When and How to Switch Business Entities to Maximize Tax Savings

As your business grows, the structure you chose at the beginning might not be the best fit anymore. Changing your business entity can help you save on taxes, protect your assets, and make growing more accessible. Knowing the right time to make the switch and doing it the right way is essential to avoid costly mistakes.

This article will discuss the common signs that changing your business structure is time. We'll explain when switching can save you money and the steps you need to take to make the change. We'll also cover some tax implications and pitfalls to help you make the best decision.

Please note: Make Taxes Fair is not a legal firm, and this article is general in nature and scope and should not be relied upon to finalize your decision regarding your entity selection. We advise you to consult an attorney and a qualified tax professional to ensure that your entity selection is optimal.

Signs It's Time to Switch Business Entities

The business structure that worked when you started might not fit as your business grows and becomes more complex. Here are some signs that it might be time to change to a new structure:

1. Increased Profits

If your business makes more money, you could pay more in self-employment taxes than necessary. Sole Proprietors, Partners, and LLC owners must pay self-employment taxes on their net earnings. You could save money by switching to an S-Corp if your profits are high. 

This way, you can pay a reasonable salary and take the rest as distributions, which aren't subject to self-employment taxes. This strategy could save you thousands of dollars each year.

2. Expansion

Your current structure may not be the best fit if your business is growing and you need new partners or investors. Switching from a Sole Proprietorship to an LLC can make ownership and profit-sharing more flexible while giving you better asset protection. 

If you want to raise a lot of money or attract outside investors, switching from an LLC to a C-Corp is often the best choice. C-Corps can issue stock and are more attractive to investors.

3. Increased Risk

If your business activities or risks have increased, you might want to move from a Sole Proprietorship or Partnership to an LLC or Corporation. These structures can provide better liability protection for your assets. 

If your business has grown and taken on more risk, switching to a structure with liability protection will help protect your finances from business debts or lawsuits.

4. Wanting Better Fringe Benefits

Switching to a C-Corp could be helpful if you want to offer your employees better benefits, like health insurance, retirement plans, or educational assistance. C-Corps provides the most flexibility in offering tax-deductible fringe benefits. 

While S-Corps and LLCs can offer some benefits, a C-Corp often provides you and your employees the best range of benefits.

Common Scenarios for Switching Entities

Here are some common scenarios when it makes sense to switch your business structure:

1. From Sole Proprietorship to LLC

Forming an LLC is an excellent next step if you started as a sole proprietor because it was easy, but now you need liability protection. An LLC protects your assets from business debts and lawsuits. 

This is very important if your business has employees, contracts, or owns valuable assets. It also keeps the pass-through taxation of a Sole Proprietorship, making taxes more straightforward.

Before you do this, please make sure that you consult an attorney and verify if any restrictions in your State apply that prevent you from becoming an LLC. In this event, you may need to create a C-Corporation and then elect to be taxed as an S-Corporation.

2. From LLC to S-Corp

If you have an LLC and earn enough that self-employment taxes are becoming a burden, it might be time to switch to an S-Corporation. 

By electing S-Corp status, you can pay yourself a salary and distribute the remaining profit, which isn't subject to self-employment taxes. 

This can help you reduce your tax bill, improve your cash flow, and use that extra money to grow your business.

3. From S-Corp to C-Corp

If you want to raise money for your business, switching from an S-Corp to a C-Corp can help you bring in investors by issuing stock.

C-corporations can have unlimited shareholders and offer different classes of stock, which makes them very attractive to venture capitalists and other investors. C-corporations also make it easier to provide fully tax-deductible fringe benefits, which is helpful if you want to expand and offer more to your employees.

This election is not very common but is included in the "common scenarios" for your knowledge. Before you make the switch from S-Corporation back to C-Corporation taxation status, you should do a thorough analysis to determine this is the optimal move.

4. From C-Corp to S-Corp

If you initially set up your business as a C-Corp but want to avoid double taxation, you might consider converting to an S-Corp. S-corps prevent double taxation, which happens when C-Corps pay taxes at the corporate level, and shareholders also pay taxes on dividends. 

This switch is a good option if you want to simplify taxes and reduce the overall tax burden for owners.

How to Make the Switch

Switching business entities involves several steps to ensure the transition goes smoothly and follows all the necessary rules from the IRS and your state. Each step is essential to avoid penalties and problems later on. We recommend engaging the services of a qualified professional to assist in the preparation and processing of legal and tax forms.

1. Legal Steps

• File Articles of Amendment: Depending on your state, you may need to file Articles of Amendment to officially update your business's structure. This might mean changing your operating agreement (for LLCs) or issuing new stock certificates (for corporations). These documents must be updated so your business complies with state laws and shows your new structure.
• Create New Operating Agreements or Bylaws: If you're switching to an LLC or corporation, you'll need new operating agreements or bylaws that reflect how the new entity will work. These documents explain how your business will run, the roles and responsibilities of owners, and how decisions will be made.
• Notify Stakeholders: You should inform everyone involved—partners, investors, and employees—about the change. This will help prevent confusion and make the transition smoother.

2. IRS Forms

• Form 2553: If you are switching to an S-Corporation, you must file Form 2553 with the IRS to make the election. This form must be submitted within 2 months and 15 days after the beginning of the tax year for the election to take effect that year. If you miss the deadline, you might be able to file it late if you have a valid reason.
• Form 8832: If your LLC wants to be taxed as a C-Corp or S-Corp, you must file Form 8832, called the Entity Classification Election. This form lets you choose how your business will be taxed, and filling it out correctly is critical to getting the tax savings you want.

3. State Requirements

Each state has its own rules for changing your business structure. Check with your state's Secretary of State office for any filings or fees, like updating business licenses, paying registration fees, or submitting annual reports. Some states may also have particular forms or timelines for making these changes, so paying attention to those details is essential.

Tax Implications of Switching

Switching your business structure can significantly impact your taxes, so knowing what those changes will mean for your tax filings is essential. 

Understanding the tax effects can help you make the best decision and avoid surprises.

1. Built-In Gains Tax

If converting a C-Corp to an S-Corp, be aware of the built-in gains tax. This tax applies to any gains on the corporation's assets earned before the conversion but sold after the switch. 

The built-in gains tax, which is charged at the corporate level, can apply for up to five years after the switch. 

Planning can help you minimize or avoid this tax, especially if you have assets that have gained value over time.

2. Timing of the Election

Filing the proper forms with the IRS by the required deadlines is essential. For example, Form 2553 must be filed within 2 months and 15 days after the start of the tax year to elect S-Corp status. 

Missing deadlines could mean you don't get the tax benefits until the following year. Filing on time will help you avoid penalties and ensure you get the benefits you want immediately.

3. Potential Pitfalls

Some common mistakes include:

• Missing deadlines for filing tax forms. You may have to wait until the following year to get your desired benefits if you miss the deadlines.
• Not paying yourself a reasonable salary if you switch to an S-Corp. The IRS expects S-Corp owners to pay themselves a fair wage based on industry standards. If you don't, you could face penalties or have to pay back taxes.
• Ignoring state tax differences for your new structure. States have different rules for business taxes, which could lead to unexpected costs or tax problems.

Our Final Thoughts

Switching your business entity can help you save on taxes, protect your assets, and open up new growth opportunities. However, changing your structure requires careful planning to ensure smooth operation. 

Evaluating your business regularly can help you determine when it's time for a change and ensure that your structure still meets your needs.Talk to a tax professional or legal advisor for guidance. 

They can help make sure the switch is done correctly and on time, which will help you avoid mistakes and take advantage of the benefits of your new business entity. Next, in our series, we'll discuss common tax pitfalls for business owners and how to avoid them. Stay tuned! Have questions or need help? Reach out and start a conversation today.