1. State Law Regarding Conversion
2. Alternatives to Converting to an LLC
3. How to Convert to an LLC

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.

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.

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.

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