Key Takeaways

  • Converting from a sole proprietorship to an LLC in California provides personal liability protection, credibility, and potential tax advantages.
  • California offers multiple legal paths for conversion, including statutory conversion, statutory merger, and nonstatutory conversion.
  • Business owners must consider EIN updates, business licenses, bank accounts, and tax implications when converting.
  • Sole proprietors should notify relevant agencies and vendors after the LLC is formed.
  • Converting is especially useful when the business is growing or looking to protect its name or assets.
  • Professional legal guidance can help avoid missteps and ensure compliance with California law.

If you are considering converting S Corp to LLC in California, it's important to do your research. Before making the leap, consider the advantages and disadvantages of doing business as an LLC in California, as well as the costs associated with making this change.

Most businesses decide to convert from a corporation to an LLC in order to avoid the double tax that corporations may face. Both S corporations and LLCs enjoy the benefits of limited liability. S corporations also benefit by avoiding the double tax typically associated with other types of corporations. If S corporations are not double-taxed, then why would a company consider using an LLC structure?

LLCs offer the following advantages:

  • LLCs are easier to set up.
  • LLCs do not have as many formalities that a corporation has.
  • LLCs have more flexible tax options.
  • LLCs do not have to maintain a board of directors, nor are they responsible for keeping minutes.
  • LLCs can be member-managed.
  • Membership interests in LLCs are shielded from creditors. This means that a creditor cannot obtain a member's interests. This can be a major benefit to companies that have valuable assets or may be liquidated in the near future.

In a corporation, as assets accumulate and depreciation continues, the tax on the asset will increase. When this occurs, the company will pay the increased tax when liquidation occurs. You may also wish to convert an S corporation to an LLC for tax reasons if you want to liquidate the business when liquidation costs would be lower.

Another reason for converting an S corporation would be if there is a plan to bring in outside investors. If the new investor is foreign, this will cause a termination of the S corporation tax status, and the company would start to be taxed at the normal corporate rate. An LLC provides for much more flexibility in terms of ownership.

State Law Regarding Conversion

When converting from an S corporation to an LLC, the process that must be followed will vary from state to state. In many states, the procedure is as simple as filing a form with your secretary of state's office.

But not all states offer this simplified conversion procedure. In these states, you must first form the LLC and then merge the S corporation into it. Such a transaction that can be quite complex.

Legal Methods of Converting to an LLC in California

In California, a sole proprietor can convert their business to an LLC through several recognized legal mechanisms:

  1. Statutory Conversion
    This streamlined process is only available in some states, including California. It allows a business to convert into a new entity (like an LLC) by filing a Certificate of Conversion and Articles of Organization with the California Secretary of State. This is generally the simplest method, avoiding the need to dissolve and re-form the business.
  2. Statutory Merger
    If statutory conversion isn't appropriate, a sole proprietor can form an LLC and then merge the sole proprietorship into it. This requires creating a merger agreement, filing merger documents, and ensuring the original business's assets and liabilities transfer to the LLC.
  3. Nonstatutory Conversion (Asset Transfer)
    This method involves manually transferring the sole proprietorship’s assets and liabilities to a newly formed LLC. Though more flexible, it's also more paperwork-intensive and may have different tax and legal implications.

Each method has unique requirements, so it’s important to choose the one that best suits your business situation. When in doubt, a business attorney can clarify the best route forward.

Alternatives to Converting to an LLC

In states where the process of conversion is more complicated and the shareholders wish to avoid the legal expenses that they may encounter with a merger, there is always the option of liquidating the S corporation and transferring its assets to the various shareholders. Then the shareholders can, in turn, use these assets to make contributions to the new LLC.

Signs It’s Time to Convert to an LLC

While some sole proprietors delay forming an LLC, there are key indicators that it may be time to convert:

  • You’re hiring employees and want to shield personal assets from potential liabilities.
  • Your business is growing, bringing more exposure and increased legal risk.
  • You’re seeking funding or investors, who typically prefer investing in a formal business structure.
  • You want to protect your brand name, as forming an LLC can help secure your business name in California.
  • You want to improve credibility, as customers, partners, and lenders often view LLCs as more professional entities.

Even if your sole proprietorship has served you well, converting to an LLC may better support long-term goals.

How to Convert to an LLC

Converting to an LLC is not always straightforward due to the fact that the shareholders may be responsible for paying tax on the liquidation of the corporation. There are some important things that need to be considered before the conversion can take place:

  • The conversion should be authorized by a resolution passed by the shareholders.
  • Most states require a unanimous vote of the shareholders before the conversion can occur.
  • Once conversion has been authorized, a certificate of conversion must be filed with the state authorities or a merger needs to take place
  • The S corporation and its assets are liquidated and go to the newly formed LLC.
  • Outright liquidation causes the corporation to be subject to capital gains tax.

There are several things that must be considered when it comes to liquidating the business assets and also some important distinctions between liquidating assets in a C corporation and liquidating assets in an S corporation:

  • S corporations only have to pay tax at one level.
  • Be careful when contributing shares of stock from an S corporation to an LLC. Since an LLC is not considered to be an eligible shareholder of an S corporation, contributing stock to the LLC causes the S corporation election to be considered terminated.
  • The company will have short S and C years unless its assets are liquidated on the same day as conversion.

Additional Steps to Take After LLC Formation

After you've formed your LLC in California, converting from a sole proprietorship isn’t just about paperwork—it requires practical follow-through steps:

  • Apply for a New EIN
    The IRS generally requires a new Employer Identification Number for your LLC, even if you already had one as a sole proprietor.
  • Update Licenses and Permits
    Notify local and state licensing agencies that your business structure has changed and update or reapply for any licenses in the LLC's name.
  • Open a New Business Bank Account
    Keeping your LLC finances separate from personal and previous business accounts helps preserve your liability protection and simplifies accounting.
  • Update Contracts and Agreements
    Notify vendors, clients, and partners that your business is now an LLC, and update all contracts to reflect the new entity.
  • Transfer Business Assets
    Officially transfer business assets—such as domain names, equipment, and inventory—from your sole proprietorship to the LLC.
  • Inform the IRS and the FTB
    Update your business structure with the Internal Revenue Service and California Franchise Tax Board. You may need to file final returns for your sole proprietorship.

These steps ensure your LLC is properly recognized and operates with full legal standing, avoiding future complications.

Frequently Asked Questions

1. Can I keep my business name when I convert to an LLC in California?Yes, but you’ll need to check availability and register the name with the California Secretary of State as part of the LLC formation process.

2. Do I need a new EIN when converting from sole proprietorship to LLC?Yes, in most cases the IRS requires a new EIN when the business structure changes to an LLC, even if the ownership remains the same.

3. How long does it take to convert a sole proprietorship to an LLC in California?Processing times vary but typically range from a few business days to a few weeks, depending on whether you file online or by mail.

4. Is there a fee to convert to an LLC in California?Yes, the filing fee for Articles of Organization is $70. Additional fees may apply for expedited service or business licenses.

5. Will converting to an LLC affect my taxes?Yes, converting may change how your business income is reported and taxed. Sole proprietorship income is reported on a personal tax return, while an LLC may choose default pass-through taxation or elect to be taxed as an S corporation.

If you need help with converting S corp to LLC in California, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.