How Can I Restructure My Business Entity to Pay Lower Taxes?

If your business has been operating under the same entity structure since it was founded, there is a strong possibility you are paying more in taxes than necessary. Business income levels, tax laws, and personal financial situations all change over time, and the entity structure that made sense when the business started may no longer be optimal. Restructuring your business entity is one of the most impactful tax planning moves available.

Identifying the Problem

The first step is understanding where the current structure creates tax inefficiency. The most common issues include sole proprietors and single-member LLC owners paying self-employment tax on their entire net income under IRC Section 1401, S corporation owners paying themselves unreasonably low salaries to minimize payroll tax (which invites IRS scrutiny), C corporation owners facing double taxation on distributions, and pass-through entity owners failing to maximize the qualified business income deduction under IRC Section 199A.

Each of these problems has a structural solution, but the solution must be tailored to the specific business -- there is no universal fix. The analysis requires comparing the current structure's total tax cost (including federal income tax, self-employment or payroll taxes, state taxes, and the NIIT under IRC Section 1411) against the total tax cost of alternative structures.

The S Corporation Election

For sole proprietors and single-member LLC owners with consistent net income above a reasonable salary level, electing S corporation status is often the single most impactful restructuring step. The election is made by filing Form 2553 with the IRS, and it changes the tax treatment of the business without changing the underlying legal entity.

Once the S election is in effect, the owner pays self-employment tax (in the form of payroll taxes) only on the reasonable salary drawn through the corporation's payroll. The remaining net income passes through to the owner as a distribution that is not subject to self-employment tax. Under IRC Section 1402(a)(1), limited partners' distributive shares are excluded from SE tax, and a similar principle applies to S corporation distributions -- they are return on investment rather than earned income.

The key requirement is that the salary must be reasonable. The IRS examines factors such as the duties performed, comparable compensation for similar roles, the corporation's revenue and profitability, and the shareholder's training and experience. Setting the salary too low invites reclassification of distributions as wages, plus penalties and interest.

Converting Between Entity Types

Converting from one entity type to another has tax consequences that must be carefully managed. Converting a C corporation to an S corporation is accomplished by filing Form 2553, but the conversion triggers the built-in gains tax under IRC Section 1374 if the corporation had appreciated assets at the time of conversion. This tax applies to recognized built-in gains during the five-year recognition period following the conversion, at a rate equal to the highest corporate tax rate.

Converting a C corporation to a partnership or disregarded entity is treated as a complete liquidation of the corporation under IRC Sections 331 and 336, triggering gain recognition at both the corporate and shareholder levels. This conversion is generally the most tax-expensive restructuring option and is rarely advisable unless the corporation's assets have minimal built-in gain.

Converting from an S corporation to a C corporation is simpler -- the revocation is effective as of the date specified in the revocation statement filed with the IRS. However, once revoked, the S election generally cannot be reinstated for five years under IRC Section 1362(g).

Multi-Entity Restructuring

Some situations call for splitting a single entity into multiple entities to optimize tax treatment across different activities. A business that provides services and also owns real estate might benefit from operating the service business through an S corporation (to reduce SE tax) while holding the real estate in a separate LLC (to preserve partnership flexibility and Section 1031 exchange eligibility).

This type of restructuring requires careful attention to the transfer of assets between entities. Contributions of property to a partnership or LLC are generally tax-free under IRC Section 721, while contributions to a corporation qualify for non-recognition treatment under IRC Section 351 if the contributors own at least 80% of the corporation's stock immediately after the transfer.

Timing and Implementation

Restructuring decisions should be made with forward-looking tax projections, not just based on the current year. Model the tax outcomes over at least a three- to five-year horizon, accounting for expected income growth, planned distributions, and potential exit events. The restructuring itself should be implemented with the assistance of both a tax advisor and an attorney to ensure proper legal documentation and avoid inadvertent taxable events. When executed properly, entity restructuring can produce tax savings that compound year after year.

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This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.