Your LLC has been established for a while, and things are going well. Your profits have increased steadily over the years, and so has your self-employment tax bill. It’s time to make a change, but you’re facing multiple options. Regarding potential business structures, should you convert LLC to S corp or C corp?
What is an S Corp?
An S corp is a business structure that is treated like an LLC except for taxation purposes. An LLC’s profits and losses pass straight through to the owners and are taxed as part of their income. In contrast, the profits you earn in an S corp are taxed separately. You can choose to become an employee of the S corp, be paid a reasonable salary, and incur payroll taxes on those wages.
How to Change LLC to S Corp
To begin the process of converting an LLC to an S corp, submit Form 2553 (Election by a Small Business Corporation) to the IRS. This form will ask for a detailed description of your business, including basic information such as address and EIN, the tax year that this change will apply to, details that confirm your company meets the requirements to become an S corp, and information about each of the individuals/groups who will hold shares in the newly formed Subchapter S corporation.
It is crucial to keep in mind the timeframe when submitting Form 2553. You can apply at any point in the current tax year to begin converting an LLC to an S corp for the following tax year. You can also apply to change LLC to S corp in the current tax year. The only caveat is that you must file within ten weeks and five days of the start of the current year.
One of the main criteria to convert LLC to S corp is to have at most 100 owners or members. A workaround that the IRS allows is to treat individual family members as one family ‘shareholder’. Under this workaround, you, your spouse, and your estates can also be treated as one shareholder in order to pass the eligibility test. Your company must be based in the US, and none of the shareholders can be considered a ‘nonresident alien’.
After the relevant forms have been submitted, the next step is to transfer the LLC’s assets to the newly formed S corp. After that, it is time to apply for the relevant state and local business permits. You will also have to update your LLC Operating Agreement (if there is one). Your LLC’s existing contracts with suppliers and customers must be amended. You will then file Form 8832 (Entity Classification Election), to inform the IRS that the conversion is complete.
Convert LLC to S Corp – Advantages
The difference in how the profits are taxed is the main advantage of converting an LLC to an S corp. If you receive $200,000 as an LLC member, the total amount is subject to self-employment tax. If you receive $200,000 as an S corp employee, you’ll only pay payroll taxes on what you decide is a reasonable salary, say $120,000. The remaining $80,000 will be subject to income tax but not Social Security.
As an employee of an S corp, you have more options when it comes to preparing for retirement. You’re also able to contribute more to those efforts. However, you must ensure you are not contributing more than the salary you receive from the S corp. You can contribute to both a 401K and Sep-IRA as an employee of an S corp. In contrast, you can only contribute to a Sep-IRA as an owner or member of an LLC.
As part of the process of converting LLC to S corp, all members of the LLC will be given shares in the new entity. Being able to issue shares makes it easier for members of the S corp to raise capital. It is also easier for individual shareholders to transfer their ownership stake to another party. Additionally, it can provide a higher level of credibility with potential investors, suppliers, and customers
Convert LLC to S Corp – Disadvantages
Complexity and Cost
Becoming an S corp is a complex process that is both time-consuming and potentially expensive. You may have to incur legal costs as you amend all the existing contracts associated with the LLC. You will have to make sure there are no ineligible institutions (for example, banks) in your membership. In LLCs with large memberships, converting an LLC to an S corp may have a high administration cost.
Differs by State
Subchapter S corporations are treated differently depending on the state. This can significantly impact the benefits of converting an LLC to an S corp. For instance, in states like Florida, you will not pay state income tax on profits earned through an S corp. However, if you attempt to change LLC to S corp in New York, you will discover that S and C corps are treated similarly. This dramatically reduces the tax benefit and the incentive to convert LLC to S corp.
Less Flexibility, More Formality
Being part of an S corp means you and your fellow shareholders will be subject to more duties and requirements. You will have to hold regular director and shareholder meetings and maintain corporate records.
There is also less flexibility regarding areas such as profit sharing. In an S corp, you must share profits and losses with shareholders in proportion to the amount of the company they own. This may not suit your individual circumstances.
Convert LLC to C Corp
A C corporation is the standard business structure for corporations. In a C corp, the business is separate from its shareholders. The C corporation is subject to double taxation — the company is taxed on its corporate profits and the company owners are taxed on any dividends they receive.
Converting from LLC to C corp is similar to converting an LLC to an S corp. For example, your LLC will have to inform the stakeholders, update contracts and transfer all of its assets to the new entity. However, unlike the process required to change LLC to S corp, it will also need to obtain a new EIN and file articles of incorporation with the state.
Converting LLC to C Corp – Advantages
Applying to an Accelerator
Accelerators or incubators that take equity often require their participants to incorporate as a C corp. That’s because it makes it easy for you to give others equity, which is how accelerators make their money. Also, successful incorporation shows accelerators that you have your business ducks in a row.
The C corp structure allows investors to create ‘preferred shares’ of stock. Becoming a C corp provides a consistent legal structure that makes it easy for investors to compare companies.
In a corporation, reserving shares that your company can later distribute to employees is easy. In an LLC, the partners own 100 percent of the company, and if you want to give equity to a non-partner employee, you must make that person a partner.
Separate Legal Existence
In contrast to LLCs, a C corp will continue existing regardless of how often the company changes hands. This could be due to the existing owners selling their shares or perhaps passing away. An LLC may not have specific provisions in its operating agreement for such an event or may not have an operating agreement at all. You may have to dissolve your LLC in order to resolve the legal consequences of losing a member.
Converting LLC to C Corp – Disadvantages
Unlike an LLC, a C corp has to pay taxes. When the company then distributes its income (to pay its founders and investors), each person will also have to pay income taxes on those funds. That can feel like a big shift if your company has been operating as an LLC.
Increased Complexity and Administration
The process for converting from LLC to C corp can be complicated. It all depends on the state in which you formed your LLC. Some states, such as California, allow for fast-track conversions that let you convert LLC to C corp in another state, such as Delaware. In other states, the process can be much more arduous.
Extra Tax Payments as Part of the Transfer
You may be able to simply convert all of your LLC’s assets and liabilities over to your new C corp, which is considered a tax-free contribution under IRS Code Section 351. If that’s the case, you won’t have to pay taxes.
But you will have to pay taxes if your LLC contributes more liabilities than assets to the new C corp. For example, say your LLC contributes $50,000 in assets (cash, inventory, accounts receivable) and $70,000 in liabilities (accrued expenses, debts). Your LLC partners will essentially have just unloaded $20,000 in debt onto the new C corp.
The IRS classifies that $20,000 as income, and the LLC partners will need to pay income taxes on it as soon as possible.
The IRS also expects a tax return from the now-dissolved LLC. The LLC partners have 3.5 months from the dissolution date to file what’s known as a short tax year return. Otherwise, the partners will be on the hook for a $195 penalty per month each, in addition to any income taxes from the transfer of assets.
Before You Decide to Convert LLC to S Corp or C Corp…
Issues around tax and accounting for startups can be complicated to sort through on your own. You’ll want to consult a lawyer who specializes in corporate law. From there, if you’re an inDinero client, we can help you file the paperwork on time. If not, make sure you have a tax expert available to help you cover your tax filing bases. Our financial experts are happy to talk to you about your tax needs and see if we can help.
At inDinero we want to help businesses like yours understand their tax responsibilities and save time and money by preparing year-round. Our tax experts have put together a resource pack designed specifically for business owners. Download your copy of The Entrepreneur’s Business Tax Pack now.