Many entrepreneurs in the United States opt to establish a Limited Liability Company (LLC) when launching their ventures. And rightly so – LLCs offer simplicity, flexibility, and crucial liability protection, making them an attractive choice for startups. However, as businesses grow and generate more income, transitioning from an LLC to an S-Corporation (S-Corp) can unlock significant financial advantages that are often overlooked.
Why Consider Switching from LLC to S-Corp?
Here are a couple of main benefits of switching to an S-Corp:
Firstly, you can save on self-employment taxes.
As your LLC's income increases, so does the burden of self-employment tax. With an LLC, all profits pass through to the owner and are subject to a 15.3% self-employment tax. Self-employment tax is a significant expense on top of income tax that you need to pay. Enter the S-Corporation offers a solution to this tax burden. By taking a reasonable salary from S-Corp profits, owners can minimize self-employment tax while still enjoying the benefits of pass-through taxation.
Secondly, you can save on tax-deferred Retirement Savings.
Another compelling reason to consider the switch is the opportunity for enhanced retirement savings. With an S-Corp structure, owners can establish a Solo 401(k), unlocking the ability to contribute significantly more to retirement accounts compared to traditional IRA or 401(k) plans. While Roth IRA/401(k) contributions are typically capped at $6,000 for individuals earning under $120,000, a Solo 401(k) allows for much higher contributions.
The business owner wears two hats in a 401(k) plan: employee and employer. Contributions can be made to the plan in both capacities. The owner can contribute both:
Elective deferrals up to 100% of compensation (“earned income” in the case of a self-employed individual) up to the annual contribution limit:
$22,500 in 2023 ($20,500 in 2022), or $30,000 in 2023 ($27,000 in 2022) if age 50 or over; plus
Employer nonelective contributions up to 25% of compensation as defined by the plan.
Total contributions to a participant’s account, not counting catch-up contributions for those age 50 and over, cannot exceed $66,000 for 2023 ($61,000 for 2022).
Example: Ben, age 51, earned $50,000 in W-2 wages from his S Corporation in 2023. He deferred $19,500 in regular elective deferrals plus $7,500 in catch-up contributions to the 401(k) plan. His business contributed 25% of his compensation to the plan, $12,500. Total contributions to the plan for 2023 were $39,500. This is the maximum that can be contributed to the plan for Ben for 2023.
A business owner who is also employed by a second company and participating in its 401(k) plan should bear in mind that his limits on elective deferrals are by person, not by plan. He must consider the limit for all elective deferrals he makes during a year.
In addition, for older entrepreneurs seeking to maximize retirement savings while minimizing tax liability, a defined benefit profit-sharing plan offered by an S-Corp can provide additional opportunities to save substantially more for the future.
The Right Time to Convert:
So, when should you make the switch from LLC to S-Corp?
From a tax perspective, it's advisable to consider the conversion when the self-employment tax burden outweighs the tax advantages offered by the S-Corp structure. As a general guideline, businesses generating around $40,000 in net income should seriously consider transitioning to an S-Corp. However, depending on individual circumstances, the breakeven point could be even lower, possibly around $25,000 in net income.
Conclusion:
Switching from an LLC to an S-Corp can offer significant tax benefits and retirement savings opportunities for entrepreneurs as their businesses thrive and income grows. By understanding the advantages of each structure and determining the right time to make the transition, business owners can maximize their financial efficiency and secure a more prosperous future. The decision to convert your LLC to an S-Corp is not one-size-fits-all and should be based on a careful assessment of your business's financial situation, growth projections, and long-term goals.
If you're considering the switch or need guidance on optimizing your business structure for tax purposes, don't hesitate to reach out for expert advice and support. We're here to help you navigate the complexities of business taxation and ensure you're making the most of every opportunity to build wealth and secure your financial future.
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