Key Takeaways

  • Converting an S Corp to an LLC can trigger capital gains taxes under IRS Section 336.
  • LLCs offer greater operational flexibility, fewer formalities, and favorable partnership taxation.
  • Merging or converting methods can preserve S Corp tax status while gaining LLC structure benefits.
  • The tax impact depends heavily on asset appreciation, timing of conversion, and state laws.
  • Always consider both federal and state tax consequences before making a structural change.

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.

Additional Tax Implications and Timing Considerations

Converting an S Corp to an LLC is not always a tax-neutral transaction. When you dissolve an S Corporation to form an LLC, the IRS treats it as a taxable liquidation. This means the corporation is deemed to have sold its assets at fair market value, triggering capital gains or losses that flow through to shareholders.

Key tax considerations include:

  • Built-in gains tax: If the S Corp was previously a C Corporation, assets appreciated during that time may be subject to built-in gains tax if sold within five years of the S election.
  • Recapture of depreciation: Certain assets, like equipment, may be subject to depreciation recapture, increasing the shareholder’s tax burden.
  • Double taxation risk during conversion: Though both entities avoid double taxation by default, if the conversion is mishandled, distributions during liquidation may be taxed again at the shareholder level.
  • State-level taxes: Some states treat S Corp and LLC conversions differently, potentially triggering additional taxes or filing fees.

Timing the conversion strategically—such as during a low-valuation period—can help reduce the amount of taxable gain. Shareholders planning to exit or bring in investors may benefit from converting early while valuations are still modest.

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.

When Retaining S Corp Tax Status After Conversion Makes Sense

In some cases, business owners want the structural advantages of an LLC while maintaining the S Corp tax classification. This is possible by forming an LLC and electing to be taxed as an S Corporation using IRS Form 2553.

Benefits of this approach include:

  • Maintaining pass-through taxation with payroll tax savings typical of an S Corp.
  • Preserving liability protections and structural simplicity of an LLC.
  • Avoiding the complex liquidation process that comes with converting a traditional S Corp into a disregarded entity.

However, not all LLCs qualify to be taxed as an S Corp. To maintain this status, the LLC must:

  • Have no more than 100 shareholders (or members).
  • Only issue one class of membership interest.
  • Be owned by U.S. citizens or resident aliens (no foreign members or corporations).
  • File Form 2553 within 75 days of formation or by the IRS deadline for existing entities.

This hybrid structure is appealing to businesses looking for payroll tax savings without corporate formalities.

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.

Alternative Structures and Practical Steps for Conversion

There are a few strategic methods to convert an S Corporation into an LLC:

1. Statutory ConversionAvailable in many states, this streamlined process involves filing a certificate of conversion and articles of organization. It legally dissolves the S Corp and forms a new LLC in one step, but still triggers a liquidation event for tax purposes.

2. Asset Transfer (Asset Sale or Distribution)The S Corp sells or distributes its assets to shareholders, who then contribute them to a newly formed LLC. This may create a higher administrative burden and significant tax consequences if appreciated assets are involved.

3. Merger with an Existing LLCIf the business already owns an LLC, the S Corp may merge into that LLC. This allows some flexibility in preserving entity history, contracts, and tax elections, but still invokes IRS liquidation treatment unless done solely for administrative convenience.

Before any method is chosen, it’s essential to:

  • Conduct a valuation of business assets.
  • Analyze the impact on depreciation schedules.
  • Review contracts and licenses that may be affected by the change in business structure.
  • Consult with a tax professional or legal advisor.

Frequently Asked Questions

What are the tax consequences of converting an S Corp to an LLC? A1: The IRS treats the conversion as a liquidation of the S Corp, potentially triggering capital gains and depreciation recapture for shareholders.

Can an LLC be taxed as an S Corporation? A2: Yes, if it meets IRS eligibility criteria and files Form 2553 in time, an LLC can elect S Corp tax treatment.

What’s the main difference between an S Corp and an LLC? A3: Structurally, LLCs offer greater flexibility and fewer formalities. Tax-wise, both can be pass-through entities, but S Corps allow for potential payroll tax savings.

How do I minimize taxes when converting an S Corp to an LLC? A4: Timing the conversion when asset values are lower and planning ahead with a tax advisor can help reduce capital gains exposure.

Is converting from S Corp to LLC right for every business? A5: Not always. It depends on growth plans, investor goals, state laws, and the company's asset structure. Legal counsel can help assess suitability.

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.