Converting Your LLC to an S Corporation: Pros, Cons, and How-to Guide

f you’ve started your business as an LLC, adjusting your business structure can seem complex and time-consuming. However, converting your LLC to an S Corporation may not be as complicated as you think. In the long run, it can save you money on taxes and help your business grow faster. Here are some tips to help you understand why, how, and when to convert your LLC to an S Corporation.

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What is an LLC?

LLC stands for limited liability company, which is a business structure that grants business owners protection from personal liability for business debts and liabilities. That means LLC owners aren’t personally responsible for business debts and obligations such as legal judgments. Usually, only the LLC as an entity is responsible for those obligations. An LLC can have one owner, which is a single-member LLC, or multiple owners, which is a multi-member LLC.

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Pros of an LLC

• Personal liability protection: Forming an LLC helps you keep your personal finances and assets separate from your business and helps protect your personal assets if the LLC needs to pay taxes, debts, or other obligations.
• Tax flexibility: An LLC can choose to be taxed in a number of ways as long as the business meets the applicable requirements. LLCs can elect to be taxed as a sole proprietorship, partnership, S Corporation, or C Corporation.  
• Formation flexibility: You can form an LLC as a single member, but you also can have an unlimited number of members.
• Less red tape: An LLC typically means less paperwork, fewer compliance requirements, and simpler taxes than other business structures.

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Cons of an LLC

• Required registration and renewal fees: When you register your LLC for the first time, you’ll have to pay a state fee. You’ll also have to pay an annual or biannual fee in most states to renew your registration.
• Additional taxes: Many states impose a franchise tax (a tax levied on businesses for the privilege of doing business within a particular state or jurisdiction) on LLCs. Usually, a franchise tax is either a flat fee or is based on a business's net worth, the value of the business's property, or the value of its stock. Additionally, depending on your LLC’s filing status, you may have to pay self-employment tax.
• More difficult to get funding: Investors often favor corporations over LLCs, so it can be harder to raise capital if your business is an LLC.

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What is an S Corp?

Like an LLC, an S Corporation is a type of business entity that provides personal liability protection. An S Corporation protects shareholders from being personally liable for the corporation’s obligations and protects them from having their personal assets used to satisfy the corporation’s debts and liabilities.

There’s also a tax advantage to forming an S Corporation. S Corporations utilize “pass-through” taxation. Pass-through entities pass corporate income, losses, deductions, and credits directly to shareholders for federal tax purposes. Pass-through taxation allows S Corp shareholders to avoid double taxation because corporate income is only subject to federal tax at a personal level.

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Pros of an S Corp

• Pass-through taxation: Profits are “passed through” to the shareholders. This means only the shareholders pay tax. The business doesn’t have to pay federal taxes at the entity level.
• Easy ownership transfers: Compared to an LLC membership stake, it’s usually easier to give or sell your S Corp or S Corp shares to someone.
• Greater credibility: An S Corporation is perceived as a more credible business entity than an LLC. This can be attractive to employees, clients, investors, and customers.
• Boost your investor appeal: Investors often prefer investing in corporations because of the rights and protections corporate shareholders have and because corporate shares are easier to sell and buy than LLC membership stakes.

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Cons of an S Corp

• Formalities and fees: In general, running an S Corporation will require more money and effort than an LLC. Your business will also need to adopt corporate bylaws, elect a board of directors, and host shareholder meetings, which can add more costs. You might also have to spend money on recording and storing shareholder meeting minutes and other documents.  
• More restrictions on stock and shareholders: Because of the liability and pass-through laws, there are restrictions on how many shareholders an S Corp can have, who those shareholders can be, and the types of shares that can be created. Unlike a C Corp, which can have several different types of shares, an S Corp can have only one class of stock.
• 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).

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How to switch from an LLC to an S Corp

Once you've identified that an S Corp is the right kind of entity for your business, there are several steps to take:

• Meet eligibility requirements
• Elect S corp status
• File to change your company's tax status
• Undergo a formal conversion
• Obtain a new Employer Identification Number  
• Notify state and local authorities

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When to convert from an LLC to an S Corporation

Timing is a key part of any successful business restructuring. Keep an eye on potential tax savings as the revenue for your business grows, and understand both the potential savings and additional costs associated with transitioning to an S Corp. There are a few times in your company’s life cycle when you may want to consider converting to an S Corporation:

• Self-employment taxes are becoming burdensome: Depending on the tax status your LLC has, you might have to pay self-employment taxes. While these taxes might be low when your company is just starting out, self-employment taxes can add up if your LLC income grows.
• You can afford to convert to an S Corp: Filing fees in most states are reasonable, but there are additional compliance costs associated with S Corporations. It’s also a good idea to work with a business lawyer who can help you navigate the S Corp conversion process, but that can be expensive as well.  
• You want to benefit from corporate formalities: When a company grows to a certain size, it can benefit from more centralized decision-making and management. S corporations are owned by the shareholders but managed by officers who are overseen by a board of directors. That can help centralize decision-making authority so that important decisions can be made more quickly.

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Challenges and risks of transitioning to S Corp status

When you restructure as an S Corp, you can lose some flexibility and increase your compliance requirements and costs. Some of the challenges you should consider before converting include the following:

• Potential loss of flexibility: LLCs are subject to fewer rules and regulations than corporations. Corporate shareholders have a number of rights and legal protections, such as rights to shareholder meetings and voting rights. That means you might not be able to carry out certain plans if your shareholders disagree with you.
• Compliance costs: When you convert your LLC to an S Corporation, you’ll also have to make sure your corporation complies with any applicable regulations and laws. Corporations are usually subject to more compliance rules than LLCs. Compliance is an ongoing task, so this can get pricey depending on where your corporation is operating and what industry you’re in.
• Change in ownership and control: Corporate shares are much easier to sell and buy than LLC membership stakes. When you convert your LLC to an S Corporation, there’s a risk that shareholders will eventually sell their shares to someone whose interests or ideas don’t align with yours. Because corporate shareholders have legal rights to meetings and votes, you also risk being outvoted on important matters such as mergers, sales, or board of director elections.

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Takeaways

Converting your LLC to an S Corporation can help prime your business for growth. S Corporations can save you money on taxes and help you attract investors. But, as with all business decisions, you’ll have to consider the costs and benefits of converting. Make sure to consult with a professional accountant and/or lawyer before making any decisions regarding converting your business structure.

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