lecting to convert your business from an LLC to an S Corporation can help position your small business for accelerated growth.
If you’ve started your business as an LLC, adjusting your business structure can seem like a complex or time-intensive process. However, converting your LLC to an S Corporation may not be as complicated as you might expect. In the long run, it can save you money on taxes and enable your business to grow faster. You may reach a point in your business journey at which it makes sense to change your business entity from an LLC to an S Corporation. Here are some tips to help you understand why, when, and how to make the change.
Should you Transition from an LLC to an S Corporation?
Pros and Cons of an LLC
An LLC stands for Limited Liability Company, which is a business structure governed by state statute that grants business owners of an LLC personal liability protection from the responsibility for debts or liabilities. Members are not personally responsible for business debts and liability, rather, the LLC entity is. Additionally, an LLC can be owned by one owner, a single-member LLC, or by multiple owners, a multi-member LLC. This tax system is often considered most simple as the members pay self-employment taxes and report business income and expenses on their personal tax returns.
- Tax flexibility. Unlike sole proprietorships, LLCs can elect to be taxed as a sole proprietorship, partnership, S Corporation, or C Corporation and may save money from doing so.
- Simpler tax filing and less paperwork. An LLC generally requires less paperwork and compliance requirements than an S Corporation. Filing tax returns for an LLC also tends to be simpler than for an S Corporation.
- Formation flexibility. You can form an LLC as a single member, but you also can have an unlimited number of members. Members can also receive revenues (and write off forfeitures) that are larger than their individual ownership percentage.
- High renewal fees or publication requirements, depending on your state. When you register your LLC for the first time, your state will require you to pay a fee. In order to maintain your LLC’s registration in that state, you will need to pay an annual or biannual fee (referred to as an ‘annual report’) in most states. While the state average in 2022 is $91, depending on your state, this annual fee may be much higher, as much as $800 per year.
- Additional taxes. Many states have a franchise or capital values tax on LLCs, ranging from a flat fee to an amount based on the company’s revenue.
- More difficult to obtain funding: Investors are more likely to put their money into a corporation, making it harder to raise financial capital as an LLC.
Pros and Cons of an S Corporation
An S Corporation is a business entity that is a tax designation that elects to pass corporate income, losses, deduction, and credit through shareholders for federal tax purposes, with the benefit of limited liability and relief from double taxation. Double taxation is the principle referring to income taxes paid twice on the same source of income. An S Corporation is a corporation within Subchapter S of the Internal Revenue Code. Similarly to an LLC, your personal assets, like bank accounts, are protected from issues with taxes, debt, or liabilities finances.
- Pass-through taxation. Profits are ‘passed through’ to the owner’s persona; on tax returns, only the shareholders pay tax. In other words, your business does not have to pay federal taxes at the entity level.
- Easy to transfer ownership. If you ever decide to give your company to a relative or sell it to another owner, it is relatively easy to do so as an S Corp compared to an LLC or sole proprietorship.
- Greater credibility. An S Corporation is perceived as a more credible business entity and can come with more authority than a sole proprietorship, partnership, or LLC. This can be attractive to employees, clients, investors, and customers alike.
- More formalities and fees. In general, running an S Corporation will require more paperwork than an LLC. Your business will also have to observe particular internal formalities such as writing corporate bylaws, having a board of directors, conducting shareholder meetings, and keeping minutes of significant meetings.
- More restrictions on stock and shareholders. Because of the liability and pass-through laws, there are some stock restrictions on shareholders. In addition, the number and nature of shareholders are limited in order for an S Corporation to maintain its status as such.
- More complex tax returns and additional obligations. If you make a simple mistake with your taxes, it can cause you to lose your S Corporation status (although this is rare).
Switching from an LLC to an S Corp
Here are a few helpful steps to consider when undergoing the change.
1. Ensure your business meets IRS eligibility requirements
In order to convert your LLC to an S Corp, you must first meet a list of requirements established by the IRS. Your business must:
- Be a U.S. business
- Have only allowable shareholders including individuals, certain trusts, and estates and may not include partnerships, corporations, or non-resident alien shareholders
- Have no more than 100 shareholders
- Have only one class of stock
- Not have owners that are corporations or partnerships
2. Seek Legal Advice
The IRS offers detailed information and instructions on how to convert your business to an S Corporation. However, If you are having apprehensions about your shift from an LLC to an S Corporation, do your research online or seek out legal advice. While this may cost upfront, it can assure that your transition is done in the most efficient and legal way possible.
3a. File With the IRS for a tax status change
If you elect to change only your LLC’s tax status, an initial step will include filing Form 2553 with the Internal Revenue Service by their deadline of March 15 of the year you would like this status to go into effect. This form will need to be signed by the shareholders and owners of your LLC.
Considering you already have your LLC established, you will already have in place your legal entity with a name, registered agent, filed your articles of organization, bank accounts, and Employer Identification Number (EIN). Keep in mind that this does not change your business entity. Read on for more information on updating your business status from an LLC to an S Corporation.
3b. Or, undergo a formal conversion
A statutory conversion is generally a simple and straightforward procedure, and it is available in most states. You will need to file a certificate of conversion, an LLC certificate of formation, and other documents required by your secretary of state.
On the other hand, a statutory merger is less simple than a statutory conversion. Check with your state on specific requirements, but generally, you will need to form a new corporation, have all LLC members vote to approve the merger as both LLC members and corporation stockholders, have all LLC members formally exchange their membership rights for corporation shares, and file a certificate of merger with your secretary of state.
Finally, a nonstatutory conversion is both the most complicated and the most expensive way to convert your LLC to an S Corporation. This process involves forming a new corporation, transferring your LLC’s assets and liabilities, and then liquidating and dissolving your existing company.
4. Open a New Business Banking Account
If you already have a business bank account, you may have to close the bank account associated with your LLC after all existing business associated with the account is finalized. On the other hand, if you are a Novo accountholder, we make the transition smooth. We will help you update the EIN associated with your account, as well as your business name and type, as soon as you change your business from an LLC to an S Corporation.
In fact, the right banking partner for your business can be a key factor in its continued growth and success. From features that speed up your cash flow or provide better visibility into your business finances to integrations with top business software, you’ll want to choose a business banking platform that simplifies and streamlines how you manage your business finances. Learn why more than 160,000 businesses trust Novo.
Converting your LLC to an S Corporation can pave the way for future growth
Converting your LLC to an S Corporation can be a beneficial transition that enables you to maximize your business growth in the long run. While making any significant change to your business can be intimidating, with the proper knowledge and legal advice you can take your company to the next level and excel to new heights as an entrepreneur.
This page is for informational purposes only and is not intended to be relied upon as legal, financial, or accounting advice. Please consult your own professional if you have any questions.