When Should You Convert to an S Corporation?
Electing to be taxed as an S corporation can be one of the most effective ways for business owners to lower self-employment taxes — but only under the right circumstances.
If you're a sole proprietor, single-member LLC, or partnership, you've likely heard about the S corp “salary and distributions” strategy. But converting too early (or too late) can create tax inefficiencies, missed deductions, and unnecessary administrative burdens.
Here’s how to know if the timing is right.
First: What Is an S Corporation?
An S corporation isn’t a business entity type — it’s a tax classification. You can form an LLC or corporation and elect to be taxed as an S corp by filing Form 2553 with the IRS.
The big benefit? You can pay yourself a reasonable salary (subject to employment taxes), then take additional profits as distributions, which are not subject to self-employment tax.
The Benefits of S Corp Status
Lower Self-Employment Tax: Only salary is subject to payroll tax; distributions are not.
Potential QBI Deduction: Up to 20% deduction on qualified business income (IRC §199A).
Audit Protection: Payroll + W-2 documentation can enhance defensibility.
The Hidden Costs of S Corp Status
Before converting, understand the additional obligations:
Payroll Compliance: You must run payroll, file payroll tax returns, and issue W-2s.
Reasonable Compensation Rules: The IRS requires you to pay yourself a fair market wage before taking distributions.
Entity Structure Restrictions: S corps can’t have foreign shareholders, more than 100 shareholders, or multiple classes of stock.
California Franchise Tax: If you’re in CA, you’ll owe the $800 minimum tax — and the 1.5% S corp income tax.
When It Does Make Sense to Convert
✅ Your business has net income above ~$80,000–100,000/year.
At this level, the savings from lower self-employment tax typically outweigh the additional payroll and compliance costs.
✅ You’ve built consistent profitability.
S corps are not ideal for highly volatile or seasonal businesses with losses or unpredictable income.
✅ You’re already structured as an LLC or Inc.
If you're operating as a sole prop, you’ll need to convert to an entity first before making the S election.
✅ You’re willing to maintain clean books.
S corps increase scrutiny and require better recordkeeping. Sloppy books undercut the whole benefit.
When It Doesn’t Make Sense
🚫 You have minimal or no profit.
There’s no advantage to paying yourself a salary (and payroll taxes) if there's no real income to split.
🚫 You’re just getting started.
It may be wiser to wait until your revenue and expenses stabilize before adding compliance burdens.
🚫 You plan to raise outside capital or add complex equity.
S corps are restrictive with ownership types and capital structures. A C corp may be a better fit.
The Tax Filing Angle
Deadline: To elect S corp status for the year, Form 2553 must be filed by March 15 (or within 75 days of incorporating).
Late election relief: If you missed the deadline but qualify, relief may be available via IRS Revenue Procedure 2013-30.
Bottom Line
S corporations are powerful tools — but they’re not universal. Like most tax strategies, the benefit comes from aligning it with your income level, business model, and goals.
📩 Want help evaluating your options? Contact me for a customized S corp analysis — and see if it makes sense to convert now, later, or never.