There are circumstances under which an S corp to LLC conversion makes sense. An S corporation is structured in such a way that income, losses, tax deductions, and tax credits are passed down to each shareholder for federal tax calculations. Shareholders of an S corporation get to report the income and losses on their own tax returns and are taxed based on their own income tax rates.
As such, S corporations do not pay corporate taxes on income – the business is not taxed, but the shareholders are. An LLC, on the other hand, is a limited liability company. Unlike S corporations, there are state-specific rules for how LLCs are created and managed. The owners of an LLC are called its members, with no limits on how many members there are or what members are (i.e., other corporations, foreign entities, etc.).
LLCs are taxed by the IRS in different ways. In the eyes of the IRS, an LLC may be considered an S corporation, a C corporation, a partnership, or a disregarded entity on the sole owner’s tax return. But without proper precautions, an S corp to LLC conversion can invite a massive taxable event and greatly impact your shareholders.
The Benefits of S Corp to LLC Conversion
The benefits of restructuring an S corporation into an LLC include wanting to change ownership from multiple shareholders to a single or two partners or wanting to take advantage of the asset protection perks of an LLC. As limited liability companies, LLCs can default without affecting the owner’s finances – in other words, even though you own the LLC (wholly or partially), the LLC’s debts are not your own.
Furthermore, LLCs have a lower recordkeeping requirement than the average corporation. No more annual meetings and less overall paperwork. Because LLCs do not have their own federal tax classification, you can choose how your LLC will be taxed federally, as mentioned earlier.
LLCs have an easier time keeping records, provide greater asset protection, and can be taxed in different ways. These are just a few of the perks of turning a corporation into an LLC. But the process of doing so can invite a taxable event. Let’s take a look at how that could occur.
The S Corp to LLC Conversion Process
Converting an S corporation into an LLC requires a vote from the board of directors and the shareholders of the S corporation. The directors must approve the conversion and the plan of conversion, and most of the stockholders of the corporation must approve as well.
From there, you must follow the state-specific steps for requesting, completing, and filing a conversion form. In some states, you might have to create a separate LLC, merge it with your S corporation, and declare the LLC as the sole survivor of the merger.
But the trouble comes when trying to convert an S corporation into an LLC with a radically different internal structure. In doing so, you are effectively liquidating the S corporation before turning it into an LLC, inviting a taxable event by distributing the entirety of the corporation’s value to each shareholder.
Doing so will convert all the shareholders’ individual unrealized gains (or losses) into capital gains (or losses). Depending on how much the business has appreciated (or depreciated), depending on the value of its initial investment, and depending on each shareholder’s individual income tax bracket and tax rate on capital gains, this can lead to a collective fortune in taxes for the year of the conversion.
Finding the Right Time
Realizing a shareholder is something a business aims to do at some point anyway. There will be a time and place when a shareholder wishes to cash out on their investment. But besides the fact that most tend to want to do so on their own terms, there are ways to bypass and sidestep capital gains or minimize them during generational transfer.
For example, passing shares to the next generation through a trust can renew the basis of the asset, and thereby avoid capital gains taxation – because the asset was received at its new value, there are no “gains” to be realized for the new owner. The process for doing this involves a complex trust and is only feasible if your goal is to transfer wealth across generations, of course.
But the fact remains that turning unrealized gains into a taxable event is something to think about before making the conversion into an LLC. There is a major flipside to this. If the company has significantly lost value over the last few years, then now might be the perfect time to convert into an LLC and change ownership.
Not only can a conversion help you restructure leadership within the company for the coming years and minimize liability via an LLC, but because the conversion triggers a taxable event, shareholders will now be able to utilize their capital losses to offset capital gains made elsewhere throughout the year. Unused capital losses can be carried over into future years when calculating the tax on your capital gains.
Minimizing Tax Liability
We have established that converting an S corporation into an LLC might invite taxation because the S corporation is effectively liquidated during the process. However, you can take certain steps to avoid this. You can consider a compromise wherein your conversion into an LLC includes continued taxation as a sub-S corporation, meaning your company is simply restructuring rather than being liquidated and converted, or simply merged into an existing LLC.
If your business exists as an LLC but continues to be taxed as an S corporation, and the ownership of the LLC matches that of the original S corporation, the IRS will not tax any capital gains made between the founding of your corporation and its restructuring. This exception was clarified in an IRS-issued Letter Ruling back in 2005. However, if your conversion into an LLC must involve a change in ownership, you cannot claim this exception.
Conversion into an LLC can carry a host of benefits. But you should be careful about any sweeping changes in the structure of your business. Unforeseen tax consequences can cost your shareholders a small fortune in taxes, especially if your company has grown massively since they’ve joined. The last thing shareholders want when a business is booming is to be unexpectedly taxed on their investments.
If you have more questions about how a conversion into an LLC might affect your business and your shareholders, your best bet is to get in touch with a tax professional or a tax law firm.