Key Takeaways:

  • Converting an S Corp to an LLC can offer flexibility, reduced corporate formalities, and tax advantages.
  • The process varies by state, with some allowing a simple filing and others requiring a merger or new LLC formation.
  • Tax implications must be carefully considered, particularly regarding capital gains tax and shareholder liabilities.
  • Different conversion methods exist, including statutory conversion, statutory merger, and non-statutory conversion.
  • Special elections, such as LLCs opting for S Corp taxation, can provide additional tax benefits.
  • State-specific requirements must be followed, including filing articles of conversion or dissolution procedures.
  • The transition from an S Corp to an LLC impacts management, taxation, and compliance obligations.

When changing from an S-Corp to an LLC, there are some key steps you need to take. Due diligence will ensure that everything is properly filed and approved under state laws. 

Converting S-Corp to LLC

You will enjoy limited liability whether you are a limited liability company (LLC) or an S-Corp. Although neither of these structures is taxed at the federal level, S-Corps are taxed on certain types of passive income. Since LLCs benefit from fewer formalities, simplified operations, and more flexible tax options, you may be interested in turning your S-Corp into an LLC. 

The process to do so will vary from state-to-state. In the majority of cases, you will need to file a simple form with the Secretary of State. However, in other cases, this procedure can be more complex. If your state requires you to form an LLC and then merge your S-Corp into your limited liability company, you may want to seek a professional opinion. 

Reasons to Convert an S Corp to an LLC

Many business owners choose to convert an S Corp to an LLC for various reasons, including tax flexibility, reduced compliance burdens, and changes in ownership structure. Here are the primary reasons to make the transition:

  • Less Compliance and Administrative Burden: LLCs are not required to follow corporate formalities such as board meetings, shareholder votes, and extensive record-keeping.
  • Tax Flexibility: LLCs can be taxed as sole proprietorships, partnerships, or corporations, depending on what suits their financial structure best.
  • Profit and Loss Allocation: Unlike S Corps, where income is distributed based on shareholding, LLCs can distribute profits based on agreements between members.
  • Ownership Flexibility: S Corps are limited to 100 shareholders and require U.S. citizenship, whereas LLCs have no such restrictions.
  • Dissolution and Succession Planning: Transitioning from an S Corp to an LLC may be beneficial when planning for business succession or restructuring ownership.

Converting S-Corp to LLC: General Procedures

To initially authorize conversion, a corporate resolution will be required. In the majority of states, this decision typically needs to be unanimous. Once all shareholders have agreed, you can begin the conversion. 

You will need to do one of the following:

For example, here is a Certificate of Conversion for the state of Tennessee.

Once you do convert your business from an S-Corp to an LLC, you will need to inform the IRS. 

Depending on your state, this conversion can be completed by forming a new LLC and merging the S-Corp into the new business structure. In this case, the LLC will be a survivor in the merger. Since there can be tax consequences associated with the liquidation of an S-Corporation, it is imperative that you understand your options. 

Different Methods for Converting an S Corp to an LLC

The process of converting an S Corp to an LLC varies by state and can be done in multiple ways:

  1. Statutory Conversion (Simplified Process)
    • File a Certificate of Conversion (or similar document) with the Secretary of State.
    • The S Corp is automatically restructured into an LLC.
    • Retains business history and assets while adopting the new LLC structure.
  2. Statutory Merger
    • A new LLC is formed, and the S Corp merges into it.
    • Requires shareholder approval and dissolution of the S Corp.
    • Assets and liabilities transfer to the LLC.
  3. Non-Statutory Conversion (Asset Transfer)
    • The S Corp’s assets and liabilities are transferred to the newly formed LLC.
    • Shareholders receive ownership in the LLC.
    • This process is more complex and may trigger additional tax consequences.

Each method has different legal and tax implications, making it essential to consult a professional before proceeding.

Variable Elements of Conversion

Before you begin this process, know that there is more than one type of corporation, more than one tax status for an LLC, and more than one kind of conversion. C-corporations, for instance, pay corporate taxes, whereas S-Corporations benefit from pass-through taxation. This means that only the shareholders pay taxes, not the corporation itself.

Other potential variables include the following:

  • Where your corporation was formed, as state regulations and tax laws vary
  • Whether your LLC will be a single-member or multi-member entity
  • Whether your LLC will be taxed as a corporation, partnership, or "disregarded entity"
  • How you plan to convert your business (i.e. statutory conversion vs statutory merger)

State-Specific Considerations for Conversion

Each state has unique regulations for converting an S Corp to an LLC. Some factors to consider include:

  • Filing Fees and Documentation: States like California and New York require extensive paperwork, including a formal dissolution of the S Corp before LLC formation.
  • Publication Requirements: Some states, such as Arizona and New York, mandate that new LLCs publish a notice of formation in local newspapers.
  • Liability and Tax Laws: Certain states impose additional fees on LLCs, such as California's annual franchise tax.
  • Retention of Business History: Some states allow an LLC to retain an S Corp’s Employer Identification Number (EIN) and business credit history, while others do not.

Checking with state authorities or consulting a legal professional can help navigate these regulations efficiently.

Converting S-Corp to LLC: Tax Consequences

Before you begin the conversion process, be aware of the possible tax consequences.

  • If your S-Corp increases in value between its formation and the conversion to an LLC, shareholders will be subject to capital gains tax.
  • In some states, this conversion is not a simple process. If you do not want to deal with the complications associated with a merger, you may have the option to liquidate the S-Corp. That way, all assets will be transferred to shareholders who will then contribute these assets to the newly formed LLC. In this case, Code Section 331 will apply, whereas Code Section 301 and Code Section 1368 will not. 

Other disadvantages include potential tax liability to the shareholders of a former S-Corp and more complicated taxation for single-owner LLCs. If you own a single-member LLC, you will need to report your taxes on Schedule C of your individual tax return instead of on Schedule E in relation to an S-Corp. Experts also agree that as you increase the amount of reported income on Schedule C, you are more likely to be audited. 

Tax Elections for LLCs After Conversion

Once the S Corp is converted into an LLC, business owners must decide how the new entity will be taxed. The IRS provides several options:

  • Default Taxation:
    • Single-member LLCs are taxed as sole proprietorships.
    • Multi-member LLCs are taxed as partnerships.
  • S Corp Election for LLCs:
    • An LLC can elect to be taxed as an S Corp by filing IRS Form 2553.
    • This election helps reduce self-employment taxes, making it beneficial for business owners taking large distributions.
  • C Corp Election for LLCs:
    • LLCs that want to retain earnings within the business may opt for C Corporation taxation.
    • This structure may be beneficial for businesses planning to reinvest profits or attract investors.

Understanding these tax elections can help business owners optimize their tax liability and compliance.

Converting S-Corp to LLC: Advantages

Although you will want to become familiar with the possible consequences of conversion, there are also a number of advantages, including the following:

  • Certain corporate formalities, which do not apply to an LLC, are eliminated.
  • An LLC can file for S-Corp election for tax purposes.
  • Members are protected from creditors by the "changing order" statutes. For companies that own a significant amount of assets, this is a valuable advantage. 

Frequently Asked Questions

  1. What is the fastest way to convert an S Corp to an LLC?
    The quickest way is a statutory conversion, available in states that allow it. This process involves filing a single form to officially convert the business structure.
  2. Will I lose liability protection when converting my S Corp to an LLC?
    No, LLCs offer limited liability protection similar to S Corps, ensuring that owners’ personal assets remain separate from business liabilities.
  3. Does converting from an S Corp to an LLC affect my EIN?
    In most cases, you will need to apply for a new EIN for the LLC unless your state allows entity continuation.
  4. Are there tax consequences when converting an S Corp to an LLC?
    Yes, potential capital gains taxes and distribution tax implications exist, especially if the S Corp had significant appreciation before conversion.
  5. Can an LLC elect to be taxed as an S Corp after conversion?
    Yes, after conversion, the LLC can file IRS Form 2553 to elect S Corp tax treatment, helping to reduce self-employment tax burdens.

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