From LLC to S Corporation: What to Do When a Start-up Takes Off
When a business adopts a formal entity structure, it often elects either a limited liability company taxed as a partnership (an “LLC”) or an S corporation, as each entity provides certain benefits to the owners depending upon the particular facts and circumstances. During the start-up phase, a new business often reports losses on its income tax returns as a result of business deductions exceeding the revenue generated by the business. During this period, operating as an LLC taxed as a partnership provides tax savings not available to a business operating as an S corporation. The losses of the LLC pass through to the members, resulting in a reduction of the members’ total net tax liability. Losses generated by an S corporation may not pass through to the shareholders as a result of basis and/or AAA limitations imposed upon the shareholders.
Alternatively, a business operating as an S corporation possesses the potential for self employment tax savings by paying the owners/employees reasonable salaries and distributing the profits of the business to the shareholders as S corporation dividends. Ideally, a new business would utilize the LLC loss pass through during the start-up phase of its existence and subsequently convert to an S corporation once the business becomes profitable in order to take advantage of the potential self-employment tax savings.
It is possible for businesses to experience the best of both of these worlds. Conversion from an LLC taxed as a partnership into an S corporation may be achieved by a couple of different methods. One method of conversion is for the LLC to simply elect to be treated as an S corporation solely for income tax purposes, retaining its legal classification as an LLC. In the second method, an LLC formally changes its legal classification to that of an S corporation. The manner of conversion that should be utilized depends upon a business’s specific circumstances, as the form of conversion could cause differing tax consequences. These two methods are described below.
Conversion for Tax Purposes: The default tax classification for a single-member LLC is taxation as a sole proprietor, and the default tax classification for a multiple-member LLC is taxation as a partnership. Either of these types of LLCs may elect to be taxed in a manner other than the default classification by making an election with the IRS under the “check the box” regulations. To be taxed as an S corporation, the LLC elects to be treated for tax purposes as an “association” which is taxed as a corporation. The LLC then files another election with the IRS, this time to be taxed as an S corporation.
When an existing multiple-member LLC taxed under the default classification elects to change its tax classification to that of an S corporation, the conversion is treated for tax purposes as the contribution by the partnership of all of its assets to the corporation in exchange for the stock of the corporation, and the subsequent distribution by the partnership of such stock. When converting only for tax purposes, the IRS dictates the tax treatment of such conversion.
Conversion under State Law: Under Oregon Law, a LLC may be converted to another type of business entity by preparing a formal Plan of Conversion and filing Articles of Conversion with the Oregon Secretary of State. Thus, an LLC may change its legal classification to that of a corporation, and the resulting corporation may then elect to be taxed as an S corporation. Conversion in this manner is treated differently for tax purposes from the conversion of an LLC solely for tax purposes discussed above.
The IRS has published guidance outlining three different methods for achieving the above conversion. The tax treatment of a conversion from an LLC to a corporation may vary depending upon how the taxpayer chooses to structure the transaction. The first approved method for the conversion is the same as when an LLC elects to be treated as an association for tax purposes discussed above. The second approved method is to treat the conversion as a liquidating distribution by the partnership of all of its assets to the partners, and the subsequent contribution by the partners of such assets to the corporation in exchange for stock. The third approved method is to treat the conversion as a contribution by the partners of their partnership interests to the corporation in exchange for stock, causing the dissolution of the partnership upon transfer of the interests to the corporation. Although the result of each form of conversion is consistent, the particular structure chosen by the taxpayer could cause differing tax results.
In order to determine the most beneficial manner of converting an LLC to an S corporation, the particular facts and circumstances as well as the goals of the business owners should be analyzed in order to determine the structure that will likely result in the fewest adverse tax and legal consequences. Many non-tax considerations will also influence which form of conversion should be utilized. For example, real property ownership issues, business operational issues, employment issues, and estate/succession planning issues should be considered in order to avoid any unanticipated results. If you would like more information about this topic, please do not hesitate to contact our office.