Are you a business owner considering converting your S Corporation to an LLC? Many entities are making the switch because of the advantages that come with it. This includes flexibility in management and taxation as well as other potential financial benefits.
Yet, making the switch may also come with certain disadvantages. In what follows, you will be well-equipped with how to prepare for the S corp to LLC conversion to make an informed decision for your business. Keep reading for more!
*Note that this article doesn’t include cases where LLCs elect to be taxed as S corporations
Why should convert S corp to LLC?
Converting from an S Corporation to an LLC offers a variety of benefits that could be great for your business. An LLC provides more flexibility in terms of management and taxation, allowing you to customize the organization’s structure to best fit your business’s needs.
Unlike S corporations, LLCs are able to grant their employees a “profits interest” in the business. This means that an LLC member may be able to receive profits from their ownership stake without having to take on any liability for business debts or obligations. This enables employees to benefit from the success of the business without having to be fully invested in it.
An LLC provides liability protection as it is an entity separate from its owners. An S Corp can convert to an LLC while preserving the same tax benefits, but with additional flexibility for improved asset protection.
Furthermore, LLCs have fewer ownership restrictions than S Corporations, making it easier to expand your business and bring in more investment opportunities than S Corp.
This blog article explains the benefits and drawbacks of LLCs in the USA. Find out more if you need more information.
How will S corp to LLC conversion affect your entity’s taxation?
One of the major considerations when deciding whether to convert from an S Corp to an LLC is taxes. It is difficult to definitively say that one business structure pays more taxes than another, as this depends on a variety of factors.
Both can be taxed at the personal income tax level
For tax purposes, LLCs and S Corps are both treated as pass-through entities – avoiding the headache of double taxation like a C corp. Yet, the amount of tax a business pays varies depending on the way it is set up and how much money it makes. While LLCs are most times taxed applying personal rates, some owners opt to be taxed as a separate entity. And this would result in an LLC being taxed as a C corp and subject to double taxation.
S Corps, on the other hand, are generally taxed at the same rate as individuals but may be eligible for certain tax breaks. S Corps are also able to deduct health insurance premiums from their taxable income.
The possibility of paying S corp’s capital gain tax can be avoided
Another highlight is that converting your S corp into an LLC can help you avoid paying capital gains tax on passive income and give you more flexibility in how the business is structured.
To explain, S corp business owners may need to liquidate their corporation. In this case, section 336 will then treat the business as a gain as if it sold all assets at its fair market value. An S Corp’s capital gains are realized if its assets have increased in the middle of the time the S corp was formed and the time it was converted to an LLC. As a consequence, shareholders are required to pay capital gains tax on that gain.
If the S Corp’s assets are then transferred to an LLC in exchange for LLC membership units, the S corp can convert itself into an LLC and avoid the associated capital gains tax.
Single-member LLCs may be subject to a more complicated taxation
An S corporation is taxed as a pass-through entity and passes any income or losses through to its shareholders’ individual tax returns. Single-member LLCs are taxed as sole proprietorships which can be more complicated. Taxes are assessed on all profits, and losses can be used to offset other income as long as the LLC participates in a trade or business.
Regarding reporting, for single-member LLCs, profit or loss from the business must be reported on Schedule C of the individual tax return as opposed to Schedule E for an S corp.
Extra taxes can be applied (depending on the state you choose)
Depending on your particular state laws and regulations, you may also find yourself subject to additional taxes when converting from an S corp to an LLC. For example, some states like Tennessee impose a franchise tax on LLCs.
What are the steps involved in converting S corp to LLC?
The S corp to LLC conversion process can be relatively straightforward if done correctly. The procedure required for conversion may vary from state-to-state, all business owners had better consult the legal team for the most up-to-date information.
So what are steps need to be taken in order to make the transition successful?
Factors before deciding S corp to LLC conversion
When considering the conversion, it is essential to understand relevant factors – such as:
- Whether to convert S corp to single-member LLC or multi-member LLC
- What the flexibility when it comes to managing your business structure is like
- Whether the conversion to LLC will be more costly compared to managing the S corp
- Additional paperwork, state requirements when coming to filing taxes for an LLC versus an S corp
- Converting S corp to LLC tax consequences, depending on the state in which your business operates
- The method for converting your business from S corp to LLC affects your legal and financial obligations.
Because the case of each corporation is different based on your business’s needs and objectives, it is a good idea to consult a professional who can help you weigh the pros and cons of such a conversion, along with how to make the switch properly.
Method 1: Filing the Certificate of Conversion (Statutory conversion)
Statutory conversions allow an S corp to convert directly into an LLC without dissolving the original entity. This method is often referred to as a “domestic conversion” and can be completed in fewer steps than other methods.
You’ll need to prepare a corporate resolution done through agreements of all shareholders and convert your current corporate structure. You then need to submit a Certificate off Conversion (or its equivalent) and complete the merger.
Here is the Delaware Certificate of Conversion from Corporation to LLC for your reference.
Method 2: Merging S corp into a new LLC (Statutory merger)
Statutory merger is a type of business transaction that involves two separate entities merging together into a single entity. In this case, the S corp would merge into the LLC and dissolve itself in the process. This method requires filing paperwork with the state in which the entities are registered.
You are required to file a certificate of merger with the secretary of state as well as any other documents that are legally required with the Secretary of State’s office where your S corp was formed. Once all of this paperwork is completed and the merger goes into effect, you can start running your converted S-corp-to-LLC as a limited liability company.
Method 3: Nonstatutory conversion
Nonstatutory conversions involve transferring assets from an S-Corp to an LLC before dissolving the S corp’s existence. This is a more complicated process that requires filing paperwork with the state in which both companies are registered, along with any necessary tax forms.
You need to notify the IRS that you are discontinuing your S corps existence and inform all creditors, clients, employees and shareholders of the change in corporate structure. Filing a certificate of dissolution with the Secretary of State’s office where your S corporation was formed is also required.
You’ll also need to create a new LLC and formally transfer your existing S corp assets, liabilities and ownership over to the LLC including transferring money in business bank accounts, insurance policies, and state business taxes. This is done through an asset purchase agreement, which assigns a value to each asset and states that the new LLC will own them once the sale is completed.
The transfer will ensure that the new LLC is properly recognized by the IRS and other state agencies. This method is commonly used when multiple subsidiaries need to convert into one and you want to avoid dissolving all of them.
It’s important to note that the process of converting from an S Corporation to an LLC can vary depending on your state and the method you select, so it’s important to get advice from your legal team before switching.
How to change to S corp from LLC?
If you are looking to convert your existing LLC into an S corporation, the process can be a bit complicated. You should ensure that your business meets all of the necessary requirements for an S corporation. And convert your existing LLC into an S corporation by filing Form 2553 with the IRS as well as convert any existing LLC assets and liabilities into S corporation assets.
No matter what type of business you have, it is important to understand all the different options available and their respective benefits and drawbacks in order to make the best decision for your company. Be sure to take your time and research thoroughly before starting the conversion process so that you can ensure a smooth transition.
If you need more help deciding between an S Corporation and an LLC, consider seeking practical advice from a professional team.
Disclaimer: While BBCIncorp strives to make the information on this website as timely and accurate as possible, the information itself is for reference purposes only. You should not substitute the information provided in this article for competent legal advice. Feel free to contact BBCIncorp’s customer services for advice on your specific cases.
- Why should convert S corp to LLC?
- How will S corp to LLC conversion affect your entity’s taxation?
- What are the steps involved in converting S corp to LLC?
- How to change to S corp from LLC?
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