Can an S Corp Be Converted to an LLC?

By David Carnes

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.

State Law

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.

Procedures

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.

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Tax Consequences

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.

Alternatives

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.

Advantages

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.

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How to Transition an LLC to a Corporation

References

Related articles

How to Close an S Corp With the IRS

An election with the IRS to have your corporation taxed as an S corporation can provide tax advantages over a C corporation. A corporation must meet certain IRS eligibility rules to elect to be treated as an S-corp. An S-corp is taxed as a disregarded entity and does not pay entity-level taxes. If the corporation ceases to meet the eligibility rules or decides to end its status as an S-corp, it may file to revoke the S election and continue as a C-corp. Dissolution under state law will also end a corporation’s sub-chapter S status once a final tax return is filed.

How to Merge an LLC Into an S-Corporation

Merging an LLC into an S-Corporation means that the two companies become one company -- the S-Corporation. In other words, the LLC ceases to exist as a result of the merger. Merging two business entities is complex and should not be undertaken without a thorough tax analysis regarding the effect of the merger on the company owners and the merging companies. An attorney’s services may also be required to prepare a plan and a merger agreement between the companies, as well as file the necessary documents with the state to effectuate the merger.

S Corporation Passive Income Restrictions

An S corporation is a corporation consisting of 100 or fewer shareholders that has a special tax designation granted by the IRS. While this designation offers the shareholders certain tax benefits, it requires the company to adhere to several restrictions and conditions. One of these restrictions involves how much passive income the business earns. It is important for an S corporation to closely monitor how much passive income it earns to ensure that it avoids any IRS penalties or tax repercussions.

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