How to change an LLC to an S corp: Guide for business owners
When starting a business, choosing the right structure is critical to its success and growth. Many business owners choose an LLC for its flexibility, simplicity, and protection.
However, as the business grows, the initial structure may no longer be in the best interest of the business in terms of tax benefits and growth potential. In this case, there is an opportunity to change LLC to an S corp.
The purpose of this guide is to provide business owners with a comprehensive understanding of the benefits of converting an LLC to an S corporation and the step-by-step process to make this transition a smooth one.
Comparing LLCs and S corps
While LLCs and S corps share the benefit of pass-through taxation, there are significant differences between the two, particularly in ownership structure, tax implications, and operational flexibility.
| Feature | Limited Liability Company | S corporation |
|---|---|---|
| Ownership and shareholders | - No limits on the number or type of members. - May include individuals, corporations, other LLCs, and foreign entities. |
- Limited to 100 shareholders, who must be US citizens or resident aliens. - Cannot have corporations, partnerships, or non-resident alien shareholders. |
| Management and operations | - Operational flexibility with the option to be member-managed or manager-managed. - Not required to follow corporate formalities, such as holding annual meetings or keeping minutes. |
- Must follow stricter operational guidelines, including adopting bylaws, issuing stock, and holding regular meetings. - Requires detailed record keeping. |
| Tax implications | - Members pay self-employment taxes on all profits. | - Shareholders are taxed on salary only; additional profits are distributed as dividends not subject to self-employment tax. |
| Raising capital | - Can sell membership interests, but the process is often complex and less attractive to investors. | - Easier to raise capital by issuing stock, which is a more familiar and sometimes more desirable investment structure for investors. |
The choice between an LLC and an S corp involves considering factors such as the size of the business, its income level, and long-term goals.
While LLCs offer simplicity and flexibility that appeal to many business owners, S corps can offer tax advantages and a structure that may be more attractive to certain investors.
Business owners are encouraged to consult with a tax advisor to determine the best structure for their specific needs.
Advantages of converting from LLC to S corp
Converting an LLC to an S corp can offer several advantages, especially for businesses looking to optimize their tax strategy and prepare for growth, while managing the tax preparation cost for small business. Here are some of the most important benefits:
-
Self-employment tax savings. One of the most compelling reasons for an LLC to elect S corp status is the potential for tax savings. In an S corp, only wages paid to employee-shareholders are subject to employment taxes.
Profits distributed as dividends are taxed at the shareholder's income tax rate without being subject to self-employment taxes, which can result in significant savings. - Attract investors. S corps can issue stock, which may be more attractive to potential investors than the membership interests offered by LLCs. This can make it easier for companies to raise capital.
- Credibility and prestige. The formal structure of an S corp, including a board of directors and officers, can lend credibility and prestige to a business. This can be beneficial when dealing with customers, suppliers, and financial institutions.
- Estate planning and stock transfer. S corps allows for the transfer of stock, which can be beneficial for estate planning purposes. Shareholders can easily transfer their shares to heirs or sell them without significantly disrupting the business.
Remember that an LLC is a type of business structure, while an S corporation is a tax classification. You are converting your LLC, which is currently taxed as a partnership, to S corporation tax status.
Also read. Tax classification for LLC
IRS eligibility requirements for S corps
To qualify for S corp status, a corporation must meet specific eligibility criteria set by the IRS. These criteria are in place to ensure that only particular business types can take advantage of the S corp tax framework. The primary eligibility requirements include:
- Domestic corporation. The corporation must be a domestic corporation, which means it is organized under the laws of the United States, a state, or a territory.
- Eligible shareholders. S corps cannot have more than 100 shareholders. Shareholders must be individuals and certain trusts and estates. Partnerships, corporations, and nonresident alien shareholders are not permitted.
- One class of stock. S corps may have only one class of stock, although differences in voting rights among shares are permitted. This requirement ensures that all shareholders are treated equally concerning their economic rights to the corporation's profits and assets.
- Tax year. Generally, an S corporation must use the calendar year as its tax year unless it can establish a business purpose for a different tax year.
- Eligible entity. The entity seeking S corp status must be an eligible entity, which includes a domestic business corporation. LLCs may elect to be treated as corporations and then elect S corp status.
- Timely election. The business must file Form 2553, "Election by a Small Business Corporation," with the IRS. This form must be filed by March 15 of the current tax year for the election to be effective for that year, or at any time during the prior tax year.
Meeting these requirements is the first step in converting an LLC to an S corporation.
How to convert an LLC to an S corp?
Converting an LLC to an S corp involves several critical steps. This guide outlines the process to ensure a smooth transition and compliance with both federal and state regulations.
Step 1: Verify eligibility
Before beginning the conversion process, it's important to ensure that your LLC meets the IRS requirements for S corp status.
Carefully review the criteria, including the number and type of shareholders, the single class of stock requirement, and the domestic corporation provision.
If your LLC does not meet these requirements, you must address these issues before proceeding.
Step 2: File IRS Form 2553
Once you've confirmed your eligibility, the next step is to file Form 2553, "Election by a Small Business Corporation," with the IRS. This form must be completed accurately and filed by the deadline (March 15 of the tax year for which the election is to be effective, or any time during the preceding tax year).
- Gather the necessary information. You'll need your LLC's EIN, the names and addresses of all shareholders, and their consent to the election.
- Choose a tax year. Decide on your S corporation's tax year, which in most cases will be the calendar year.
- Obtain shareholder consent. All shareholders must sign the form indicating their consent to the S corp election.
- File the form. Mail the completed Form 2553 to the IRS office for your state, which is listed in the form's instructions.
Step 4: Comply with ongoing S corp requirements
After converting to an S corporation, there are ongoing requirements you must meet to maintain your status and remain in compliance with IRS and state regulations.
- Adopt corporate formalities. Hold annual meetings of shareholders and directors, keep minutes of those meetings, and adopt bylaws if you haven't already done so.
- Pay shareholder salaries. Pay reasonable wages to shareholder-employees, withhold payroll taxes, and file required payroll tax returns.
- File an S corporation tax return. File Form 1120S, "US Income Tax Return for an S corporation," with the IRS annually, along with a Schedule K-1 for each shareholder, reporting their share of the corporation's income, deductions, and credits.
- State tax filings. Comply with any state tax filing requirements for S corps, which may include income tax returns, franchise tax returns, or other state-specific filings.
Also read. How to file taxes for LLC
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Register nowConverting your LLC to an S corp can provide significant tax benefits and growth opportunities. However, it's important to carefully follow each step, comply with all regulatory requirements, and consider consulting with a tax professional to effectively navigate the process.
Things to consider before making the switch
There are several important factors to consider before converting your LLC to an S corp. This decision should not be made lightly, as it can have long-term implications for your company's tax obligations, operational structure, and growth potential.
- While the potential for tax savings, particularly on self-employment taxes, is a significant benefit of S corp status, it's important to understand the full scope of tax obligations. These include the requirement to pay reasonable salaries to shareholder-employees, which must be justified by market standards and are subject to payroll taxes.
- Election of S corp status introduces new administrative responsibilities, including payroll processing, corporate formalities, and more complex tax filing requirements. Make sure your company is prepared to handle these additional responsibilities or can afford to hire professionals to handle them.
- The S corp designation comes with strict ownership limitations, including a cap of 100 shareholders and restrictions on who can be a shareholder. Consider whether these restrictions align with your company's growth strategy and potential need to raise capital.
- There may be costs associated with the conversion process, including state filing fees and increased expenses for tax preparation and legal advice. Weigh these costs against the potential tax savings and other benefits of S corp status.
- Consider your long-term business goals and how the S corp structure supports or hinders those goals. For some businesses, the benefits of S corp status are perfectly aligned with their growth strategy, while for others, the flexibility of an LLC may be more advantageous.
Conclusion
Converting an LLC to an S corp can offer significant benefits, including potential tax savings and enhanced credibility.
However, the decision to convert should be made after careful consideration of the impact on your company's tax obligations, administrative burdens, and long-term goals.
Once you've made the switch, maintaining your S corp status requires careful compliance with federal and state regulations.
By understanding the requirements and planning accordingly, you can maximize the benefits of S corp's status while positioning your business for continued growth and success.
FAQ
No, electing S corporation taxation does not require you to change the name of your business. The election is a change in tax classification that does not affect the legal name of your business. You can continue to operate under your existing LLC name without any changes.
Converting an LLC to a corporation and then electing S-corp status can have several tax implications. The most notable change is how the business is taxed.
As an S-corp, the business can avoid the double taxation of dividends that is common with traditional corporations (C-corps).
Instead, profits are passed through to the shareholders and taxed at their individual income tax rates.
It's important to note, however, that the IRS requires S-corps to pay reasonable compensation (wages) to shareholder-employees, who are subject to employment taxes.
Yes, you can convert your LLC to an S corporation by filing Form 2553, "Election by a Small Business corporation," with the IRS.
This form must be filed within two months and 15 days after the beginning of the tax year in which the election is to be effective.
It's important to make sure your LLC meets all the requirements for S-corp status before filing.
The cost of converting an LLC to an S corporation can vary depending on several factors, including state filing fees and professional service fees.
The IRS does not charge a fee for filing Form 2553 for an S corp election. However, state filing fees for changing your business structure can range from $50 to several hundred dollars.
In addition, if you hire an attorney or accountant to assist with the conversion, their fees will add to the total cost. It's a good idea to budget for these expenses when planning your conversion.
Generally, if your LLC already has an Employer Identification Number (EIN), you will not need to get a new EIN when you convert to an S corp.
The same EIN can be used for your business as an S corp. However, if there are changes in the ownership structure, or if you are directed by the IRS to obtain a new EIN for specific reasons related to the conversion, you may need to apply for a new EIN.
It's always best to consult with a tax professional or the IRS directly to confirm whether your specific situation requires a new EIN.
Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.
Susan Turcotte, a seasoned CPA with over 45 years of accounting experience, holds a Bachelor's in Accounting and a Master's in Taxation from Bryant College. See more
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