If you own an S corporation, you may be wondering if you can convert it to a limited liability company (LLC). The answer is yes, you can convert an S corp to an LLC. However, there are several factors to consider before doing this, such as the differences between the two types of business entities and the taxes associated with them.
The Difference Between an S Corporation and an LLC
An S corporation is a type of business structure that provides limited liability protection to its owners. This means that if the company is sued or racks up large debts, the owners’ personal assets cannot be used to pay for them. An LLC, on the other hand, also provides its owners with limited liability protection, as well as the ability to pass profits and losses through to the owners’ individual tax returns.
The Tax Implications of Converting an S Corporation to an LLC
When you convert an S corporation to an LLC, you will no longer be taxed as an S corp. Instead, you will be taxed according to the tax structure of an LLC. Depending on the size of your S corp and the number of members in your LLC, this could mean a significant change in the amount of taxes you will owe. It is important to discuss this with a tax advisor before converting your S corp to an LLC.
Steps to Convert an S Corporation to an LLC
- When converting your S corporation to an LLC, the following steps should be taken:
- Hold a meeting of the shareholders to approve the conversion.
- Obtain an employer identification number (EIN) from the IRS.
- Amend the articles of incorporation to change the business entity type.
- File the appropriate paperwork with the state.
- Obtain a new certificate of organization.
- Notify creditors and other parties of the conversion.
- Update any agreements with vendors and other parties.
- Obtain a new business license.
Converting an S Corp to an LLC can be a beneficial and profitable move for many businesses. It offers the flexibility to operate as either a sole proprietorship, partnership, or corporation. Additionally, it allows for greater protection of personal assets and more efficient tax planning. Overall, converting an S Corp to an LLC can provide a number of advantages that can help business owners maximize their profits and protect their personal assets.
In this video, you get answers to these questions:
- What Is an S Corp?
- What Is an LLC?
- How can you convert an S Corp to an LLC?
- What Are the Advantages and Disadvantages of Converting from an S Corp to an LLC?
- Why Would You Want to Convert from an S Corp to an LLC?
- How Much Does it Cost to Convert an S Corp to an LLC?
- Is There a Best Time to Convert an S Corp to an LLC?
- Are There Tax Consequences of Converting a S Corp to an LLC?
- Can an S Corp with Multiple Owners or Shareholders Be Converted to an LLC?
- What Happens to the Existing S Corp Agreements and Contracts After the Conversion to an LLC?
- How Does the Management Structure of an S Corp Differ from an LLC?
- What Is the Timeline for Converting from an S Corp to an LLC?
- What Is the Impact of the Conversion on the Company’s Legal Status and Operations?
- Are There Any Legal or Regulatory Requirements to Be Met During the Conversion Process from an S Corp to an LLC?
Can you convert an S Corp to an LLC? What are the pros and cons? You will get the answer to those questions and more in this video today. Now let’s play out the scenario. When would you want to convert an S Corp to an LLC? Perhaps you are bringing on some other owners, and S Corps have certain restrictions on ownership. So, these new owners entering the S corporation would disqualify the corporation from being taxed as an S corp, which means it is taxed as a C corp, and that results in double taxation or a higher tax bill.
So that is one example where you may not want to keep an S Corp anymore; you want to roll it into an LLC. There might be other examples as well. There are a lot of benefits to an LLC that you don’t have in an S corp. So if you are wondering, by the way, about how to convert from an LLC to an S corp, I have a whole video on that. The link is in the description below. But today, we are talking about converting from an S corporation to an LLC. So if you want an LLC but you already have an S Corp, what are your options? What are the problems you might encounter? What is the process of converting an S corporation to an LLC? That is what we are talking about today.
I am Aaron Hall. I am an attorney for business owners and entrepreneurial companies. I help business owners avoid legal problems, and one part of doing that is creating these educational public videos. This isn’t a replacement for an attorney. I encourage you to work with a local business attorney who can assist you in your business.
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All right, so here we are today. Can you convert an S corp to an LLC? Yes and no. Here is what I mean. It is possible to have a whole business that is currently an S corp in an LLC, but there isn’t a process to actually just converting it.
What you have to do is form an LLC, merge the S corp into the LLC, or sell the S corp shares to the LLC. And then, if you have done a merger, that S Corp disappears. Generally speaking, the merger is the preferred option, so that is the way that you can generally do that, and we will talk more about that in the video here, but let’s cover some basics.
What Is an S Corp?
An S corp is a corporation filed in your state, which then elects with the IRS to be taxed under Subchapter S. So it is a corporation that is filed in your state, but then you file a form, and it is free with the IRS to be taxed under Subchapter S of the Internal Revenue Code. We call this an S corp, but technically speaking; it is a corporation that has elected to have a particular tax status with the IRS. So that is what an S corp is, or an S corporation.
What Is an LLC?
An LLC is a limited liability company registered in your state with your Secretary of State or whichever branch of government handles the registration of business entities. Here in Minnesota, it is handled by the Secretary of State. Other states have different departments that handle that.
Once you register an LLC with the state, you need to decide how it is going to be taxed. And if you don’t do anything, there are some defaults. So if you are a single-owner LLC, the default is you will be taxed as a sole proprietor. If you are a multiple-owner LLC, the default for your tax is as a partnership, and that is with the IRS.
But you might say, I don’t want to be taxed as a sole proprietor or as a partnership. Can I be taxed as a C corporation or an S corporation? You certainly can. Assuming you qualify, you just file a tax selection form, which your CPA can help you do. There is no cost to it. Many people can just do it on their own.
How can you convert an S Corp to an LLC?
The standard process is to create an LLC and then file articles of merger, which essentially merge the LLC and S corporation together. The same branch of government that you filed the LLC with is who you are going to file the merger documents with, and when you merge two companies, you need to decide which one is swallowing the other. In other words, which one is terminating and which one is engulfing the other or surviving? And so, in this case, once you have started the LLC and you would file the paperwork for the merger, you would designate that the LLC is going to swallow essentially the S corp. The LLC is going to be the surviving entity, and then that LLC should elect how it is going to be taxed with the IRS. That is the standard way that you convert an S Corp to an LLC.
There is one other option. And I don’t often use this, but it is available in a toolkit for business attorneys. An S corporation can continue to exist. You start an LLC, and then the shares of the S corporation are sold to the LLC for a dollar or maybe even just transferred. That way, for example, the LLC now owns the shares in the S corp. Then, you may have the S corp sell the assets of the S corp to the LLC. So, for example, let’s say the S corp owns customer lists, contracts, office furniture, computer equipment, whatever it is. The escort may sell those assets to the LLC. You don’t have to do that. You could keep it running within the escort, but usually, there is a reason you want to have an LLC. So you are selling those assets up to the LLC.
You might ask, what if we don’t transfer the shares of the S corp to the LLC and we just do a straight sale of assets from the S corp to the LLC? You certainly can do that as well. That is another option that is within the toolkit of options for attorneys.
What Are the Advantages and Disadvantages of Converting from an S Corp to an LLC?
Well, there are some benefits to an S corp and there are benefits to an LLC, and so sometimes what happens is you have figured out that you have an S Corp, but you want the advantages of an LLC. I am not going to go into a lot of what those are right here. I have got some other videos on that. The links in the description below. But once you figure out which entity taxation you want, you might say, all right, I have got an S corp, and I want to move over to an LLC. And so, the reason you would be doing this is to take advantage of the benefits of an LLC. The reason you might not is that LLC has certain drawbacks or consequences. There is time and money involved in doing this sort of transaction; you are going to have to pay an attorney, for example.
How Much Does It Cost to Convert an S Corp to an LLC?
In my experience, it is about $1,500 here in 2023.
Is There a Best Time to Convert an S Corp to an LLC?
Generally, no. You can do it any time of year. The consideration here is that if you are doing it mid-year, now, you are going to have to do tax returns for the original entity, the S corp, and the new LLC. And so, often, business owners will time this on December 31st or January 1st just to avoid having to do separate tax returns and figure out how everything should be calculated mid-year.
Are There Tax Consequences of Converting a S Corp to an LLC?
Yes, there are. Although they are both pass-through entities, which means the IRS ignores them for tax purposes. An S corp has certain tax benefits that an LLC does not have. For example, in an S corp, the business owners may be able to reduce payroll tax or self-employment tax, whereas, in an LLC, they don’t have that feature or ability under the current IRS code. So if you convert from an S corp to an LLC, you would then be losing any tax benefits that are available only in an S corp and not in an LLC. I have another video on that if you want to check that out. The link is in the description below, and it relates to figuring out whether an LLC or S corp is better for you.
Can an S Corp with Multiple Owners or Shareholders Be Converted to an LLC?
The answer is, quite simply, yes. Now you do that, certain shareholder agreements may become lost in the S corporation that dies or is terminated, and you will need a new ownership agreement called an operating agreement in the LLC. A shareholder agreement in an S corp and an operating agreement in an LLC have the same purpose. It is an agreement of the owners regarding voting, control of the company, how decisions are made, how profits are distributed, all of those sorts of issues related to the rights of the owners and the responsibilities of the owners.
What Happens to the Existing S Corp Agreements and Contracts After the Conversion to an LLC?
So let’s play this out. Imagine you have converted your S Corp to an LLC. What do we need to worry about as it relates to contracts? Well, every contract of the S corp will essentially die or be breached unless it is assigned over to the LLC. So, for example, let’s say you have a big customer in the S corp, and you want to have that contract with your big customer moved over to the LLC; you will need to assign that contract to the LLC. That might require the customer’s consent. To figure out whether assignment of a contract requires consent of the party in the contract, you need to look at the contract language. If the contract language is silent, then you go to default assignment laws in your state. States have different rules about this. From my experience, the general rule is if a commercial contract does not say it cannot be assigned, then it can’t be assigned. But again, their issue varies from state to state.
So what do you need to do if you have contracts in an S corp and you are converting that entity to an LLC? You need to make sure all those contracts are assigned over, or new contracts, replace the old ones that are then signed by the LLC and whoever the parties were in the old contract.
How Does the Management Structure of an S Corp Differ from an LLC?
In an S corp, you generally have shareholders at the highest level, and then corporate board of directors at the next level, and then officers who might also be shareholders or directors, and then the employees who report to the officers. That is a fairly standard approach in an S corporation, and that is prescribed by the corporation laws in each state.
Contrast that with an LLC. An LLC is designed to be highly flexible. So, for example, there may be no board of directors. In an LLC context, that is called Board of Governors, but there may be no board. In an LLC, you may not have regular shareholder meetings. It might be that you are operating kind of as a partnership where either owner can bind the LLC in a contract or can make other big decisions for the LLC. So there’s a high amount of flexibility in an LLC and the degree to which the LLC is flexible, and the rules that are in place are all covered in the operating agreement.
By the way, if there is no operating agreement, you look to the default rules in the LLC statute in your state. So, how does the management structure of an S corp differ from an LLC? S Corp is strict, it is regulated by corporate law and LLC is highly flexible and in general, the LLC owners can set up their own structure that is not bound to a statute imposed traditional corporate structure.
What Is the Timeline for Converting from an S Corp to an LLC?
You know, if you work with an attorney who is used to doing this, it can happen in one day. It really just takes putting together the legal documents, filing with the state, and you are done. No need to drag this out. Now if you have to renegotiate contracts with vendors, contractors, customers, etc., then that might take a little more time. But, usually, that is fairly quick when customers, vendors, or contractors realize it is essentially the same entity, or I should say it is the same people, it is the same business just moving to a new entity.
What Is the Impact of the Conversion on the Company’s Legal Status and Operations?
Well, when you move to a new entity, as a general rule, the old liabilities of the old entity may be lost or terminated. However, and this is a big however, there is the fraudulent conveyance act. Basically, the idea is you can’t just get out of a contract by terminating an entity and moving everything over to the new entity. If you convey assets from an old entity to a new entity for the purpose of avoiding liabilities to creditors, then the fraudulent conveyance act kicks in, and the creditors can go after you.
Let me say that in more simple terms. If you want to avoid paying your debts in the old entity, so you start a new entity, and now you say to the old, creditors who you owed money to, “Haha. Too bad. I have a new entity, and that old entity has nothing.” State law generally kicks in and says, “No, you can’t do that. It is against public policy. We want creditors, banks, lenders to be able to rely on the contracts that they have.” So if you are going to move all the assets of the old company to a new company, then the creditors are going to be able to go after that new company under the Fraudulent Conveyance Act. States have different statutes on this, so it is very important if you are dealing with that issue to work with an attorney who is familiar with fraudulent conveyance.
Are There Any Legal or Regulatory Requirements to Be Met During the Conversion Process from an S Corp to an LLC?
Yes. When you set up that LLC, you are starting a new entity. You need a new tax I.D., which is an EIN, also known as Employer Identification Number. You need to register in your state if that is required by your state to establish that you are doing business there. You will be paying taxes there under the new entity. So just like when you start a new business, you need to do various filings with the federal and state government. You will need to do that when converting an S Corporation to an LLC.
So as you can see, there are a lot of pitfalls here when trying to convert an S corp to an LLC. It is not something I would recommend doing without an attorney. I believe the money is well spent working with an attorney to do this and even figuring out whether it makes sense for you. Because, in general, companies that exist over time become more profitable, and I often see them converting from an LLC to an S corp, not the other way around.
So, in other words, converting from an S corp to an LLC like we talked about today. That is fairly uncommon, and usually, it is not something that business owners are contemplating unless it is absolutely required. For example, they are bringing on a non-resident alien as an investor. Those sorts of investors cannot qualify as owners of an S Corp. So you have to move over and have it be owned as an LLC. That is one example.
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