How to Convert an LLC into an S-Corps

Business owner thinking about converting his LLC into an S-Corps

LLC vs S-Corp. What’s the Difference?

An LLC is a very common entity choice for business owners who are just starting out. LLCs offer a number of benefits that make it a popular option. An LLC is a flexible business entity that combines elements of a partnership and corporation. [1] It offers limited liability protection, meaning the personal assets of the owners (called members) are generally protected from business debts and claims. LLCs are also known for their flexible management structures and fewer compliance requirements compared to corporations. However, as beneficial as LLCs are, at a certain point, many business owners find that it makes better sense to convert their LLC into an S-Corp. This typically happens as a result of business growth and/or a change in the business goals.

An S-Corp is another form of business entity available to corporations and LLCs that allows the income, losses, deductions, and credits to pass through to the shareholders’ personal tax returns, thus avoiding double taxation. [2] It’s important to know that, unlike LLCs, S-Corps have more stringent requirements, including limits on the number of shareholders (no more than 100) and restrictions on who can be a shareholder (must be U.S. citizens or residents). But, as long as your LLC still meets the criteria, it’s perfectly allowable to convert an LLC into an S-Corp.

Why Convert to an S-Corp?

Converting an LLC into an S-Corp has several advantages, not the least of which is the difference in taxation and payroll. The potential for tax savings as an S-Corp is hard to resist. LLC members are on the hook for self-employment taxes, based on their share of business earnings. S-Corp shareholders pay only self-employment taxes on their own salaries.

Another reason why many businesses convert an LLC to an S-Corp is growth and complexity. When a small business is successful, it often develops complexities that it didn’t have previously, such as retirement plans, health insurance and other things. For example, shareholders may come and go. If a member or owner leaves an LLC, the entity may be dissolved. But in an S corporation, once it’s formed, the entity is perpetual, even if the shareholders change.

The other big reason why business owners often convert from an LLC to an S-Corp is because the shareholders of an S-Corp can be both owners and employees. [3] This allows the owner to offer employees stock options, which is a useful way to attract talent. This is especially valuable for small businesses that may not be able to compete salary-wise against competitor employers in the marketplace.

Is Your Business Eligible to Operate as an S-Corp?

Not every business qualifies to be an S-Corp, especially businesses that have already been operating—and been successful—while being an LLC. Before even considering converting an LLC into an S-Corp, it’s imperative to review the criteria for an S-Corp, to ensure that your business meets the eligibility requirements. The specific requirements include:

A maximum of 100 shareholders. LLCs aren’t limited to the number of members, but S-Corps are. In addition, ownership of the S-Corp is restricted to U.S. citizens and permanent residents.

Only one class of stock. Other business entities can have multiple classes of stock, but S-Corps are limited to a single class. This is something to consider, as it means that you could have obstacles in the future if you want to raise capital by taking on new investors. [4]

male and female business owners reviewing terms for S Corps business

Other Considerations to be Made Before You Convert LLC to S-Corp

It’s no simple matter to convert an LLC to an S-Corp. Other considerations must be made before you convert in order to avoid regret or errors. One of the first things you should know is that S-Corps carry with them more stringent record-keeping requirements. They must adhere to corporate formalities such as holding annual meetings and maintaining corporate minutes. The corporate veil of protection is at risk unless you carefully follow all the record-keeping requirements.

What to Know About The Corporate Veil of Protection

The corporate veil of protection is a concept that puts into place a layer of protection for owners of an S-Corp and certain other legal entities. It protects owners from personal liability in the event of legal action against the company. To summarize, with the corporate veil in place, the business assets can be at risk, but the owner’s assets are not at risk. However, if you fail to adhere to the record-keeping and other requirements of an S-Corp, an argument can be made that the business is not operating as a true S-Corp, which could potentially allow the corporate veil to be pierced. [5]

Steps You Must Take to Convert to an S-Corp

1. Complete & Submit Form 2553, “Election as a Small Business Corporation”

business owner taking steps to convert her LLC business to an S-Corp

2. File on Time – Be sure to file all articles of conversion, also known as “certificate of conversion,” with the Secretary of State or another filing office. You may also need to file articles of incorporation and other legal documents. Note that there will be deadlines attached to each filing.

3. Ensure You Meet State Requirements – Check with your state to make sure that it permits entity conversions. Not all states do.

4. Determine Reasonable Compensation – The IRS wants to know that you are paying shareholder-employees reasonable compensation. This helps to ensure that the appropriate payroll taxes are being paid. One of the easiest ways to determine reasonable compensation is with RCReports. With RCReports, you or your client can fill out their quick questionnaire about the tasks they perform in their business, and you’ll receive a report with details about comparable and reasonable compensation based on their location.

5. Set Up Payroll – Once you’ve determined a satisfactory range for reasonable compensation with RCReports, there’s another benefit you can consider. RCReports can recommend some vetted payroll services providers, which can help you set up your payroll faster than if you tried to start from scratch.

Converting from an LLC to an S-Corp could be one of the smartest decisions you’ll ever make for your business. Just be sure you carefully review all of the considerations listed above. Then, when it comes time, work with RCReports to ensure you’re paying reasonable compensation to yourself and your key employees. Contact us today to learn more.

Sources

1. Law, S. F. J. ·. U. G. S. O. (2023, April 3). What is a Limited Liability Company (LLC)? www.nolo.com. https://www.nolo.com/legal-encyclopedia/what-is-a-limited-liability-company.html

“An LLC, or Limited Liability Company, combines the best parts of corporations, sole proprietorships, and partnerships into one business entity offering owners liability protection, flexible management structure, and certain tax advantages.”

2. Kagan, J. (2024, March 22). What is an S Corp? Definition, taxes, and how to file. Investopedia. https://www.investopedia.com/terms/s/subchapters.asp

“An S corp (or S corporation) is a business structure that is permitted under the tax code to pass its taxable income, credits, deductions, and losses directly to its shareholders. That gives the S corp certain advantages over the more common C corp.”

3. Griswold, D. (2024, July 26). S corporation advantages & disadvantages. Wolters Kluwer. https://www.wolterskluwer.com/en/expert-insights/s-corporation-advantages-and-disadvantages#:~:text=S%20corporation%20shareholders%20can%20be,their%20investment%20in%20the%20corporation.

“S corporation shareholders can be employees of the business and draw salaries as employees. They can also receive dividends from the corporation, as well as other distributions that are tax-free to the extent of their investment in the corporation.”

4. S corporations | Internal Revenue Service. (n.d.-b). https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

“To qualify for S corporation status, the corporation must meet the following requirements:

Be a domestic corporation

Have only allowable shareholders

May be individuals, certain trusts, and estates and

May not be partnerships, corporations or non-resident alien shareholders

Have no more than 100 shareholders

Have only one class of stock

Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).”

5. piercing the corporate veil. (n.d.). LII / Legal Information Institute. https://www.law.cornell.edu/wex/piercing_the_corporate_veil

“”Piercing the corporate veil” refers to a situation in which courts put aside limited liability and hold a corporation’s shareholders or directors personally liable for the corporation’s actions or debts. Veil piercing is most common in close corporations.”

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