Can I convert from LLC to S-Corp to avoid paying self-employment taxes?

April 1, 2014 10:14 AM

Is it possible to convert my LLC to an S-Corp to avoid paying $10,000+ in 2013 self-employment taxes?

I've been a freelance web developer for only 2 years. I was advised to set things up as an LLC. The first year I barely made any money, the second year I made about $80,000. Which brought self-employment taxes to $10,000 and total federal taxes to $20,000. I don't have the money for this and don't want to pay it every year.

I've heard that an S-Corp is more troublesome, but cheaper. I've also called local tax professionals and they have all been too busy to handle this, or think that it's too late for this tax period. Is it? What if I filed an extension and converted my LLC in the meantime? What other steps do I need? I am very green at this so simplified explanations are ideal. Sorry & thanks!

posted by anonymous to Work & Money (10 answers total)

Not an accountant/lawyer but my day job is corporate filings. I can't tell you about whether you should do this, but I can tell you how you'd start:

Depending on the state, you may be able convert the LLC to a C-Corp depending on your state's regulations. This is done on the state level. Then you'd have to elect that C-Corp to be an S-Corp on the federal and possibly state level (the latter again, depending on your state's regulations.) There may be other steps, but I generally advise people to speak with an accountant about them. Those steps are required, though.

Also, you're supposed to file that S-Corp election within something like 90 days of formation of the Corp at the start so I have no idea how this works if you're converting from an LLC to a Corp.

You can MeMail me or send the mods a note to update this with the state in which your corporation is filed.
posted by griphus at 10:23 AM on April 1, 2014 [1 favorite]

When you say you were advised to set things up as an LLC, do you mean by an attorney that you had retained? If so, then you could ask that attorney to review your current situation and advise you of tax and other consequences.

If you didn't have legal counsel when organizing your company, now would be a good time to find an attorney. Many states have organizations that can refer small business owners to attorneys providing low- or no-cost legal advice.

Either way, a lawyer licensed in your state and experienced in business law can help you understand the pros and cons of LLCs and S-Corps.
posted by Handstand Devil at 10:26 AM on April 1, 2014

(Also, just as a sidenote: yours is the kind of question which, if I get at work, I will stress very firmly that you shouldn't do any corporate filings without first speaking with an accountant or attorney. If you screw this up, it can get really expensive. Much more than the money you'd save.)
posted by griphus at 10:26 AM on April 1, 2014

Oh, sorry, one step I missed (among numerous others that are out of my wheelhouse, I'm sure) is that you need to notify the IRS that you've converted your LLC to a Corporation, as your EIN (tax ID number) is linked to the type of corporate entity you have and its name, and the state generally doesn't update this info with the IRS on your behalf.

No idea how that is done, unfortunately. But if you don't do it, you're liable to gum up the works.
posted by griphus at 10:31 AM on April 1, 2014

It is possible to make a late S corp election (in some cases). You'd have to make a check the box election to be taxed as a corporation, then an S election, and request late election relief under both (and get it). Whether that is advisable or even possible in your case would need to be examined by a professional in your jurisdiction. This is not a simple thing to do and brings with it a whole host of additional filing requirements. In addition, this could impact your state filing requirements and tax obligations.

You'd be required to pay yourself a reasonable salary (which is generally what it would cost to hire someone to do what you did). This salary is subject to payroll tax (employer and employee share) and payroll tax filing requirements. You're already late with those for 2013, if you did manage to make an S election effective for 2013, and that will carry penalties of its own.

Try to find more deductions to reduce your self employment income. You can also enter an installment agreement with the IRS. Whatever you do, make sure you file your return on time and pay as much as possible with that return. Going forward, set aside at least 30% of each payment you receive for your tax liability (increase this for your applicable state taxes).

Edit: And your S-corp return would already be past due for 2013, as 1120S is due on March 15.
posted by melissasaurus at 10:32 AM on April 1, 2014 [2 favorites]

Probably much simpler in your case to to just terminate your old LLC and form a new one with your preferred tax election than to try to convert your existing one.

But before that, you really should talk to a tax professional to determine how much (or how little) you might save compared to the complexity and expense of an S-corp. And don't bother trying to get any assistance in the next few weeks. They are all in 24/7 crunch mode.

> think that it's too late for this tax period

Nothing you can do to change your 2013 taxes now. Your 2013 taxes are determined by what you did in 2013, not 2014. But if you are not up to doing your taxes alone, you can file an extension and then seek help from a tax professional later. You still need to pay your estimated tax bill on time.
posted by JackFlash at 10:58 AM on April 1, 2014 [1 favorite]

This is not something you should need an attorney for, because you don't actually have to reorganize as a corporation; there's some weirdness to do with the IRS not knowing how to handle LLCs, and so you're not really going to have an S-corp so much as you're going to have an LLC that the IRS sees as having S-corp status. Confused yet? It's not as hard as it sounds but it's not for the amateur. Get a CPA. It's theoretically possible you could save money for this year, but you'd have to send a giant chunk of cash in very soon with an extension to prevent getting any later than you already are, and have a CPA figure out whether you can still get in this late and whether the assorted late fees are less than the additional tax. In either case, yeah, you need to be setting money aside every time money comes in, or else this tends to happen; the nice thing about the S-election is that by setting up a salary payment, you know how much is going to be going out every month.
posted by Sequence at 11:03 AM on April 1, 2014

Also, yes, file on time, pay whatever you can now, don't freak out and avoid them, talk to them. I'd rather make payment arrangements with the IRS than pretty much anybody else around.
posted by Sequence at 11:05 AM on April 1, 2014

Agree with melissasaurus - why would you do this? You know that, between you and the S Corp., you would have to pay both sides of the payroll tax, right?

Why don't you focus on finding more business expense deductions among your purchases for 2013?
posted by Joey Buttafoucault at 11:41 AM on April 1, 2014 [1 favorite]

I think you're misunderstanding how taxation works for an S-corp.

S-corps flow all business profit through to the owners as income. Which you don't have to pay payroll or entitlement taxes on, so hurray, there's that. You avoid the self-employment tax that way.

BUT you still need to draw a "reasonable" salary, in proportion with the money you're taking personally from the business.

An example:

I am a 50% owner of a company. I make, say, $100k per year as a salaried employee of the company. This means that my W-2 shows those wages, my payroll system deducts my payroll taxes from my wages, and it also deducts the portion of my payroll taxes my employer (which, me again!) is responsible for. This ensures that the money I receive as part of my normal pay is accounted for, tax-wise, since I'm withholding, and my company is making payments on my behalf. Cool.

However, the business earns profit above and over what they pay me and my other employees. That profit, for the purpose of my taxable income, is split between myself and my partner equally. This does NOT mean that the money magically flows into our bank accounts. It does not. Instead, it shows up on what's called a Schedule K-1, which is then considered income on my personal return. So now I'm personally responsible for paying income tax on that "profit", even if it's not sitting in my bank account. Weee.

Now the business can make a distribution to cover the additional burden, which is how we normally do things. That's good on the tax front.

We can also make a profit distribution where we actually transfer profit (equally, since we're equal partners) to our personal accounts as well. Since ALL of the business's income is already being split for tax purposes, the portion we're ACTUALLY taking out of the business bank account and giving to ourselves is not taxed as a separate event. This is the wonder of an S-corp.

We're responsible for it just the one time. We also don't pay payroll taxes on it (like Medicare/Medicaid/Social Security), which is even more awesome. Just income tax.

But the IRS is on to this. They're willing to allow you to take profit distributions, but you have to maintain a salary at a reasonable level. Salary that still pays payroll taxes, etc, and shows up as W-2 wages.

A cautionary tale exists of an accountant (no less) who earned $30,000 in W-2 wages, but was taking $300,000/year in profit distributions. The IRS did not find that to be an appropriate distribution ratio compared to his salary, and demanded back taxes and interest on the full amount for the past several years.

This is by way of saying that unfortunately there is no hard and fast rule on what constitutes the proper balance. I've heard it advised that you DEFINITELY don't want to do more than 50% as a distribution, but I've heard others say even lower. This is a question for your tax professional.

Also, don't go near a C-Corp. They're expensive to maintain, require insane records, and the COMPANY pays income taxes on its income but then YOU ALSO PAY INCOME TAX on any distributions (called "dividends" in a C-Corp) you give yourself, so you literally are double taxed.
posted by disillusioned at 11:53 AM on April 1, 2014 [4 favorites]