Converting a California LLC to an S-Corporation
August 2009 - Does your client want to convert their limited liability company (LLC) to an S-Corporation and continue to have the profits and losses flow through to its members? Did you know that you can convert an LLC into an S-corporation for tax purposes by making an election?
An LLC can elect to be classified as an association taxable as a corporation. An association can be taxed as a corporation by election under the default rules in Internal Revenue Code (IRC) Section 301.7701-2a.
If an LLC elects to be classified as an association, it is deemed that it contributes all of its assets and liabilities to the association in exchange for stock in the association. Immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners.
To become an LLC taxed as an S-corporation, the eligible LLC can use the IRS Form 2553, Election by a Small Business Corporation, to elect to be treated as an S corporation. The LLC must meet certain tests to be eligible to be treated as an S corporation. It does not need to file Form 8832, Entity Classification Election (see article in last month’s Tax News). The federal election automatically applies for state tax purposes once it has been accepted by IRS. The classification must be the same for both state and federal tax purposes.
An eligible entity must meet all of the following tests to elect to be treated as an S Corporation:
- It is a domestic corporation or a domestic entity eligible to elect to be treated as a corporation, that timely files Form 2553 and meets all the other tests.
- It has no more than 100 shareholders.
- Its only shareholders are individuals, estates, exempt organizations described in IRC Section 401(a) or 501(c)(3), or certain trusts described in IRC Section 1361(c)(2)(A).
- It has no nonresident alien shareholders.
- It has only one class of stock. See Regulations Section 1.1361-1(l) for details.
- It is not one of the following ineligible corporations.
- A bank or thrift institution that uses the reserve method of accounting for bad debts under Section 585.
- An insurance company subject to tax under subchapter L of the Code.
- A corporation that has elected to be treated as a possessions corporation under Section 936.
- A domestic international sales corporation (DISC) or former DISC.
- It has or will adopt or change to one of the following tax years.
- A tax year ending December 31.
- A natural business year.
- An ownership tax year.
- A tax year elected under section 444.
- A 52-53-week tax year ending with reference to a year listed above.
- Any other tax year (including a 52-53-week tax year) for which the corporation establishes a business purpose.
- Each shareholder consents as explained in the instructions for column K.
For more details on the eligibility tests see the IRS Instructions for Form 2553, Election by a Small Business Corporation.
An LLC that is classified as an S-corporations must file California Form 100S.
Note: There may be tax and legal consequences in electing to be treated as an S-corporations. Taxpayers may wish to seek further advice from an expert before making an election.