Benefits of Converting S Corporations to LLCs
By: Morris Law Group - March 15, 2015
Operating a business in an S corporation is a relatively common practice for many business owners. S corporations avoid the double taxation that inherently occurs with C corporations, and to a large extent, they avoid the self-employment taxes that are normally imposed on limited liability companies (“LLCs”) opting to be taxed as partnerships. While dividends from S corporations are not subject to self-employment taxes and are therefore preferable for income tax reasons, S corporations do have a weakness from the standpoint of asset protection.
Stock in S and C corporations can easily be accessed by judgment creditors. In that sense, the stock in a small family business is just as easily transferrable through adverse litigation as stock in a Fortune 500 company that trades on a major public stock exchange. This is obviously a risk that needs to be addressed if you have accumulated significant assets inside of an S corporation. Otherwise, a judgment creditor could potentially take ownership of your S corporation stock and could potentially force the sale of corporate assets or a complete liquidation of the company. Few results could be worse when it comes to your wealth.
While S corporations have stockholders (which means that the stock can be seized by judgment creditors), LLCs have members. This difference is quite significant. Think of an LLC as a country club that has members. While membership has certain privileges and an ascertainable value, the country club gets to decide who it wants to allow as a member. The same is true with an LLC. You get to decide upfront who can permissibly become a member (i.e. owner), which means that if your LLC documents are drafted properly, a judgment creditor will never gain voting rights or have an opportunity to access assets held inside the LLC. In short, a judgment creditor will never be invited to “join the club.”
From the standpoint of wealth preservation, it should be clear that an LLC is a far superior vehicle in which to run your business.
If you currently have an S corporation, there is still hope! You can convert an S corporation to an LLC under state law without adverse federal tax consequences, provided that ownership of the new LLC is exactly identical to the ownership of the corporation.
The newly converted LLC can elect to continue being taxed as an S corporation after filing IRS Form 8832, which means that you can continue to avoid adverse self-employment taxes. Everything else remains the same with your business entity. All the assets and liabilities of the new LLC will be the same as the preexisting S corporation, and title in real estate will automatically vest in the newly converted entity. In Revenue Ruling 73-526, the IRS stated that the new entity can even operate under the same taxpayer identification number.
Again, given the current state of the law, there are few if any good reasons to continue operate in a corporate structure rather than in an LLC, especially if you are concerned about creditor protection. This is a technical area of law that requires precise legal planning, but it is possible to achieve a higher level of protection. If you have questions about this topic, or if you’d like to have us evaluate an existing S corporation to determine if it is a good candidate for conversion, please contact our office.
** Disclaimer Required by IRS Circular 230** Unless otherwise expressly approved in advance by the undersigned, any discussion of federal tax matters herein is not intended and cannot be used 1) to avoid penalties under the Federal tax laws, or 2) to promote, market or recommend to another party any transaction or tax-related matter addressed.