3 Steps to Change Your S Corp to an LLC

If you’ve decided to convert your S Corporation into a limited liability company (LLC), understanding all the details of such a conversion is crucial.

This guide will walk you through converting your business entity from an S Corp to an LLC. It’ll also explain why this might be an excellent move for your business, in case you have any doubts. Let’s begin.

Key Takeaways

• If you have a C Corp with S Corp status, you can convert to an LLC in three ways.

• If you have an LLC taxed as an S Corp, it can be converted back to its original tax status.

• Converting an S Corp into an LLC offers numerous benefits, including management and tax advantages.

Why Change an S Corp to LLC?

Before presenting a step-by-step guide on changing an S Corp to an LLC, let’s see why you should consider this move. Remember that an S Corp is only a tax classification, not a business structure. So, you aren’t changing the business entity, but its tax treatment. 

LLC No Longer Meets the S Corp Requirements

The Internal Revenue Service (IRS) requires businesses to meet specific requirements to qualify as an S Corp.[1] This includes the following:

• Must have more than 100 shareholders.

• Can not have partnerships, corporations, and non-resident aliens as shareholders

• Can only have one class of stock

Let’s say your business has expanded and now has over 100 shareholders. Or, perhaps shareholders the IRS deems not “allowable” are set to join your S Corp. In this case, you have no choice but to abandon your S Corp status.

Greater Management Flexibility

An LLC allows you to completely customize your business entity’s structure to fit your business needs. This means an LLC imposes no limit on how many owners or members there can be.

Fewer Formalities

Many formalities are associated with running an S Corp. These concern virtually every part of the entity’s operation, from approving corporate decisions and drawing resolutions to requiring annual meetings and maintaining detailed corporate records.

In contrast, LLCs tend to have significantly fewer formalities, thus providing a more flexible operational framework. For instance, getting a specific activity approved only requires the approval of the LLC members and not an entire board of directors.

Better Profit Distribution

With everything LLC-related, “flexibility” is the key word. Profit distribution is no different. 

In an S Corp, shares are used to distribute profit, with every share being worth equally. So, naturally, shareholders with more shares receive more profit.

The same can apply to an LLC; profits can be shared based on ownership interest. However, they can also be shared based on initial contributions, as outlined in the LLC’s operating agreement. In other words, members contributing more cash will receive a higher profit share.

Tax Advantages

Though an S-Corp designation can help businesses save money on taxes, so can reverting the business entity to an LLC. It all depends on your specific circumstances.

For instance, if your LLC’s taxable income decreases, reverting to your default tax election might be more cost-effective than running an S Corp.

Plus, as an LLC, you don’t have to pay capital gains tax on passive income. If your business starts generating substantial passive income (e.g., from investments or rental properties), then reverting to an LLC status is the way to go.

Of course, with an LLC, you can also choose to be taxed as a partnership (for multi-member LLCs) or a sole proprietorship (for single-member LLCs), which is on par with the flexibility of this business type.

S Corp vs. LLC

Let’s briefly review how S Corps compare to LLCs so you can solidify your decision to change your business entity’s tax designation.[2]

How to Convert an S Corp to an LLC

The exact conversion process primarily depends on whether you already own an LLC taxed as an S Corp or you own a C Corp with an S Corp status, which you want to convert into an LLC.

LLCs Taxed as an S Corp

Let’s start with the simpler option first. While some details might vary from state to state, the following step-by-step guide provides a general outline for the conversion process.

1. File a Revocation of S Corp Status With the IRS

If you already own an LLC with S Corp status, all you have to do is have this status revoked by the IRS. To do so, you must compose a document called a statement of revocation.

The IRS’s official website offers guidelines on what to include in your statement of revocation, as this is not an “official” form. Note that the agency uses the word “shareholders” to refer to the owners of the S Corp. Since you’re reverting to an LLC, this term refers to your LLC members.

Your statement of revocation must start by declaring that your organization revokes the selection made under Section 1326(a) of federal law. From there, you should include all the basic information about your business as instructed by the IRS, including members’ information, your S Corp’s EIN (Employer Identification Number), and the date of revocation.

Your deadline to submit this form to the IRS is the 16th day of the third month of the tax year if you want the revoking effective on the first day of the same year. In other words, if you want your revocation to be effective on January 1, you must file the form by March 16.

2. File an Entity Classification Election

As its name suggests, the statement of revocation revokes your business entity’s status as an S Corp. Now, it’s time to re-classify how your LLC will be taxed. For this, you must file Form 8832, aka the Entity Classification Election.[3]

Generally speaking, you need to file this form at the same address as your tax return.

Form 8832 doesn’t have a deadline per se. However, it can’t be filed more than 75 days before the desired effective election date. At the same time, this date can’t be more than 12 months before the election date is filed.

3. Consider Future Tax Implications

Once you convert from an S Corp to an LLC, your business will likely experience certain tax consequences. Here are some important considerations to keep in mind:

• Single-member LLCs can be subject to more complicated taxation, as taxes will now be assessed on all profits.

• Your business might be subject to additional taxes, depending on your state. For instance, Tennessee imposes a franchise tax on LLCs.

• Your financial projections and budget might change based on your new tax structure.

If any of these consequences deter you, think twice before going through the revocation process. Once your S Corp status is revoked, you can only get it back after at least five years have passed.

C Corporations With S Corp Status

Suppose you own a C Corporation with S Corp status. In that case, you can convert it into an LLC in three ways: statutory conversion, statutory merger, and non-statutory conversion. Your chosen method will primarily depend on applicable state laws.

1. Statutory Conversion

Statutory conversion (domestic conversion) is the simplest of these three methods. This process allows you to convert your S Corp directly into an LLC without dissolving the original corporation. To achieve this, you must do the following:

1. Get authorization from all shareholders.

2. Prepare a corporate resolution or a plan of conversion.

3. File the resolution with a Certificate of Conversion with the Secretary of State.

2. Statutory Merger

A statutory merger calls for merging the existing S Corp into the LLC, effectively dissolving the original S Corp. The S Corporation’s assets and liabilities will be vested in the new LLC, and its owners (shareholders) will become the new LLC’s owners (members).

This process involves filing a Certificate of Merger with the Secretary of State. Depending on your state, you’ll likely need to submit more documents to complete this process.

3. Non-Statutory Conversion

Non-statutory conversion is the most complex of these three methods. It involves transferring assets from the S Corp to an LLC before dissolving the former entity. This process is quite time-consuming, as it essentially involves going through the entire formation and dissolution process.

Here’s what it generally entails:

1. Notify the IRS about the S Corp dissolution and liquidation

2. Inform all creditors, clients, shareholders, and employees of the change

3. File a Certificate of Dissolution with the Secretary of State’s office

4. Create a new LLC

5. Transfer your existing S Corp’s assets, liabilities, and ownership over to the new business

FAQs

What happens when you convert an S Corp to an LLC?

When you convert an S Corp to an LLC, all the corporate rules these corporations observe are eliminated. You’re left with an LLC that’s most commonly taxed as a partnership or a sole proprietorship.

Is converting from an S Corp to an LLC taxable?

Converting from an S Corp to an LLC can be taxable if your S Corp has increased in value after its formation. If so, shareholders might be subject to capital gains tax.

How do I terminate an S Corp election and revert to an LLC?

You can terminate an S Corp election and revert to an LLC by submitting a statement of revocation and filing the Entity Classification Election form with the IRS.

Can an S Corp revert back to an LLC?

Yes, an S Corp can revert back to an LLC. The exact process depends on whether you own a C Corp with an S Corp status or an LLC taxed as an S Corp.

What are the benefits of converting from an S Corp to an LLC?

There are many benefits of converting from an S Corp to an LLC. Some of the most appealing include greater management flexibility, better profit distribution, and fewer corporate formalities.

What is the difference between an S Corp and an LLC?

There are several differences between an S Corp and an LLC. The most notable being that an LLC is a legal entity, while an S Corp is only a taxation status. Other than that, S Corps have more formalities and a limited number of shareholders, while LLCs are substantially more flexible.

What is a legal conversion of an S Corp to an LLC?

A legal conversion of an S Corp to an LLC is a process that involves filing a conversion form with your Secretary of State to officially change your organization’s legal status.

Bibliography

1. The Internal Revenue Service. “S Corporations.” Accessed January 17, 2024.

2. The Internal Revenue Service. “Tax Information on S Corporations.” Accessed January 17, 2024.

3. The Internal Revenue Service. “Revoking a Subchapter S Election.” Accessed January 17, 2024.