Newly created LLC - Best Practices, S Corp vs Sole Proprietor, etc

[syndeyredlegs]

Hi there,

I have a newly created single member LLC in Colorado. From my understanding, if I want to change my tax filing from sole proprietor to S-Corp, I have until early January to change my tax filing status for 2024, or mid-March for 2025.

When do you typically recommend that an LLC file under S-Corp versus the default? I think I shouldn't worry about 2024 (I won't have much income in 2024), but I imagine it could matter in 2025. 

What other best practices do you recommend for an early stage LLC? Any key considerations for movement of cash or key things to look out for with taxes? What can you deduct as a single member LLC?

Thank you!

[FranklinF · Accepted solution]

FIRSTLY, a corporation or other entity eligible to be treated as a corporation files IRS Form 2553 to make an election under section 1362(a) to be an S corporation.

SECONDLY, the time-frame to make the above election is:

• No more than 2 months and 15 days after the beginning of the tax year the election is to take effect, or

• At any time during the tax year PRECEDING the tax year it is to take effect.

THIRDLY, a Single-Member LLC is a State Entity and NOT a Tax Entity, that for Tax Purposes is considered a Disregarded Entity whose Tax Return will flow to either a Schedule C (Profit and Loss from Business) or Schedule F (Profit and Loss from Farming), as applicable, if the Election to be treaded as an S-Corporation is NOT made.

FOURTHLY, the idea of transitioning to an S-Corporation Status should make business sense, that is, the income derived from the business activity is appropriate to manage expenses, especially payroll expenses and related (major issue). In addition an Owner-Operator, per IRS regulations, MUST pay himself/herself compensation that is REASONABLE. Reasonable Compensation to Owner-Operators must be paid out FIRST before any owner's draws are taken.

The IRS defines Reasonable Compensation as the value that would ordinarily be paid for like services by like enterprises under like circumstances. Reasonableness is determined based on all the facts and circumstances.

LASTLY, as you transitioned from a Schedule C (or Schedule F) to an S-Corporation Status, it very important to properly handle the business assets that are being transferred in terms of basis and depreciation. As mentioned earlier, payroll is a major issue, and thus, it is advisable to have a payroll team in place (it could be one person) whether it is in-house or a third-party for the transition.

There are more deductions and benefits available to S-Corporations as compared to Sole Proprietors, but an S-Corporation Status should be elected if it makes business sense, which is something that each individual will have to determine after properly reviewing and understanding their respective Financial Statements (Income Statement, Balance Sheet, etc.).

Instructions for Form 2553 
Meaning of "reasonable" compensation 

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[Cindy4]

In order to make an entity declaration as an S-Corp you'll need to file an entity election with an effective date no earlier than 75 days prior to making the election or 12...There is a 60-month limitation rule, so once you make the election, you generally have to stick with it for five years.  

An S-corp election can help reduce employment taxes once you are making enough to be considered a fair salary.  After that point, the money can be taken out as a distribution.  Because S-corp shareholders are taxed on income at the time it is reported by the S-corp, they build basis.  When a distribution is taken, the money isn't taxable as long as there is basis.   This article explains it quite well.

A single member LLC is allowed basically the same business deductions as any other business.  Anything that is considered "ordinary and necessary".  Things like supplies, office expenses, insurance, advertising, vehicle costs, travel, legal & professional fees.  Here are a couple of good resources regarding business deductions:

TurboTax Tax Moves  and  This IRS publication has a very comprehensive list.

Hope this helps!

Cindy

[dsoile]

Hello syndeyredlegs

In addition to making sure that it makes business sense to go for the S-Corp election, also keep in mind that an S-Corp has stricter eligibility requirements compared to sm-LLC. In addition, this entity type is alsosubject to closer IRS scrutiny, thus making it important that you are meeting the qualifications and requirements to keep your S-Corp status.