How to Know When to Convert to an S-Corp

July 27, 2022

The tax benefits of converting to an S-Corporation are plentiful, BUT there is a specific time and way to go about converting. In this article I will cover some of the biggest benefits to becoming an S-Corporation as well as what you should consider about timing your conversion.

Should  You become an S-Corp?

One of the most powerful tax reduction strategies is to maximize an S-Corp.

But it can be confusing for people to understand when it might be a good idea to become an S-Corporation.

Some of the questions we're going to answer in this article are: Is it a good idea for most businesses to switch from a sole proprietorship to an s-corporation? How do you know if converting to an s-corp is right for your small business? When do you have to convert to an S-Corp? Is there a deadline for a 2553 s-corp conversion How much might I save as an S-Corp?

The tax benefits of converting to an S-Corporation are plentiful, BUT there is a specific time and way to go about converting. In this article I will cover some of the biggest benefits to becoming an S-Corporation as well as what you should consider about timing your conversion.

How Big are the S-Corp Benefits?

We're going to dive into some specifics, but theres' a ton of potential tax savings with an S-Corp.

100k in Net Profits? You might save $2500 to $5500 a year in taxes.
250k in Net Profits? You might save up to $8,000 a year.

Obviously, this depends, but we often find massive tax savings for our small business clients, and the benefits are even more dramatic for California small business.

We Help Convert & Maximize S-Corps for California & US Based Small Businesses

We can help you get the most of an S-Corp.

Here at Asnani CPA, we help entrepreneurs, tech startups and small businesses lower their taxes, file their business taxes and keep pristine financial records.

If you like the idea of working with a tax reduction focused accountant, then request a consultation.

We help tech professionals, financial businesses, construction, and we have a particular affinity for fitness professionals.

We are California's best accountants for small business! 

Before you start: How to Set up an LLC

The first thing you need to do before you can even consider becoming an S-Corp is to become an LLC. While there are stand-alone business filings where you can file as an S-Corp, it is best to be an LLC that converts their tax status to be taxed as an S-Corp. This allows you to avoid a lot of the headaches that go along with being an S-Corp from an entity standpoint, but reap all of the tax benefits.

Need to Setup an LLC in California?

We've put together a guide on how to setup your llc in California.

Sole Prop vs. S-Corp Benefits

What are some of the benefits from an S-Corporation? The main benefit for being taxed as an S-Corp is a decrease in your tax liability due to a lower amount of self-employment taxes that are owed. In other words, the main benefits of converting to an S-Corp is to reduce your social security taxes and your medicare taxes, which is also called your self employment taxes.

Remember, you'll pay Medicare, and Social Security totally 15.3% on your schedule C income.

That's 12.4% for Social security up to the limit.

That's 2.8% for Medicare taxes, and it goes up as income reaches certain thresholds.

The S-Corp Helps you reduce the amount of income that's subject to self employment tax.

Did you know?

“When you own your own business, you pay a ~8% (7.6% to be exact) higher tax rate than someone working for a business in the same profession. This is because as an employee your employer pays half of the Social Security/Medicaid/ Medicare tax (half of 15.3%), but as a business owner you are responsible for paying the full amount."

S-corp status can decrease your tax liability because it allows you to pay yourself a salary and you only have to pay yourself-employment taxes on the salary amount.

To give an example, if a business owner made $100k last year, but only paid themselves a $40k salary, then they would only have to pay that 15.3% tax on the 40k salary, and the remaining 60k would be eligible for the QBI (qualified business income) deduction where they can deduct up to 20% of your QBI on your taxes. Here is a simple chart for comparison for the above scenario of 100k income.

Total Savings: $6,363

Want to know how much you could save? Check out this calculator here.

So, When Should You Convert to an S-Corporation?

The great question is when should you actually convert to an S-Corp?

You'll need to make sure you're actually eligible to become an S-Corp, and I'll also quickly tell you that buy and hold real estate should not be placed in S-Corps, but let's answer this conversion question a little bit.

When should you convert to an S-Corp?

When the tax reduction benefits far outweigh the cost for compliance.

An S-Corp could reduce your self employment taxes in proportion to whatever amount

S-Corps Require a Payroll System

One of the biggest obstacles to becoming an S-Corporation is to be able to pay yourself a payroll. This means you have to have consistent income or enough in the bank to cover payroll each time it comes out. This can be hard for small businesses because they may have long sales processes that make it so that paying yourself a salary of 3-5k/month isn’t doable.

If you have issues running a consistent payroll the IRS may come back and take away your deductions during an audit.

S-Corps Require a "Reasonable Salary"

So, the Salary is subject to self emplyoment tax, but the distribution is not.

You'd want to take as low of a salary as possible, right?

Well, the IRS knows this and has determined you must take what's called a "Reasonable Salary.

You must take a "Reasonable Salary" for your role in the business.

Part of being an S-corp is that you have to pay yourself a reasonable salary. While it would be advantageous to pay yourself a $1k/year salary to maximize on the tax savings, it would likely get you flagged for an audit. Your salary needs to be in line for industry standards and deemed reasonable.

We like to use the Bureau of Labor Statistics charts located here to determine reasonable salaries. However, please note that there is no guarantee that a salary will be considered reasonable in the IRS’ eyes.

Only Become an S-Corp if the Benefits Outweigh the Costs to Comply.

You'll need an accountant, payroll, compliance and a bigger tax return at the end of the year, so you'll want to make sure the benefits outweigh the costs.

Becoming an S-corp only makes sense tax-wise if you are making more money than the salary you are paying yourself. If you are bringing in $50k/year and the BLS says you should pay yourself a 40k salary, it probably doesn’t make a ton of sense to switch over to becoming an S-corp since you’ll have to deal with the added burden of having consistent income and running payroll (which has a cost).

 S-Corp Tax advantages decrease with more income

The Social Security portion of the self-employment tax (which is the largest portion) is phased out once you make more than $147,000. Meaning, you only pay that tax on the first $147,000 you make. This means that the tax benefits of being an S-corporation are only large up to that $147,000 number, but after that you’ll see the tax difference drop.

It is still 100% worth it to be an S-corp as you’ll maximize your savings early on, but it just won’t continue to scale as you make more money.

 Having Financial Intelligence

In order to be able to accurately make the above decisions you need to have financial intelligence about your business and know your books are accurate and timely. This can be a problem for a lot of small businesses who are smaller operations and don’t have designated bookkeepers or accountants. Making sure you are able to answer these questions is critical to knowing the right time to transition to being an S-corp.

We make setting up & maximizing an S-Corp Easy

Here at Asnani CPA, we work with business owners to give them financial intelligence and information that is critical to running their businesses. We let them focus on what they’re best at while we focus on what we’re best at – doing the books, tax planning, and advising on business health.

We don’t offer all of these services at every level, but we do have plenty of services where we will work directly with a company to either let them know with confidence they are ready to swap to an S-corp status for the tax savings, or we will monitor their business on a monthly basis and let them know as soon as they are ready to transition!

Please don’t hesitate to reach out to us here if you’d like more information.