Making the Switch from an S Corporation to an LLC
Operating your business as a limited liability company may provide you with many advantages. If you currently have your business structured as an S corporation and are considering converting to an LLC to take advantage of the benefits that business entity offers, you should weigh your situation carefully. While LLCs offer noteworthy benefits, the conversion process from an S corporation to an LLC contains many potential pitfalls, including the realization of gain under Section 336 of the Tax Code.
The legal aspects of converting from an S corporation to an LLC are not overwhelmingly difficult. It generally starts with your S corporation’s directors voting to approve the concept of converting to an LLC and creating a plan of conversion. Then, a majority of stockholders would need to approve the action. If all this transpires, the next step varies depending on your state. In some states, the process involves completing a conversion form and filing it with the Secretary of State or other governmental entity that oversees corporations and other business entities. In other states, it may involve creating a new LLC, merging the S corporation with the LLC, and naming the LLC as the survivor of the merger.
Even though the process from the legal standpoint is relatively simple, you should take great care before making the conversion, since the tax consequences can be significant for the shareholders. This is because the Internal Revenue Service will treat the conversion action as a liquidation of your S corporation. As a result, if your S corporation’s assets have declined in value or have increased only very slightly, and you wish to convert to an LLC, now may be a good time. This is a very possible scenario if your S corporation owns real estate that lost value in the recent market crash.
On the other hand, if the assets held by the S corporation have appreciated in value, that appreciation will be taxable, probably as capital gains, for the shareholders. If your S corporation has accumulated a large amount of goodwill, or has assets that increased substantially during your business’ operation, this conversion could potentially be very costly.
There are some options that could be less onerous in terms of tax liabilities. In 2005, the IRS issued Letter Ruling 200528021. In that ruling, the agency addressed the issue of whether an S corporation can convert to an LLC, file an election to retain its tax treatment as a corporation, and also hold onto its S status. The IRS ruled that, if the business made this conversion and filed this election to continue to be taxed as a corporation, the conversion was a reorganization under Section 368 and tax-free.
Converting your S corporation to an LLC takes careful planning and a detailed knowledge of both business entity law and the Tax Code. For advice and counsel that can reliably help you navigate this process, talk to the tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.