Businesses sometimes convert from a limited liability company (LLC) to an S-corporation to gain potential tax benefits. While both structures offer liability protection, an S-corporation can provide a way for businesses to save on self-employment taxes. However, converting also comes with potential tax consequences that businesses should consider.
Changes in tax treatment
One of the biggest changes involves the way business income gets taxed. As an LLC, the company passes its income through to the owners, who report it on their personal tax returns. When the business converts to an S-corporation, a portion of the income shifts to wages, subject to payroll taxes. This change means owners must follow strict IRS rules for reasonable compensation, which affects how much profit gets classified as wages versus dividends.
Impact on self-employment taxes
Many businesses convert to reduce self-employment taxes. LLC owners usually pay self-employment taxes on all profits, but S-corporation owners only pay these taxes on wages. The remaining profits may avoid additional employment taxes, which could lead to savings. However, underpaying wages can lead to IRS scrutiny and possible penalties.
Possible tax consequences on assets
Converting an LLC with significant assets, such as property or equipment, can also lead to unexpected tax consequences. During conversion, the IRS may treat the transaction as a sale of those assets, which could trigger capital gains taxes or other costs. Reviewing the value and type of assets helps determine if the move will create a tax burden or benefits in the long run.
Evaluating the impact of converting
Switching from an LLC to an S-corporation can change the way a business handles taxes and profits. Careful planning and understanding the rules can help businesses decide if converting offers the best strategy for future growth.
