Limited liability companies (LLCs) and S corporations (S corps) are both popular types of business entities that offer liability protection and tax benefits. However, depending on your business needs and goals, you may find that converting your LLC to an S corp is a more suitable option. In this article, we’ll discuss the pros and cons of converting an LLC to an S corp to help you make an informed decision.
First, let’s briefly review what LLCs and S corps are:
LLC: A limited liability company is a type of business structure that combines the liability protection of a corporation with the simplicity and flexibility of a partnership. LLC owners are called members and enjoy limited liability, meaning their personal assets are generally protected from business debts and lawsuits.
S corp: An S corporation is a special type of corporation that has elected to be taxed as a pass-through entity, meaning the company itself does not pay income tax. Instead, the company’s income, losses, deductions, and credits are passed through to the shareholders, who report them on their individual tax returns. S corps are subject to strict eligibility criteria, such as having no more than 100 shareholders and only one class of stock.
Now, let’s explore the pros and cons of converting an LLC to an S corp:
Pros:
- Tax savings: One of the biggest advantages of an S corp is the potential for tax savings. S corps do not pay federal income tax, so all income and losses are passed through to shareholders, who report them on their personal tax returns. This means that S corp owners can potentially save on self-employment tax, which is a tax that LLC owners have to pay on their entire net income.
- Employee benefits: S corps can offer their owners and employees tax-free benefits, such as health insurance, retirement plans, and other fringe benefits. These benefits can be deducted as business expenses, reducing the company’s taxable income.
- Credibility: Converting to an S corp can increase your business’s credibility in the eyes of investors and lenders. S corps have a more formal structure than LLCs and are subject to stricter compliance requirements, which can signal to potential investors and lenders that your business is more established and reliable.
Cons:
- Increased paperwork and compliance: S corps are subject to more strict compliance requirements than LLCs. This includes holding annual shareholder meetings, keeping minutes of those meetings, and following specific bylaws. Failing to meet these requirements can put the company’s S corp status at risk.
- Limited ownership and stock structure: S corps are limited to 100 shareholders and can only issue one class of stock. This can be a disadvantage if you plan to raise capital or bring on investors, as it can limit your options for issuing stock or taking on new shareholders.
- More difficult to dissolve: S corps are more difficult to dissolve than LLCs. Dissolving an S corp requires the consent of all shareholders, which can be a lengthy and complicated process.
In conclusion, converting an LLC to an S corp can offer significant tax savings and other benefits, but it also comes with increased compliance requirements and limited ownership options. It is important to weigh the pros and cons carefully and consult with a tax or legal professional before making a decision.
Video Transcript
In this video, you get answers to these questions:
- What Is an LLC?
- What Is an S Corp?
- Who Might Want to Convert an LLC to an S Corp?
- What Are the Advantages of Converting from an LLC to an S Corp?
- What Are the Disadvantages of Converting from an LLC to an S Corp?
- What Are the Steps of Converting an LLC to an S Corp?
- Is There a Best Time to Convert an LLC to an S Corp?
- Are There Tax Benefits to Converting an LLC to an S Corp?
- Are There Tax Consequences of Converting an LLC to an S Corp?
- Are There Any Tax Implications for the Owners of the LLC During the Conversion Process?
- Can an LLC with Multiple Owners Be Converted to an S Corporation?
- What Happens to the Existing LLC Agreements and Contracts After the Conversion to an S Corporation?
- How Does the Management Structure of an LLC Differ from an S Corporation?
- Can an LLC Have Foreign Owners?
- Can an LLC Taxed as an S Corp Have Foreign Owners?
- Are There Any Restrictions on the Ownership of an LLC?
- What Is the Timeline for Converting from an LLC to an S Corporation?
- What Is the Impact of the Conversion on the Company’s Legal Status and Operations?
- Are There Any Legal and Regulatory Requirements to Be Met During the Conversion Process from an LLC to an S Corporation?
Can you convert an LLC to an S corp? If so, what are the pros and cons? That is the question I am answering today. Now, you may have heard of the benefits of an S corp, and I have some other videos on that. If you are interested in those, you can check out the link in the description. But if you are thinking about having your LLC take advantage of the benefits of an S corp, you are probably wondering, how do I do that? Do I have to start a brand new S corp, or is there a way to convert my LLC to an S corp? That is what we are talking about today. Now to cover that, I will cover the difference between an LLC and an S corp. We will talk about some of the advantages and disadvantages at a high level, and then we’ll talk about actually converting an LLC to an S corp and some other options that are available and then what is the process for doing that.
I am Aaron Hall. I am an attorney for business owners and entrepreneurial companies. My goal with these educational videos is to help you spot issues to discuss with your attorney, your CPA, or accountant. This isn’t a replacement for having an attorney, so you can try to do this stuff yourself, but I do want to empower you with education so that you know the kinds of questions to ask and you can avoid common problems and legal pitfalls. You can also avoid expenses associated with legal mistakes. If you are a business owner and you haven’t yet received my free cheat sheet, Seven Common Legal Mistakes Made by New Businesses, you can download that right now while you are listening at aaronhall.com/free, and that is a series of educational videos that helps you avoid some of the most common mistakes that business owners make. There is no charge to the videos. There is no charge to the checklist. The goal of this video is to try to help you avoid some of these problems yourself. And if you find this is helpful, and you want more videos like this, just subscribe to this channel. Let’s get into it.
What Is an LLC? What Is an S Corp?
All right, so can you convert an LLC to an S corp? Yes, you can. What is an LLC? LLC stands for Limited Liability Company. It is a particular type of legal entity that you can register under a state statute. Contrast that with an S corp. You might be asking, what is an S Corp? An S corp is a corporation registered under a state corporate statute, and then you file an election with the IRS that says, I don’t want you to tax both the corporation and me. I want the corporation to become a pass-through entity ignored for tax purposes and just tax me as the business owner. So by electing to have your corporation taxed as an S Corp under subchapter S, you are avoiding double taxation at the corporate level and the shareholder level, and you are just having all the proceeds, all the profit flow through to you as a shareholder, and you get taxed once for income tax at the shareholder level. That is what an S corp is.
Who Might Want to Convert an LLC to an S Corp?
Well, quite simply, it would be any business owner who wants to take advantage of the tax benefits available to an S corp. This relates to payroll tax and self-employment tax, essentially saving 15% of the profit distributions each year after accounting for wages paid out to the owner for work being provided by the owner. All right, so let’s get into that a little deeper.
What Are the Advantages of Converting from an LLC to an S Corp?
Imagine you are an LLC owner, and you are generating $100,000 of profit each year. So, for example, you might have a $300,000 income, $200,000 in expenses. And so, at the end of the day, you have $1000 in profit. That is your take-home pay. In an LLC, you pay about 15% self-employment tax. Now, that is not income tax. That is a whole separate category. You will have to pay that too, but you will pay 15% self-employment tax on a hundred thousand dollars. That is $15,000 per year in self-employment tax.
But with an S corp, there is a tax savings. Let’s say, for example, that you could hire somebody to do your job for $60,000 a year. Well, that means you in an S corp can pay yourself $60,000 in wages. That $60,000 is subject to the 15% tax. But the remaining $40,000, which isn’t going for wages, that is just a profit distribution to you. That $40,000 is free of the self-employment tax or payroll tax; whether you call it self-employment tax or payroll tax, it doesn’t matter. It is about 15%. After you have paid yourself for wages in an S corporation, the additional proceeds you get, called profit distributions, are free of the 15% payroll tax. So think about that. If you had $40,000 in profit distributions times 15%, that is $6,000 per year that you are saving. That is not a deduction or an exemption. That is $6,000 back in your pocket as a business owner by being taxed as an S corporation instead of an LLC.
Now, every scenario is different. It might be more or less than $6,000. I had a multi-owner business, and each owner was able to save $11,000 a year in payroll tax or self-employment tax by changing from an LLC to an S corp. So think about that. If there are two owners, that s $22,000 more per year in their pocket. Every single year, that is a lot of money. That illustrates the advantages of being taxed as an S Corp instead of an LLC.
Now, if you don’t have significant profits, an LLC may not be beneficial, and again, in the description below, you can click on a link. I have another video on figuring out LLC versus S corp. The focus of this video today is, can you convert from an LLC to an S corp, and what are the pros & cons? All right.
What Are the Disadvantages of Converting from an LLC to an S Corp?
Well, if you are taxed as an S corp, you have to report to the IRS every quarter, and you have to pay taxes, estimated taxes every quarter. Now, if you already have employees and you are paying payroll, you are already doing that. So that is not a significant downside or disadvantage, but that is probably the largest disadvantage of being taxed as an S corp. There are a couple of other unique situations, which we will talk about a little bit later.
By the way, if you are in an LLC, and you are having to pay that 15% self-employment tax at the end of the year, it means you are having to set aside money for that throughout the year. It might be said that having to pay S-Corp taxes quarterly is a benefit or an advantage rather than a disadvantage because you make sure you come up with that money on a quarterly basis and you are not having to worry about coming up with all the money for the IRS at the end of the year like you would in an LLC.
What Are the Steps of Converting an LLC to an S Corp?
You have two options. Option number one is the easiest and cheapest. An LLC can elect to be taxed as an S corp simply by filing a form with the IRS, and you can do it yourself; you can have your CPA do it. The CPAs might do it for free if they are already doing other work for you or may charge less than a hundred dollars on average. So think about that. That is a very quick and easy thing to do.
The more complicated and expensive way is to convert your LLC to an S corp. And you must do that by starting an S corp and then filing papers to merge the LLC with the S corp, where the S corp swallows and envelops the LLC. Essentially in that merger, the S corp is the surviving entity, and the LLC is swallowed and no longer exists. That is another way to do it. If you do it that way, you only will have an S corp. You will no longer have an LLC.
So to summarize, there are two ways to convert an LLC to an S corp. One is just to have your LLC taxed as an S corp, and you do that by filing a form with the IRS. The second way, which is more expensive and time-consuming is creating a corporation. You then file merger documents with the state to have the LLC and the S corp merge, and the S Corp takes over. And then, of course, you need to file with the IRS to have that corporation taxed as an S corp.
Is There a Best Time to Convert an LLC to an S Corp?
Yes, there is. Essentially, it is either in the very first days of setting up an LLC, or the IRS says you can do it by March 15th or the first 75 days of a calendar year in which it is to apply. So if it is October and you want to be taxed as an S corp, you can file the paperwork, but it doesn’t take effect until the next calendar year. But if it is January or February and you file paperwork to be taxed as an S corp, it will take effect in that calendar year starting on January 1st.
Are There Tax Benefits to Converting an LLC to an S Corp?
Quite simply, yes. In many cases, if you are a small LLC, typically, rule of thumb is if you are earning less than $50,000 a year in profits, it may not be worth being taxed as an S corp. But if you are earning more than $50,000 a year in profits, again, that is just a rule of thumb. It is probably going to save you money on self-employment tax or payroll tax. The specific circumstances will vary. It is important to speak with a tax professional to figure out whether an S Corp would save you money. I recommend a CPA. Or a business attorney licensed in your state. Honestly, I would probably start with the CPAs. CPAs live and breathe numbers, and they are outstanding at these sorts of issues. Any sort of CPA that deals with small business.
Are There Tax Consequences of Converting an LLC to an S Corp?
The main downside is that you will have to file quarterly tax returns and make payments based on those returns to the government. That is the most significant downside, but often that is offset by the significant tax benefits of having your LLC taxed as an S corp.
Are There Any Tax Implications for the Owners of the LLC During the Conversion Process?
The short answer is no. Aside from the long-term tax impact, there’s no short-term impact. In other words, during the process, you don’t have to worry about anything extra. And I do recommend that you work with a CPA or perhaps a business attorney in doing this process.
What Happens to the Existing LLC Agreements and Contracts After the Conversion to an S Corporation?
Well, it depends on how you did the conversion. If your LLC elects to be taxed as an S corporation, then the LLC operating agreement remains in effect. But if your LLC was merged with an S corporation, then the shareholder agreement in that new S corporation is what will prevail and guide the governance and the rights of the business and the business owners.
How Does the Management Structure of an LLC Differ from an S Corporation?
If you are a single-owner LLC, it is not going to change at all if you become a single-owner S corporation; no difference whatsoever. But if you have multiple owners, there may be differences in how voting is done and how control is established.
If you have multiple owners in your business, I would highly recommend you work with a business attorney. That attorney might even represent the business. But explain to the business owners what’s changing, if anything, when converting from an LLC to an S corporation. There might be a lot of things.
Can an LLC Have Foreign Owners?
Well, resident aliens may own an LLC and an S corp. A nonresident alien may not be a shareholder in an S corporation, but a non-resident alien may own an LLC. So if you are a resident alien, no problem. You can own either. If you are a nonresident alien, that is where you are going to have trouble owning an S corporation. There are some other ownership restrictions on S corporations related to trusts and rare circumstances that I won’t get into here, so that is where you are going to need to work with a business attorney in your state.
Can an LLC Taxed as an S Corp Have Foreign Owners?
So, I will tell you this, though, if you are wanting to elect to be taxed as an S corporation, the owners of your LLC need to qualify as though they were owners of an S corporation. In other words, if the IRS has certain requirements for S corporations and you don’t meet them in your LLC, then your LLC does not qualify to be taxed as an S corporation.
Are There Any Restrictions on the Ownership of an LLC?
Are there any restrictions on the ownership of an LLC? Ownership of LLC is broadly permitted. In other words, an LLC can be owned by a corporation that is not in the United States. There might be multiple owners. In other words, an LLC is broadly permitted as an entity without the narrow restrictions that apply to an S corporation.
What Is the Timeline for Converting from an LLC to an S Corporation?
In order for it to have effect in a calendar year, you need to file the paperwork with the IRS within the first 75 days. That means by March 15th.
What Is the Impact of the Conversion on the Company’s Legal Status and Operations?
All right, so let’s say you have an LLC, and it converts to be taxed as an S corp. If you are a single-owner LLC, no difference. If you are a multiple-owner LLC, so like you have two or three owners, and now you are being taxed as an S corp, you will want to work with a business attorney to find out how in your situation, your rights may have changed or may need to be changed under the LLC operating agreement.
If you have an S corporation, you are going to be governed under the corporate law in your state as it relates to the rights of shareholders and voting and all the other issues covered by the corporate statutes. So if you convert from an LLC to an S corp by having a merger of two entities and the S corp takes over the LLC and is a surviving entity, you are going to be governed under the corporate statute.
Are There Any Legal and Regulatory Requirements to Be Met During the Conversion Process from an LLC to an S Corporation?
Yes. You typically need to at least file paperwork with the federal and state taxing authorities to notify them of the change.
Now, you may not have to do that immediately. For example, you might file the notice with the IRS to elect to be taxed as an S corp, but you may be able to wait sometime in your state and do that notice to the state at the next tax reporting date. So to answer that question more specifically, it will depend on your state, and you should work with a CPA who works with small businesses in order to figure out what do you need to report to your state when you convert from being taxed as an LLC, to being taxed as an S corp.
Conclusion
All right. We covered a lot here. This is all part of a series of videos I am providing to the public for free to help you as a business owner avoid legal problems for your company. Why? Because legal problems are stressful and frustrating. They are distracting. They prevent you from doing what you love, which is being an entrepreneur, solving a problem in the world, and making a difference in people’s lives.
With legal problems, you end up getting distracted with all the issues and expenses of attorneys and all the stress that goes along with legal problems. So if you haven’t yet downloaded the Seven Common Legal Mistakes Made by New Businesses, it is a PDF. Go get that at aaronhall.com/free, and you will also get, as a bonus, a series of videos that are only available to people who subscribe.
Again, it is free, but these videos will help explain from an educational standpoint how you can avoid these seven issues, and I am not selling these seven videos; it is entirely for free, and you can use this to educate yourself on how to speak with a business attorney in your state about how to avoid these problems. Why? Because I want your company to excel, and I want you to be free from the distraction and the stress associated with legal trouble.
If you have questions about today, feel free to put them in the comments section I use those comments to provide ideas for future videos, and sometimes I even can provide quick answers to them.