The business you set up as a sole proprietorship, partnership, or LLC is doing well. Revenues are increasing and you need to grow. In such situations, it may be advantageous to change your organizational structure to a subchapter S corporation.
Reasons to Consider an S Corporation
In general, a corporation offers more flexibility for growth than other types of business entities. Venture capitalists and other potential investors often prefer to invest in corporations, rather than in entities such as LLCs—some even restrict their investments to corporations. Commercial lenders are generally more familiar with the corporate structure and may therefore be more likely to lend to a corporation.
Another reason to consider an S corp. is if you may want to create a reward or incentive system that allows employees to acquire an ownership interest in the business. With an S corp., you can give employees shares of stock, which is easier than adding them as new partners or LLC members.
Not all businesses can be organized as an S corp. To elect this type of business entity, a company must comply with all of the following limitations:
- It may not have more than 100 shareholders.
- It may issue only one class of stock.
- It may not offer shares of stock to the general public.
- It may not have shareholders who are not U.S. citizens or residents.
- It may not have shareholders that are other corporations, LLCs, partnerships, or trusts.
Keep in mind that switching to an S corp. comes with a few increased administrative burdens, such as complying with legal requirements for record keeping, holding periodic shareholder and officer meetings, and filing periodic government reports.
Converting a Sole Proprietorship
If your business is currently a sole proprietorship, you may want to change to an S corp. for the reasons mentioned above. The only way a sole proprietor can take on new investors is to change the entity to a partnership, LLC, or corporation.
Another primary reason that many sole proprietors change to an S corp. is to limit personal liability for business debts.
However, both an LLC and an S corp. offer limitation of liability, as well as the option of having your business taxed in the same manner as a sole proprietorship. So before jumping to an S corp., be sure you understand the relative benefits of an S corporation versus an LLC.
Converting a Partnership
If you are currently operating as a partnership of some sort, taking on new investors can be fairly complicated. The process requires complying with the terms of the partnership agreement, which usually involve getting the approval of any existing partners. This can be burdensome, especially if you anticipate adding more investors periodically. Changing to a corporate structure makes it easier to add investors by selling shares of stock to them.
Another advantage of converting is liability. If some or all of the partners do not have limited personal liability, changing to an S corp. provides all owners with limited liability.
Converting an LLC
New companies often choose an LLC over a corporation because there are fewer legal requirements governing the administration of an LLC, whereas the tax ramifications are the same. As revenues increase, a point is often reached where an S corp. has tax advantages over an LLC, including:
- Lowering the self-employment tax. LLC profits are considered to be self-employment income of the members and are therefore subject to self-employment tax. Profits of an S corporation are taxed to the shareholders as dividends, which are subject to income tax but not to self-employment tax.
- The ability to make greater contributions to retirement accounts. An S corp. may be able to set up various types of retirement plans that are not available to LLCs and other types of entities.
State law may limit the number of owners of an LLC. Changing to an S corp. allows your business to have up to 100 investors.
Even if you elected to have your LLC treated as an S corp., your state may still tax it differently than a corporation. Changing the entity from an LLC to a corporation may be necessary to obtain the desired state tax treatment.
Forming an S Corporation
Regardless of how your business is currently organized, forming an S corporation begins with creating corporate documents, including articles of incorporation and bylaws. These documents replace the partnership agreement or the articles of organization for an LLC.
The filing of articles of incorporation creates a C corporation. You then need to make an S corp. election, which notifies the Internal Revenue Service (IRS) that you have chosen to have your corporation treated as an S corporation rather than as a C corporation.
Changing your business to an S corporation should only be done after careful consideration of how this will change your tax liabilities. Consultation with a tax expert is strongly advised.