course the biggest mistake is not even making the S election in the first place and paying way too much in taxes. So in summary, when may an S corp not be the right fit yet? You're still in the startup phase and not profitable enough. You're running rental properties or passive investments through the entity. You've got a side hustle, you're a 1099 contractor and you're just earning a few thousand dollars and haven't even formed your first LLC yet. Let's hold off or you plan to bring in partners or outside investors soon. That's when an LLC is going to be a great fit for the partnership and then your S corp would be an owner of that. So when you have partners you want to look at a different type of structure. And a great rule of thumb is don't force it. Let the numbers tell you when it's time and see where your profit levels at halfway during the year to the end of the year. And then meet with your tax advisor to pull the trigger at the right time. And remember what happens after the switch you're going to be getting two types of income that will flow onto your 1040. You're going to get a W2 and a K1 where before it was just a form on your 1040. So you're going to have this S corporation generating two forms of income that will come to your 1040, which is great. That's where the tax savings is and it's going to open other doors for you. Your chances of an audit actually go down. You actually have less chance of an audit with the S corporation and it's going to open up the door to maybe a solo 401k or taking other deductions that don't really give you as much bang for their buck. As a sole proprietor, you also build a cleaner paper trail which helps you look good for a home loan application with a real W2 and real paperwork to show your income rather than being a sole proprietor. And you're going to maintain the same legal protection you would get with an LLC and an S corporation because remember, at the end of the day you're still an LLC for legal purposes. You're just adding the S corp election on for the tax treatment. But bottom line, it's not just about saving taxes, it's about leveling up your entire business structure. Switching from an LLC to an S corporation is one of the most powerful tax strategies available to small business owners. But timing is everything. So let's recap one last time. Start thinking about it. Once your net income hits around 40 to $50,000, elect an S corporation status using the proper form, pay yourself a reasonable salary and take the rest as a K1. Watch your self employment tax drop every year and see your chance of an audit go down. Now if you want help setting this up correctly, which I strongly recommend, please reach out to my law firm, KKOS Lawyers. The links are down below. Do not go to a website and just click a few buttons and think it's going to help you by cutting corners and doing the DIY approach. This is fraught with mistakes that could cost you thousands and we've helped so many business owners over the years do it right. But we're also not that expensive. Just because you're using a lawyer doesn't always mean it's more expensive. I've got a lot of competitors that aren't even lawyers that charge more than we do. Please check out the information below and schedule the discovery call to see how we can be of service. And if this video helped you, please like subscribe and hit the bell so you don't miss any future videos on building wealth, saving taxes, and protecting what you've worked so hard for. I'm Mark J. Kohler. Thanks for watching and I'll see you in the next one.