An LLC is a popular entity choice for new business owners. However, as your business grows and evolves there may come a time to reconsider your business structure and convert to an S corp.
An S corporation is a corporation structured to avoid double taxation (a common drawback of C corporations). An S corp enables profits, and certain losses, to pass through to the owner’s personal income without being subject to corporate tax rates.
An S corp can be a useful option for a business that would otherwise be structured as a C corporation – if it meets the criteria to file as an S corp.
This article discusses when it's a good idea to convert your LLC to an S corp, considerations to keep in mind, and tips for making the switch.
Why switch from an LLC to an S corp?
Making the move from an LLC to an S corp is a complex decision and depends on multiple business factors. Typical reasons for becoming an S corp include:
- Self-employment tax savings: A popular reason for becoming an S corp is the savings you can realize on self-employment tax. S corps pay the owner(s) a salary and only pay payroll taxes on that amount. Any other distributions aren’t typically subject to self-employment taxes. Owners of S corps can also receive tax-free dividends if certain criteria are met. If your business has significant earnings, you may save on taxes by becoming an S corp. However, check with your tax advisor to understand if you qualify to become an S corp. For more information, see LLC electing S corporation tax status.
- Growth and complexity: Another reason for converting your LLC to an S corp is if your business has grown into a more complex operation than when you started out. S corporations have similar management and ownership traits as a traditional C corporation. For example, an S corp has shareholders, directors, and officers. Shareholders own stock in the company, directors set corporate policy and oversee strategy, which officers take the lead on everyday operations. Moreover, unlike an LLC, once an S corp is formed its existence is perpetual. If a member or owner leaves an LLC, the entity may be dissolved.
- Investors favor corporations: Corporations are generally better for recapitalizing and reorganizing a company over time as it grows. As a result, investors and some banks prefer investing in corporations. Corporations are also subject to formalities, many of them mandated by state law, that allow investors to see how the company operates.
- Employee compensation: The shareholders of an S corp can be both owners and employees. This allows you to offer employees stock options – a useful way to attract talent.
Note: An LLC can only convert to an S corp after it has converted to a corporation or C corporation.
Considerations when choosing an S corp business structure
There are some very specific requirements for S corporations that don’t apply to LLCs or traditional corporations.
- An S corp can only have 100 shareholders, and ownership is restricted mostly to individuals, who must also be U.S. citizens or permanent residents, as well as certain domestic trusts and estates. As a result, other corporations and partnerships cannot own stock in a C corporation.
- S corps can only issue one class of stock. The disadvantage of this is that you may not be able to issue stock or take on new shareholders if you plan to raise capital or bring on investors. C corporations can issue more than a single class of stock.
- Several companies may not be eligible to become S corporations, including financial institutions, insurance companies, and domestic international sales companies.
- The compliance requirements for S corps are more stringent than those for LLCs. Annual shareholder meetings must be held, minutes must be kept, and bylaws must be followed. A company's S corp status can be jeopardized if it fails to meet these requirements.
- S corps may attract closer attention from the IRS. S corps must adhere to a reasonable salary for all shareholders. If they exceed what is deemed reasonable by the IRS, wages may be recharacterized as dividends, which can mean a smaller deduction for wages paid. The IRS closely monitors how profits are distributed to ensure adherence to such regulations.
It’s important to take these factors into account when deciding whether to convert your LLC to an S corp.
Steps to converting an LLC to an S corp
A statutory conversion is one of the most efficient ways to change entity types. To convert from one entity to another, a document must be filed with the state filing office. A new entity does not need to be formed.
Below are the basic steps for converting an LLC to an S corp through a statutory conversion. Keep in mind that an S corporation is a designation given by the IRS to corporations. To be taxed as an S corporation, you must convert your LLC into a traditional corporation (C corporation) with the state, and file IRS Form 2553 "Election as a Small Business Corporation" with the IRS.
- For your business to qualify as an S corporation, make sure it meets the IRS's specific guidelines.
- Be sure the governing state statutes permit conversions. The statutory conversion of a business entity is a recent innovation that is not authorized by every entity statute. (see more below)
- Develop a plan of conversion that outlines the terms and conditions of the transaction.
- Obtain the approval of the LLC members for your conversion plan.
- File articles of conversion aka a "certificate of conversion” with the Secretary of State or another filing office. You may also need to file articles of incorporation and other legal documents.
- Make sure the new corporation's directors and shareholders approve the election of S corporations. You can find the required procedure in your articles of incorporation or bylaws.
- You can file IRS Form 2553 once you have the appropriate approval.
Additionally, if the original LLC qualified to conduct business in any foreign state, it is important to update the official records with each state's filing office. Depending on the state, this can be accomplished by filing an amendment or change certificate, or by withdrawing the pre-conversion entity and qualifying the post-conversion entity.
As part of creating and maintaining a new corporation, you'll have to do all the usual tasks, including drafting and maintaining corporate bylaws, issuing stock certificates, and holding and documenting annual shareholder and director meetings. For more information, read What is an S corp?
Not all states allow statutory conversions
Each state has its own process for converting a business entity type.
States that do not permit statutory conversions may allow statutory mergers instead. As a result of a statutory merger, the old entity type is merged with the new and will cease to exist. The assets and liabilities of the previous entity will be vested in the new entity, and its owners will become the new entity's owners.
A new business entity can also be formed after dissolving the original business entity. Changing entity forms this way is the most difficult and expensive method.
When should you convert from an LLC to an S corp?
To qualify for S corporation status in your first year of business, you need to file Form 2553 within 75 days of the date of the state conversion. The election will not be in place until the following year if this is not completed within that time frame.
BizFilings can help
BizFilings conversions service can help you convert your LLC to an S corp. We determine the appropriate process for conversion in the state where you company was formed, obtain and prepare the right state forms, and submit them to the appropriate state agencies. We can also ensure ongoing compliance with state requirements for your new business structure.
