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Changing Your LLC to an S Corp: What You Must Know Before Doing So

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Let’s assume you are a business owner operating as an LLC. If you consider changing your current business structure, transitioning to an S corporation (S corp) might be a viable and strategic move.

March 11, 2024
Author: NCH

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The shift from an LLC to an S corp can provide numerous advantages, such as increased flexibility, simplified management, and potential tax benefits.

Comparing LLCs vs. S Corps

An LLC combines a corporation’s limited liability protection with a partnership’s simplicity. LLCs can have one or multiple owners (members) and enjoy pass-through taxation, meaning that business profits and losses are reported on the owners’ individual tax returns.

On the other hand, an S corp is a tax designation, not a business structure in itself. A regular corporation (C corp) is usually elected to be treated as an S corp for tax purposes. 

Why Consider Turning an LLC Into an S Corp?

Tax Savings

Unlike a traditional C corporation, S corporations do not pay federal income tax at the entity level. Instead, profits and losses flow through to the shareholders’ personal tax returns. This can result in a lower overall tax liability for the business and its owners or members.

Credibility and Perception

S corps often have a more established and credible reputation in the business world. Some clients and investors may prefer to work with S corps over LLCs, which can enhance your company’s credibility and potentially attract more business opportunities.

Enhanced Credibility

An S corp status can enhance your business’s credibility in the eyes of customers, suppliers, and partners. It often implies a higher level of commitment and professionalism. This allows you to secure valuable partnerships and contracts down the line.

Limited Liability

Both LLCs and S corps offer limited liability protection. In simpler terms, the owners are not personally responsible for the company’s debts and liabilities. Such a feature offers peace of mind and financial security for business owners of any industry.

Prerequisites for Conversion

Eligibility

Not all LLCs are eligible for S corp status. Your business must meet various criteria to be eligible to be considered as an S corp:

  • Be a domestic corporation.
  • Have only allowable shareholders, including individuals, certain trusts, and estates, but not partnerships or other corporations.
  • Have no more than 100 shareholders.
  • Have only one class of stock.
  • Does not have non-resident alien shareholders.

Consider turning to an attorney or tax professional for expert guidance. They can help you assess the potential benefits and drawbacks based on your circumstances.

Unanimous Consent

All LLC members must consent unanimously to convert the entity into an S corp. Be sure to consult with all stakeholders and ensure they agree to the transition.

Steps to Change From an LLC to an S Corp

1. File IRS Form 2553

To elect S corp status, you need to file IRS Form 2553, also known as the Election by a Small Business Corporation. You can obtain this form from the IRS website or your tax advisor. 

Complete and submit the form before the deadline, typically no later than two months and 15 days after the start of the tax year in which you want the S Corp status to take effect.

2. Update Legal Documents

If your LLC has an operating agreement, you must update it to reflect the new S-corp structure. This includes changes in ownership percentages, voting rights, and profit distribution.

3. Address Tax Implications

Converting to an S corp has tax implications, including potential capital gains taxes. Work closely with your CPA to understand and address these tax consequences. You may need to adjust your compensation structure to maximize the tax benefits.

4. Inform State Authorities

In addition to federal tax considerations, you must notify your state’s taxing authority and follow state-specific requirements for turning your LLC into an S corp. This may involve filing additional forms or paying state fees.

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5. File Necessary Forms

Depending on your state’s requirements, you may need to file additional forms to document the change from an LLC to an S corp. Always follow your state’s rules and meet all deadlines.

6. Handle Payroll Taxes

As an S Corp, you’ll need to set up payroll for yourself and any other employees. This includes withholding and remitting payroll taxes to the IRS and state tax authorities, as applicable.

Potential Considerations

Self-Employment Taxes

All income in an LLC is subject to self-employment taxes. In an S corp, however, only salaries are subject to these taxes, not dividends. This means you could save on self-employment taxes by paying yourself a reasonable salary and distributing the remaining profits as dividends.

Reasonable Salary

When determining your salary as an S corp owner, ensure it’s reasonable for the services you provide to the business. Paying yourself an unreasonably low salary to reduce self-employment taxes could raise red flags with the IRS.

Limited Growth Potential

S corporations have limitations on the type of shareholders they can have, such as restrictions on foreign ownership and non-individual entities. If you plan to attract a broad range of investors, this may not be the best structure for your business.

Disadvantages of Operating as an S Corporation

Administrative Complexity 

More often than not, S corps require more administrative work than LLCs, including payroll processing, shareholder meetings, and formal record-keeping.

Eligibility Restrictions 

As previously mentioned, S corps have eligibility restrictions, such as the 100-shareholder limit and one class of stock requirement.

Strict Compliance 

Maintaining an S corporation status requires strict compliance with IRS and state regulations. Failure to do so can result in penalties or the loss of S corp status.

Final Thoughts

The decision to transform your LLC into an S corp can significantly affect your business’s tax structure and financial outlook. While it can provide tax advantages and a more professional image, it also includes additional compliance and administrative responsibilities.

Consulting with a knowledgeable professional will help ensure the transition aligns with your business’s goals and objectives. Although the process may seem complex, its potential benefits can make it worthwhile for many business owners.

At NCH, we are committed to providing guidance and support for your business endeavor, regardless of your chosen path. Our business formation experts will help you change your LLC to an S corp and put you in the best position to succeed.

Check out our website or call us at 1-800-508-1729 to schedule your free consultation!

DISCLAIMER: The above material has been prepared for informational purposes only, containing opinions of the provider and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.

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