Your LLC has been established for a while and things are going well. Your earnings have steadily increased over the years, as has your self-employment tax bill. It’s time to change, but you’re faced with many options. Regarding potential business structures, should you convert your LLC to an S corp or a C corp?
What is an S Corp?
An S corporation is a business structure that is treated like an LLC except for tax purposes. Profits and losses of an LLC are passed directly to the owners and taxed as part of their income. In contrast, profits earned in an S Corp are taxed separately. You can become an S Corp employee, earn a reasonable salary, and pay payroll taxes on that salary.
How to Convert an LLC to an S Corp
To begin the process of converting an LLC to an S corporation, file Form 2553 (Election by Small Business Corporation) with the IRS. This form asks for a detailed description of your business, including basic information such as address and EIN, the tax year to which the change will apply, details that prove your company meets the requirements of an S corporation, and information about each. Individuals/groups owning shares in a newly created Subchapter S corporation.
When filing Form 2553, it’s important to keep the deadlines in mind. You can apply at any point during the current tax year to begin converting your LLC to an S corporation for the next tax year. You can also apply to change your LLC to an S corp in the current tax year. The only caveat is that you must apply within ten weeks and five days of the start of the current year.
One of the main criteria for converting an LLC to an S Corp is a maximum of 100 owners or members. The solution the IRS provides is to treat individual family members as “shareholders” of the same family. Under this solution, you, your spouse and your estate may also be treated as a single shareholder to meet the eligibility test. Your company must be based in the US and none of the shareholders can be considered “non-resident aliens”.
After filing the appropriate forms, the next step is to transfer the LLC’s assets to the newly formed S Corp. After that, it’s time to apply for the appropriate state and local business permits. You will also need to update your LLC operating agreement (if applicable). Your LLC’s existing contracts with suppliers and customers will need to be changed. You will then file Form 8832 (Entity Classification Election) to notify the IRS that the conversion is complete.
Convert an LLC to an S Corp – Advantages
The difference in how profits are taxed is a major advantage of converting an LLC to an S corporation. If you earn $200,000 as a member of an LLC, the entire amount is subject to self-employment tax. If you earn $200,000 as an S Corp employee, you will only pay payroll taxes on what you decide is a reasonable salary, such as $120,000. The remaining $80,000 will be subject to income tax but not Social Security.
As an S Corp employee, you have more options when it comes to preparing for retirement. You can also contribute more to this effort. However, you must ensure that you do not contribute more than the wages you receive from the S corporation. You can contribute to both a 401K and a Sep-IRA as an S Corp employee. 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 an LLC to an S corp, all members of the LLC will be given shares in the new entity. The ability to issue shares makes it easier for members of an S corporation to raise capital. It is also easy for individual shareholders to transfer their ownership stake to another party. In addition, it can provide a higher level of credibility with potential investors, suppliers and customers
Convert an LLC to an S Corp – Disadvantages
Difficulty and cost
Becoming an S Corp is a complex process that is time-consuming and potentially expensive. You may have to incur legal costs in amending all existing LLC agreements. You must ensure that your membership does not include any ineligible institutions (for example, banks). In LLCs with large memberships, converting an LLC to an S corporation can have high administrative costs.
Varies by state
Subchapter S corporations are treated differently by state. This can significantly affect the benefits of converting an LLC to an S corporation. For example, in states like Florida, you won’t pay state income tax on profits made through an S Corp. However, if you try to replace an LLC with an S corp in New York, you’ll find that S and C corporations are treated similarly. This dramatically reduces the tax benefits and incentives of converting an LLC to an S Corp.
Less flexibility, more formality
Being an S Corp means you and your fellow shareholders are subject to more duties and requirements. You will need to hold regular director and shareholder meetings and maintain corporate records.
There is also less flexibility in areas such as profit sharing. In an S corporation, 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
An AC corporation is the standard business structure for corporations. In a C corporation, the business is separate from its shareholders. A C corporation is subject to double taxation—the company is taxed on its corporate profits and the company’s owners are taxed on the dividends they receive.
Converting from an LLC to a C corporation is similar to converting an LLC to an S corporation. For example, your LLC will need to notify stakeholders, renew contracts, and transfer all of its assets to the new entity. However, unlike the process required to convert an LLC to an S corp, it will also require obtaining a new EIN and filing articles of incorporation with the state.
Converting an LLC to a C Corp – Advantages
Appeal to the accelerator
Accelerators or incubators that raise capital often require their participants to incorporate as a C corporation. This is because it makes it easier for you to give capital to others, which is how accelerators make money. Also, a successful incorporation shows the accelerators that you have your business in line.
of risk capital
The C corporation structure allows investors to create “preferred shares” of stock. Becoming a C Corp provides a consistent legal structure that makes it easier 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
Unlike LLCs, a C corporation will continue to exist regardless of how often the company changes hands. This may be because existing owners have sold their shares or may have died. The LLC may not have specific provisions in the operating agreement for such an event or may not have an operating agreement at all. You may have to dissolve your LLC to deal with the legal consequences of losing a member.
Converting an LLC to a C Corp – Disadvantages
Unlike an LLC, a C corporation must pay taxes. When the company then distributes its earnings (to pay the founders and investors), each person must also pay income tax on those funds. This can be a big change if your company operates as an LLC.
Increased complexity and administration
The process of converting from an LLC to a C corporation can be complicated. It all depends on the state in which you created your LLC. Some states, such as California, allow quick conversions that allow you to convert an LLC to a C corporation in another state, such as Delaware. In other countries, the process can be much more complicated.
Payment of additional fees as part of the transfer
You can simply transfer all of the assets and liabilities of your LLC to your new C corporation, which is treated as a tax-free contribution under Section 351 of the IRS Code. If so, you won’t have to pay any taxes.
But you will have to pay taxes if your LLC contributes more liabilities than assets to the new C corporation. For example, say your LLC has $50,000 in assets (cash, inventory, accounts receivable) and $70,000 in liabilities (accrued expenses, accounts payable). Your LLC partners essentially just offload the $20,000 of debt onto the new C corporation.
The IRS classifies that $20,000 as income and the LLC partners must pay income tax as soon as possible.
The IRS also expects tax returns from the now dissolved LLC. Limited partners have 3.5 months from the date of dissolution to file what is known as a short tax year return. Otherwise, partners will be awarded $195 per month, net of any income taxes on asset transfers.
Before you decide to convert your LLC to an S Corp or C Corp…
Tax and accounting issues for startups can be complicated and need to be solved independently. You want to consult a lawyer who specializes in corporate law. From there, if you are an inDinero client, we will help you submit your documents on time. If not, make sure you have a tax expert 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 being prepared throughout the year. Our tax experts have put together a resource pack designed specifically for business owners. Download your copy Entrepreneur’s Business Tax Package Now.