1. Tax Consequences of Converting S Corp to LLC
2. Tax Benefits of an S Corp and LLC
3. How to Convert from an S Corp to an LLC

Updated June 24, 2020:

Tax Consequences of Converting S Corp to LLC

There are some tax consequences of converting S Corp to LLC, and it is important that you are aware of such tax implications before converting your S Corp to an LLC.

Both S Corps and LLCs (Limited Liability Companies) offer limited liability. Other advantages of LLCs are that they offer flexibility in terms of the company’s operations, little formalities, and additional options for managing and oversight of the business.

Therefore, there are many S Corps that wish to convert to LLC for such benefits. Another reason for converting from an S Corp to an LLC is due to the fact that LLCs can be treated as a partnership for federal tax purposes. Being treated as a partnership for tax reasons provides enhanced flexibility over the tax rules for corporations.

Tax Benefits of an S Corp and LLC

Both LLCs and S Corps are treated as pass-through entities for tax purposes. This means that any income, deductions, and tax credits are passed through to the owners of the business, and therefore, are filed on those owners’ individual tax returns.

There is also no corporate tax return that mustbe filed for an LLC or S Corp. For this reason, these two types of business structures avoid the issue of double taxation. C Corps are subject to double taxation, as these corporations are first taxed at the corporate level, and then if the company passes on additional profit to the shareholders in the form of dividends, those dividends would have to be reported on those shareholders’ personal tax returns.

How to Convert from an S Corp to an LLC

Before you choose to convert your business structure, you should always think of all of the consequences of such a conversion. While there could be many benefits, there are usually some consequences, too.

You’ll probably have to liquidate your S Corp, which will then be recognized as a gain under Section 336 as if it sold all of its assets. If the S Corp’s assets have increased between the time of the formation of the business and the time of the conversion to an LLC, a capital gain is realized. This means that the shareholders must pay capital gains tax on the amount of that gain.

With that being said, you might still want to convert your business structure, particularly in the following circumstances:

• The S Corp wants to create a liability shield. In most states, LLC members are shielded from creditors under what are called ‘charging order’ statutes.

• The S Corp wants to liquidate assets ahead of time. While the S Corp is required to liquidate assets when converting to an LLC (this is the main tax consequence), it could also be viewed as a benefit to an S Corp that continues to grow exponentially. Therefore, the S Corp might want to convert while the tax consequence of such liquidation would be lower than at a later point, when the tax would continue to grow based on the amount of assets being liquidated.

• The S Corp wants to bring in a new investor. If the S Corp brings in a new investor, this will cause the termination of the selected Corp, which will result in tax implications. For that reason, the S Corp may want to convert to an LLC before choosing an additional investor.

Some S Corps want to convert to an LLC but still be taxed as an S Corp. There are two ways to do this. The first way is to create an LLC and subsequently convert the corporation into the LLC. The corporation will then be referred to as an LLC, and the corporation’s assets will transfer to the new LLC.

The second way is to merge the corporation into an existing LLC that already has assets. When a corporation has assets with built-in appreciation, the conversion to an LLC can still allow that corporation to be taxed as an S Corp but operate as an LLC. The only issue you might face would be whether or not the conversion increases income tax, as you are now transferring over assets from the corporation into an LLC that also has profits of its own.

If you need help converting your S Corp to an LLC, 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.