Switching from S Corp to LLC (taxed as S Corp) Just Got Easier
If you’ve talked to Diane or I in the past year about choice of entity, we’ve probably told you about our favorite combination, the LLC taxed as an S Corporation. But what about those of you who already have a business? Do you change it, or do you start over? And what are the tax consequences of making a switch? A new letter ruling just released by the IRS offers good news!
The reason Diane and I like the LLC-S combination so much is that it gives you a fantastic combination of asset protection and tax savings. Many people know that your LLC interests are protected by law in most states, from being seized by creditors. So if you get sued, your LLC interests (and by extension everything IN your LLC) are protected. But not as many people know that your shares in a corporation, C or S, are NOT protected in the same way. Now if you get sued, those shares - and everything in your S Corporation - are at risk.
This difference in legal protection is usually the catalyst for change, but the devil is in the details - and in this case, in the taxation of the assets held within the S Corporation when the change is made. When you roll assets out of an S Corporation and into an LLC, there is often a capital gain due to the assets gaining in value. Depending on how much the gain is, you can wind up paying capital gains tax even though nothing really changed in the business, the assets or the ownership, AND you are just moving them from one entity to another.
But the new letter ruling helps us out here, by stating that you can make the change from an S Corporation to an LLC taxed as an S Corporation without disturbing anything. In fact, the IRS has made it easy, by allowing you to contribute all of your S Corporation stock and property into an LLC, in exchange for your 100% ownership in the LLC. Your S Corporation status doesn’t terminate, there is no capital gain - it’s just a straightforward entity conversion. File some paperwork with the Secretary of State, make sure you have some Minutes documenting the change, prepare the new Operating Agreement and other documents, and you’re done. (I can help you with that if you need it - email me at info@businessfirstformations.com to learn more).
So if you started your S Corporation on a shoestring years ago and have put off the conversion because you didn’t want a tax bill, this letter ruling makes the decision a lot more affordable!
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That’s great news! I hadn’t converted my S for the tax reasons. So how do you see this change affecting corporate structure strategies, such as the creation of separate holding companies for assets that are then leased back to the original corporation? The asset protection becomes a non-issue, so what benefits remain?
Thanks!
1) What happens to existing contracts, 401K plans, bank accounts, insurance, etc.. after the conversion? Do you have to close and reopen 401K / bank accounts after the conversion?
2) How does this work if you incorpoated outside of your home state, and filed as a foreign corp within your home state?
3) If you are a single-owner of the S-Corp, would you convert into SMLLC? I heard SMLLC should be avoided due to the lack of asset protection.
Hi Penny - actually I think that strategy will still remain valid. The whole point with the holding companies is to separate the assets out of the active, operating business because that’s where the lawsuit target is. A dental practice is a great example - lots of expensive equipment. If a patient was injured by a technician, they would have a lawsuit against the operating dental practice, and a potential claim on the expensive equipment. Moving the expensive equipment out of the operating practice and leasing it back would help to lessen the risk. The leasing company may get named in the suit, but not necessarily found liable.
Does that make sense?
Hi Ally
No, I don’t think you will need to close anything - the Tax ID Number is staying with the entity and that’s what everything else is hanging off. I think you’ll wind up needing to notify banks and vendors that the company has changed its name - just the same way you would in any other typical business change circumstance.
To make the change at the Secretary of State level, in state or out of state, you would need to do something called a conversion - we’ve talked about it on the Forum. It’s the other half of the equation, really. Changing at the IRS is one half, changing at the Sec of State level is the other. Not hard to do - a filing fee, and some paperwork. In your case, you would likely make the conversion in the base state, and then I’d want to talk to the foreign registry to see if we could circumvent having to do the conversion filing in both states. My guess is no, they’ll want it done in both, but I wouldn’t know without actually going through the steps … and each two states are going to be different.
This particular IRS letter ruling addresses going from an S Corporation to an LLC taxed as an S Corporation, without rolling the assets out, paying tax on them and then rolling them back into the new entity. Converting an S Corporation to an LLC taxed as a sole proprietorship would be a different animal with a different tax consequence. Not sure if you’d want to do that, unless the S Corporation was the wrong entity for tax purposes and you wanted to go to passive taxation.
Thanks for the reply, Megan. I’m with you on the active operating practice being the lawsuit target and minimizing the target size. But with the risk protection that the LLC provides with the charging order remedy, is it still worth the extra effort to maintain a separate company for assets? Or does this reduce to Diane’s favorite answer, “It depends,” and depend on the size of the business assets potentially at risk? Seems to me that first layer of protection just got beefier with a change to an LLC to discourage frivolous suits and that the holding company provides for the case where you might actually lose.
And here’s an unrelated but important question. Since the S-corps were just recently allowed to deduct medical insurance premiums for owners and shareholders, is this deduction still allowed with the change to an LLC taxed as an S?
Thanks!
Penny, as far as how many entities: I look at two primary issues. (1) What is the total value of business at risk? (2) What is the inherent liability with the business?
As an example for Question (2): You might have an Internet business that sells affiliate products. That’s probably pretty low risk. Or, you could be a OB/Gyn, which is very high risk.
On the second question: The LLC-S is subject to all the same rules and regs of a regular S Corp. So, yes, the medical insurance rules for the S Corp are exactly the same for the LLC-S.
Hi Penny,
It’s definitely an “it depends” answer. In this case, it depends on who the lawsuit is being brought against — you or your business. There will be fundamental differences in how the two are treated.
For example, you hit someone with your car and get sued personally. Your insurance can’t/won’t cover you for whatever reason. The plaintiff’s lawyer is checking out your assets to see what’s what. Your LLC ownership interests are largely untouchable, as are the assets within them. That’s where the Charging Order kicks in. In that instance, one LLC, two LLCs, it doesn’t really matter.
Now, flip this and say that one of your LLC’s employees runs someone down while on company business. They are sued personally, and your LLC is named using the doctrine of vicarious liability (i.e., my time=my dime). Now the assets in your LLC are at risk - because the LLC is being named as the defendant - not you personally. This is where the 2nd LLC that holds the equipment factors in. It’s not an employer, so there is no liability attaching there. The plaintiff can sue your operating company, but it will have minimal assets to satisfy a judgment - because all the good expensive stuff is kept safe.
Thanks, Diane. It seems also that if the holding company has potential to lease to more than just the higher liability company, then you’d also want that separation of church and state, so to speak.
I do have another question for Megan on the company name change. Do you have to change your company name if it has “Inc.” to “LLC”? Would I have to change “My Cool Business Inc.” to “My Cool Business LLC”? Or should you just name it “My Cool Business”?
I am trying to start a web based business (online community) in California which I will mostly likely not be making money until the website has been developed and enough traffic creates value to sell advertisement space (i.e. high costs and possibly no revenue first year). Like many conservative entrepreneurs, I don’t know if an LLC might be the ideal structure since it would add around $800 annually without having any substantial revenues. I have considered an S Corporation or a sole proprietorship initially since it is taxed at the individual level and there is less risk initially in a start-up. Let me know if I am off base.
I guess the following questions can apply to a majority of start-ups.
Should I start off with an S Corporation or a sole proprietorship destination to lessen the burden of the $800 fee?
When can one elect to change from an S corp. or sole proprietorship to LLC status if appropriate?
I don’t like the Sole Prop idea because of the audit risk (1 out 7). For me, I’d take the LLC-S approach right now and be done with it.
Let’s see what Megan says.
Hi Penny - sorry I missed this comment!
Yes, if you do the conversion from an S Corp to an LLC (taxed as an S Corp) your business name will change as well. That will happen at the Secretary of State level, when you file the Articles of Conversion. LLCs are required by law to have the word “LLC” or some derivative (L.L.C., Limited Liability Company, etc.) at the end of their names.
You don’t want to drop the Inc or LLC from the end of the company name for liability reasons, too. If someone thinks you’re a sole proprietorship under a d/b/a and sues you over a company debt, you could have a tough time proving that you weren’t personally liable for the debt.
The $800 fee is going to hit you with the S Corporation too, although not immediately. For some reason the FTB gives S Corporations a break in their first year and doesn’t make them pay the tax until their first tax return is due. If you formed an LLC and elected S Corp tax status, the same thing would apply.
The only way to avoid the $800/year franchise tax is to stay a sole proprietorship. And while the business you are describing seems to be very low risk (probably the biggest liability issues will be over paying the bills?), the audit risk is much higher. I think I’d personally look at the $800 as just another start-up cost and go forward.
In terms of changing tax status, you can start as a sole proprietorship and subsequently incorporate into an entity. If you incorporate a business to begin with and think you may change later, then I like the LLC because it lets you do that without having to go through a conversion process (and payment) at the Secretary of State level.
Thanks Megan/Diane.
I have heard that as an S corporation (possibly LLC-S Combo) losses may not be taken currently if the funds are from a bank loan. I believe it is different if funds provided by the owners.
How are these losses treated over time if the funds are coming from a bank loan?
Hi Megan & Diane,
Here’s another twist to the holding company/operating company strategy and being sued personally. If you have an S-corp operating company and form an LLC holding company for the assets, is it still worth converting the S-corp operating company to an LLC-S for asset protection? If the key strategy is to stream assets, including profits, to the holding company via leaseback arrangements, then the service company could essentially operate at a break even point.
So if there isn’t anything to go after in the S-corp if you are sued personally, does this also have the effect to discourage lawsuits? If you have good insurance in place at the personal level, then there is also that layer of protection (we have a $2M umbrella).
Your thoughts are greatly appreciated!
Hi Penny,
Overall that’s a great strategy - keep the S Corp lean, so there’s not much to grab. You can’t gut it completely - you still need to have reasonable operating expenses covered, or you risk someone attacking it as an undercapitalized “shell” company that you’re hiding behind. But you don’t need to leave extra money lying around in it, either.
That takes care of the S Corp being sued directly, by a creditor, disgruntled client, etc. But what if you are sued personally? Your shares in the S Corporation could potentially be seized by a creditor. Your interests in an LLC could not. That’s the kicker for me in terms of asset protection.
Thanks, Megan. As I mentioned, right now we have a pretty high umbrella insurance policy on the personal side, so any personal suit would need to be beyond that.
So then what reasons would there be to have a regular S or C instead of an LLC-S or LLC-C?
Hi Megan,
If you a retaining the same FEIN number are you saying that this is merely a name change with the IRS and the S-Corp election remains in effect? Or will it default to a disregarded entity in absence of newly electing S-Corp status?
Hi Bob,
The letter ruling is addressing situations where the S Corporation still wishes to retain S Corp tax status but move into an LLC structure. The assumption is there will be no change in the tax classification. So yes, I guess essentially the IRS is looking at this as you said - nothing more than a name change, really.
If you wanted to switch from an S Corporation to an LLC taxed as a partnership or as a disregarded entity the rules would be different.
Thanks Megan,
Going one step further- would a Type F reorganization also work? (i.e. going from an S-Corp to a new LLC with elected S Corp tax status)
Hi Megan,
Can you please provide the reference number for this IRS ruling?
I cannot seem to find any evidence of it on the IRS website.
Thanks!
My husband and I have an S corp in Commonwealth of Virginia. We switched from sole proprietorship to S Corp in the year 2000 with intention of growing the business. Things happened since then that prevented this growth. Now I am interested in switching back to sole proprietorship to avoid and lessen all the paperwork involved with the S Corp. Also we would only file one tax return instead of 2. It was much simplier in my opinion when we were sole proprietorship. But we are considering the hit we will take as you described in other posts above involving converting assets. Is there a source I can look at to compare switching back to sole proprietorship versus switching to LLC with S Corp taxing?
Also, we have a sizeable amount owed back to the “Owner’s Equity” for the sub corporation. How is the owner’s equity figured into the switching, do we pay taxes on it, etc. Owner’s equity funds have already been taxed as those funds were initially claimed as income for services before it was borrowed out of business through the owner’s equity. (Hope these questions make sense). Thanks, Tricia.
Tricia, you should post this in the First Class Lounge - the comments on a blog post don't get much attention. I think there LOTS of reasons you don't want to change back to a sole proprietorship.
If you aren't a member of the FCL you can join for 30 days for free, so post your question there and I'm sure you'll get lots of information on this subject, especially from Diane. We just covered business entity pro's and con's at the 3-day Tax Seminar in Phoenix and the SP really is not a good entity for many, many reasons.
Mary
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