S corporations and limited liability companies, or LLCs, both enjoy limited liability. Neither of these entities are taxed at the federal level, except that S corporations are taxed on some forms of passive income. LLCs offer the advantages of simplified operations, reduced corporate formalities and flexible taxation options. Most states have a simple procedure for converting an S corporation to an LLC.
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The procedure for turning an S corporation into a limited liability company varies from state to state. In many states, a simple form must be filed with the state secretary of state. In others, an LLC must be formed and the S corporation must be merged into it, a transaction that can be quite complex.
The S corporation should pass a shareholder's resolution authorizing the conversion. In most states, this resolution requires unanimous consent due to the potential tax consequences on shareholders. Once the resolution is passed and recorded, proceed with the conversion procedure authorized by your state -- either filing a Certificate on Conversion or its equivalent, or completing a merger. Finally, you will have to notify the IRS of the conversion.
Carefully analyze the tax consequences of the conversion before you carry it out. Regardless of whether you file a Certificate of Conversion or complete a merger, the IRS will treat the transaction as a liquidation of the S corporation. If the S corporation increased in value between the time of its formation and the time of its conversion to an LLC, a capital gain will be realized, and shareholders will have to pay capital gains tax on the amount of the gain.
If your state does not have simplified conversion procedures and you prefer to avoid the legal expenses of a merger, you may be able to liquidate the S corporation by transferring its assets to the shareholders, and then have the shareholders contribute these assets to the LLC.
Once the S corporation has been converted to an LLC, many of the corporate formalities that the S corporation was required to observe will be eliminated. An LLC does not have to maintain a board of directors or keep minutes, for example, and the company may be member-managed. An LLC may elect to be treated as an S corporation or a C corporation for tax purposes. If it makes no special election, the IRS will tax it as a partnership as long as it has more than one member. Unlike an S corporation, it will not become subject to double taxation on distributions if organizational changes, such as exceeding 100 members, render it ineligible to continue receiving S corporation tax treatment -- it may simply choose to be taxed as a partnership.