Key Takeaways

  • Conversion Process: Changing an S Corp to an LLC typically involves either a statutory conversion (if available in your state), a statutory merger, or an asset transfer method.
  • Tax Considerations: The IRS treats the conversion as a liquidation, potentially triggering capital gains taxes on appreciated assets.
  • Advantages of LLCs: LLCs provide operational flexibility, simplified administration, and greater tax treatment options.
  • State-Specific Rules: Some states allow direct conversions, while others require forming a new LLC and merging it with the S Corp.
  • Shareholder Approval: Unanimous or majority shareholder approval is often necessary before proceeding with conversion.
  • Debt & Contracts: Outstanding debts, leases, and contracts should be reviewed for clauses that may affect the transition.
  • Ongoing Compliance: Once converted, the new LLC must adhere to state LLC regulations, including filing annual reports and maintaining proper records.

If you're looking to change from an S corporation to an LLC, there are some important things to consider. 

Both S corporations and limited-liability companies (LLC) have limited liability. Neither are taxed at the federal level, except that S corporations are taxed on some types of passive income. 

LLCs have the additional advantages of being simplified operations with fewer corporate formalities and flexibility with tax liability. 

Most states have an easy process for changing from an S corporation to an LLC. This procedure can differ depending on the state where you are located, but many states simply require you file a form with the Secretary of State for your operating state.

In some states, you must first form your LLC and then merge the S corporation into the existing LLC. This transaction can be complicated.

A shareholders' resolution will need to be passed by the S corporation authorizing the conversion. Because of the tax consequences that can result from this action, unanimous consent is required to pass this resolution in most states. The conversion process can proceed after the resolution has been passed. Generally, this means you will complete the merger and file a Certificate of Conversion with your state. You will also need to notify the IRS that the conversion has been completed.

Tax Consequences of Converting from S Corporation to LLC

Before you choose to convert your S corporation to an LLC, the tax consequences must be considered very carefully. The IRS will consider your S corporation liquidated even if your merger has been completed or you've filed your Certificate of Conversion.

A capital gain occurs if your the value of your S corporation increases from the time it was formed to when it was converted to an LLC. When a capital gain occurs, the capital gains tax will be levied against your shareholders.

Alternatives of Converting from S Corporation to LLC

If you want to avoid the expensive costs of a merger, or if there is no easy conversion process in your state, you can transfer assets to your shareholders, which would liquidate your corporation. The shareholders will then contribute the assets back to your LLC.

Understanding the IRS Tax Implications

When an S Corporation converts to an LLC, the IRS treats this as a liquidation of the corporation, which may result in significant tax liabilities. The following tax factors should be considered:

  • Capital Gains Tax: If the corporation has appreciated assets, shareholders may face capital gains taxes upon conversion.
  • Depreciation Recapture: If the S Corp has claimed depreciation on assets, the IRS may require recapture, leading to a higher tax burden.
  • Built-in Gains Tax: If the S Corp sells or transfers assets within five years of converting, the IRS may impose a built-in gains tax.
  • Distributions to Shareholders: Any assets distributed to shareholders as part of the conversion may be taxable as dividends or capital gains.

It’s crucial to consult a tax professional to evaluate the impact of these tax obligations before proceeding.

Advantages of Converting from an S Corporation to LLC

There are several advantages to converting to an LLC:

  • After conversion, the corporate rules that S corporations observe are eliminated.
  • An LLC doesn't have to keep a board of directors, nor does it have to record minutes, because the company can be member-managed.
  • For tax purposes, LLCs can be considered either a C corporation or S corporation.
  • If there are no taxation requests, the IRS taxes an LLC like a partnership as long as there are multiple members.
  • Unlike an S corporation, there will be no double taxation against an LLC if the organization is changed, such increasing ownership to more than 100 members, which would make it ineligible for S corporation tax treatment.

Key Legal and Administrative Considerations

Beyond tax considerations, several legal and administrative factors play a crucial role in a successful conversion:

  • State-Specific Conversion Rules: Some states allow direct conversion, while others require a merger or dissolution and reformation.
  • Unanimous Shareholder Consent: Shareholder approval is usually required for conversion, and any dissenting shareholders may trigger buyout obligations.
  • Contractual Obligations: Review existing contracts, leases, and financing agreements to ensure they allow for an entity change. Some agreements may require lender or landlord approval.
  • Employee Benefits & Payroll: Ensure that payroll, benefits, and retirement plans are properly transferred to the new LLC structure.
  • Licenses and Permits: Depending on your business type, regulatory licenses may need to be updated or reapplied for under the LLC.

Failure to address these administrative factors could lead to operational disruptions, additional costs, or legal challenges.

Why Convert to an LLC?

It's not hard to figure out why someone would convert an S corporation to an LLC. 

Membership interests in LLCs are protected from creditors by the “charging order” statutes. Under these statutes, the creditor of a member of the LLC doesn't get the member's interests. The creditor only receives the charge against the economic interest. The creditor doesn't receive any voting rights, but receives any profits the member earns from their investment in the business. For those with substantial company assets, the charging-order protection is very valuable. 

Many S corporations choose to convert for tax reasons. The shareholders may also plan on liquidating the corporation in the future. As the corporation grows and accumulates assets, as well as depreciating them, the tax on the liquidation will continue to grow. A shareholder may also choose this time to liquidate, since the tax liability is smaller.

Existing shareholders may choose to bring in an additional investor, or some other professional assistance. If the investor is a corporation, an LLC, or a foreign entity in relation to the shareholder status, the investor may terminate the S election of the corporation. The conversion of an S corporation to an LLC in advance may be a more desirable option. 

There are many aspects of converting from an S corporation to an LLC. In order to explore all your options, you may want to consult a professional attorney.

Steps to Convert an S Corp to an LLC

The specific process of converting an S Corporation to an LLC varies by state but generally involves the following steps:

  1. Check State Conversion Laws – Determine whether your state allows statutory conversions or requires a more complex process like a statutory merger.
  2. Draft a Shareholder Resolution – Obtain shareholder approval to move forward with the conversion.
  3. File a Certificate of Conversion (if applicable) – If your state allows statutory conversions, submit the necessary paperwork to the Secretary of State.
  4. Create a New LLC (if required) – If a statutory conversion isn't allowed, form a new LLC and transfer assets from the S Corp.
  5. Merge the S Corp into the LLC – If performing a statutory merger, the S Corp must formally merge into the newly created LLC.
  6. Dissolve the S Corporation – If not merging, complete dissolution paperwork for the S Corp after asset transfers.
  7. Update IRS and State Tax Agencies – Notify the IRS and state tax authorities of the change in entity type.
  8. Transfer Licenses and Contracts – Update all business licenses, permits, contracts, and financial accounts.

Careful planning ensures that the transition process is smooth and legally compliant.

Alternatives to Converting an S Corp to an LLC

If a full conversion is not feasible due to tax burdens or administrative complexity, consider these alternatives:

  • Revoke the S Corp Election: Instead of converting, some businesses choose to revoke their S Corp status and operate as a C Corporation.
  • Create a New LLC and Transfer Assets: Some business owners form a new LLC and transfer assets from the S Corp rather than performing a statutory conversion.
  • Sell the S Corporation to an LLC: This involves selling the business to a new LLC entity and dissolving the S Corp afterward.
  • Elect LLC Taxation as an S Corp: If the goal is to retain S Corp tax benefits while gaining LLC flexibility, an existing LLC can elect S Corp taxation status with the IRS.

These alternatives may provide similar benefits while avoiding the downsides of a full conversion.

Frequently Asked Questions

1. Can I switch from an S Corp to an LLC without dissolving the corporation? Yes, in states that allow statutory conversions, an S Corp can change into an LLC without dissolution. Otherwise, you may need to form an LLC and transfer assets from the S Corp.

2. How long does it take to convert an S Corp to an LLC? The timeline varies by state, but the process typically takes a few weeks to several months, depending on state processing times and the complexity of your business structure.

3. Will I lose my business name when converting from an S Corp to an LLC? Not necessarily. Most states allow you to keep your business name when converting, but you should check with your state’s Secretary of State office to ensure the name is still available.

4. Are there ongoing compliance requirements for an LLC after conversion? Yes. LLCs must file annual reports in most states, maintain an operating agreement, and follow state-specific requirements for recordkeeping and taxation.

5. Can an LLC be taxed as an S Corp after conversion? Yes. Once the conversion is complete, the LLC can elect to be taxed as an S Corporation by filing Form 2553 with the IRS.

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