How to Turn Your LLC Into an S Corp

In this article, we’re assuming you’re the owner and operator of an LLC. (If this doesn’t describe you, reach out to us for tailored advice.) We’ll also assume you’ve already read our article, “When to Turn Your LLC Into an S Corp.”

The first thing to understand about this process is that your LLC doesn’t go away when you begin operating as an S Corp—it gets modified. Think of it as if your LLC were a car. You’re not taking it to the dealership to trade it in; you’re taking it to the body shop for a new coat of paint and an upgraded interior.

The second thing to understand is your operating costs are about to go up. S Corps require more complicated filings and processes to maintain than LLC's do. For most clients, S Corp holding costs run $2,000–$4,000/year. These additional costs will be offset by tax savings, as long as you convert at a strategic point in time (talk to us to make sure you're doing so). Most clients see ~200% ROI on their S Corp costs via a reduction to their tax bill.

Here’s how we do it:

1. Benchmark a Reasonable Salary

Until now, you’ve probably been paying yourself by paying all your business bills, checking what's left in the business bank account at the end of the month, and transferring the surplus to your personal account. In an LLC, that’s fine.

In an S Corp, however, owners who work in the business are required to be paid a "reasonable salary" according to the IRS. But what is reasonable?

To answer this, our methodology is to conduct a fair market compensation analysis based on responsibilities, industry, and zip code, and present you with a range. Based on your judgment and circumstances, you’ll select a number from within that range, and this becomes your salary.

Your salary is paid out on a fixed schedule (most business owners choose monthly). Anything you earn beyond your salary can be taken out of the business as a distribution, typically on a quarterly basis.

2. Prepare the Business Finances

If you haven’t been processing payroll before, you’ll need to get ready to do so.

We advise all of our clients to create a bank account dedicated solely to payroll and fund it with an amount equal to three months of payroll expenses. Often, businesses need to plan and budget for this a quarter or two before the S Corp goes into effect.

You might be wondering, isn’t three months of funding overkill? But remember that every pay period you’re not just paying yourself—you’re also sending funds to state and federal agencies, insurance providers, and others. If there’s a delay in those payments, all of these entities are going to get very grumpy and assess late fees. If there’s a disruption, it could even jeopardize your S Corp status.

3. File the IRS Paperwork

This is actually one of the simplest steps in the process.

Your tax preparer will file the necessary forms with the IRS. For companies operating on a standard calendar year, the deadline is March 15.

Some states also have filing requirements for S Corps, which we'll take care of based on your jurisdiction.

4. Update Your Company Documentation

If you’re the sole owner of your business, you don’t need to do anything.

If your business has more than one owner, you’ll want to review and revise your Operating Agreement to reflect the changes in ownership and compensation structures that come with S Corp tax treatment. (This also has implications for setting payroll. Contact us to discuss the details of your situation.)

5. Set Up and Begin Running Payroll

Now that you're an employee of your business as well as an owner, we need to pay out your salary. For this, we recommend setting up a payroll provider. Gusto is our favorite.

You will also need to register for payroll taxes. "But wait", you ask, "didn't I do this whole setup to get away from taxes? Why do I need to sign up for more?" Remember, as an LLC you were paying 15.3% (plus whatever your state charges) self employment tax on your entire income. Alas, that doesn't go away, but now you'll be paying it only on your salary, and paying a lower rate on everything else.

To do this, we need to sign you up as an employer in your state. The entities who handle this vary by state, so you can either research your jurisdiction's requirements or we're happy to handle state-specific filings for you.

Closing Thoughts

Converting to an S Corp is an important milestone in the growth of a business. It demonstrates that you’ve built a solid foundation of clients and reached a point where you’re not just freelancing—you’re running a company. As part of that, it also introduces new requirements for systematization, organization, and reporting. As your business continues to grow, whether by adding employees or expanding into new territories, these requirements will grow too. One of the hardest parts of this stage is learning to think differently, but once you do, you’ll transition from operating your business to truly owning it.

Still have questions? Ask away. We’ll answer.

hello@hyperspace-enterprises.com