What is Entity Conversion?
Have you talked to an accountant, CPA or even a fellow business owner, and that individual tells you “You need to be an S-Corp,” but you have a limited liability company (or LLC) and think you made a mistake in forming your LLC?
Or, do you have “buyers remorse” over the previous formation of your company for some reason, and wish you had formed a Corporation instead of a LLC, or maybe visa-versa, finding the formalities and requirements of a Corporation is a bit much, and wished you had formed a LLC instead?
The Two Issues with Company Setups: Entity Type and Tax Status
Simply put, an Entity Conversion enables you to change the type of entity your business organization is, <strong>in the state it is formed</strong>. An Entity Conversion will not help you move your company from one state to another. Nor, will an Entity Conversion enable you to do business in another state (that’s for Foreign LLC’s and Foreign Corporations, depending on what entity type you currently have.
But, let’s not get ahead of ourselves. It’s important to understand the fundamentals, before evaluating whether an Entity Conversion is right (or necessary) for you.
When forming a company, there are two aspects of formation that are often so interchanged it can be confusing for most people: tax status and entity type. It’s confusing, because “S-Corp” can mean “an entity taxed under Subchapter S” or it can mean “a corporation taxed under Subchapter S”. Because a Corporation is one of the oldest forms of business entities, and because Corporations had two types of tax treatments (i.e. S-Corp and C-Corp), it became common-practice to simply merge the two issues together to reference the type of entity and its tax status. Hence, “S-Corp” and “C-Corp”.
This nomenclature, however, has surpassed its usefulness in today’s world of “B-Corporations”, Cooperatives and other types of business entities, but most importantly, because of limited liability companies (LLC’s).
LLC’s are a state formed entity type, and the IRS was really never in on the process. Instead, the IRS presumed various tax status, depending on how the entity was being used and/or ownership. The IRS — for limited liability companies only — devised the following four (4) tax statuses for LLC’s:
- Disregarded. This only applies to LLC’s that have one owner (or a husband and wife in a community property state). It means the LLC is “disregarded” for tax purposes. It’s like it doesn’t exist at all. Instead, all the company’s profits and losses flow through directly to the owner, as though the owner has no corporate entity at all. You report your income on Schedule C of the Federal Tax Return. A disregarded entity is considered a “pass through” entity. This is the default tax status when you apply for your FEIN with one owner (or with husband and wife as the only owners in a community property state).
- Partnership. This applies to multimember LLC’s, and cannot apply to LLC’s that have just one owner (although it can apply to a husband and wife team, even if they live in a community property state). The entity is taxed like a partnership. It issues K-1’s. Profits and losses can be distributed in whatever form the partnership decides, and is not subject to the restrictions of Subchapter S. A partnership is considered a “pass through” entity, and is the default tax status when you apply for a FEIN with a multimember LLC.
- Subchapter S (usually called “S-Corp”). This applies to LLC’s that submit IRS Form 2553 who wish to tax themselves, well, like an S-Corporation. The company issues K-1’s, and the profits and losses flow-through to the owners pro-rata according to ownership percentages. There are numerous limitations to S-Corporation status, and if you violate one of the limitations, the IRS will default you to a C-Corporation, which could be absolutely disastrous from a financial perspective. This is the last form of “pass through” entity.
- Subchapter C (usually called “C-Corp”). This applies to LLC’s that submit IRS Form 8832 who wish to tax themselves like a C-Corporation. Subchapter C is the only tax status that is not pass through. Instead, the company is taxed like it’s a person, and pays its own tax. This can lead to “double taxation,” when the company pays taxes on its profits, and then when it pays you a dividend, you pay taxes on those dividends. Because of this, it is not favored for many instances.
When someone asks or tells you that your business should be an “S-Corp,” it raises the question: “Are you referring to just the tax status, or are you saying a Corporation taxed under Subchapter S would be better than my LLC taxed under Subchapter S?”
In certain rare circumstances, especially because of Trump’s Tax Reform Act of 2017, officially called the Tax Cuts and Jobs Act of 2017, there are some instances where the answer to that question is “yes”, but typically for C-Corporations.
Therefore, Entity Conversion can simply mean “change the tax status.” This is relatively easy to do, but it requires more than simply sending in the forms. If you have a LLC, you will need to change the Operating Agreement. If you have a Corporation, you will need a Corporate Resolution and may need to update or revise the Bylaws, Buy/Sell Agreement and/or Shareholder Agreement, depending on what formation documents you have.
Changing the Entity Type is Harder
Most states (not all, specifically Montana, New Jersey and New York) support Entity Conversions. By filing the appropriate documents, it’s possible to actually change your entity type from a Corporation to a LLC, or visa-versa. Like changing the tax status, it takes more work than simply filing a conversion with the state. You need to make drastic changes to your formation documents. The legal name of your company will most likely change.
But, it is possible to change from a LLC to a Corporation, or visa-versa. We’ve seen requests for this in the following scenarios:
- Investor wants to invest in a Corporation, not a LLC
- You actually do have a tax advantage in changing the entity type, not just the tax status
- You eventually want to “go public” (although it is technically possible to go public with a LLC)
- Certain licensing requirements require a “professional” entity, instead of a non-professional entity (i.e. PLLC or PC, instead of a LLC or Corp)
- You want to be able to put “Corp” or “Inc” in the name. You cannot do this with a LLC.
We want to warn you, though, that changing the Entity Type is a lot of work. Aside from what I mentioned above, you also need to notify vendors and contracted parties of the name change (i.e. because your legal name will change). You may need to change business cards, signage, etc.
Also, your processes change. Your corporate formalities change. If you have a LLC, you’re used to following the requirements in your Operating Agreement, plus your Operating Agreement acts like a partnership agreement. Corporations don’t have Operating Agreements. They have Bylaws (which are very formal, and don’t contain language about partner requirements and duties), therefore you will need a second document (i.e. Shareholder Agreement and/or Buy-Sell Agreement) to spell out the partner requirements and duties.
Similarly, LLC’s don’t have Bylaws nor Shareholder Agreements. It is important to consider that these are very different documents, and you will need to spend some time and effort (i.e. legal costs) to convert your formation documents from one entity type to another.
This is why we recommend you carefully consider this, and if your intended tax gains are possible with simply a tax status change, then you do that and avoid an Entity Conversion.
Confused about all of this? We do offer a 30-minute tax attorney consult, and we’re happy to have a three-way conversation between ourselves, yourself and your CPA or Accountant.
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