Over the years, your business’ needs may change. For example, you may have preferred to keep things simple at the beginning, but as your business grows, you find yourself needing more out of your business structure than just simplicity.
While it’s optimal to pick the right business structure from day one, first-time business owners can’t always anticipate what they will need down the road. Furthermore, what may have worked well during your first few years may not be optimal as your revenue and business grow.
It’s important to realize that your business structure isn’t set in stone. It is more than possible to make changes as needed. The procedures aren’t necessarily complex, and typically involve a few legal steps, like a merger or the dissolution of an old entity.
Here are some common scenarios of business structure conversions. Keep in mind that any changes can have a significant impact on your taxes, so it’s best to speak with a tax advisor if you have questions about your particular situation. In addition, specific conversion procedures will vary by state. You can check with your secretary of state’s office or legal filing service to determine the specific steps required.
Scenario 1: Sole Proprietorship to an LLC
Jenny launched a consulting business in the spring. Since she didn’t form an official business entity, her business by default was structured as a sole proprietorship. She recently learned that this business type put her family’s assets at risk in the event a client sued her business or she couldn’t pay its bills.
To minimize her personal risk, she decided to form an LLC (Limited Liability Company) for her business. An LLC, like a Corporation, separates the business owner(s) from the business, helping to minimize the individual’s personal liability. Most LLCs are “pass-through” entities, meaning that their owners (referred to as members) pay taxes on the income of the LLC. The business itself does not pay taxes on its income.
Changing from a sole proprietorship (or partnership) to an LLC isn’t actually considered a conversion, since the sole proprietorship wasn’t an official business structure in the first place.
In this case, Jenny needs to form an LLC by filing the Articles of Incorporation form (also called Articles of Organization) with her state. She decided to file her paperwork so that her LLC would start at the beginning of 2015. In addition, if her sole proprietorship was operating under a different name (like Top Hat Consulting) using a DBA and she wants to continue using that name, then she just needs to open the DBA under the LLC.
Scenario 2: C Corporation to an S Corporation
Phil created a Corporation for his e-commerce business, and was surprised to learn how he was taxed. As a C Corporation, his business paid taxes on its profits, and then when Phil distributed those profits to himself, he needed to report them on his individual tax return as well. This is what’s called “double taxation” and can be costly for small business owners that opt to take their profits out of the business.
His tax advisor mentioned that he would be able to lower his taxes using the pass-through tax treatment of an S Corporation. An S Corporation is not subject to federal income tax. Instead, the S Corporation is considered a ‘pass through’ entity, and the company shareholders pay income tax on their share of the profit.
Changing from a C Corporation to an S Corporation is one of the easiest changes to make, but is time sensitive. This change is performed with the IRS, not the state, and only affects your taxes. This move is often called “electing S Corporation tax treatment.”
To make the change, you need to file IRS Form 2553 no more than 75 days from the date of incorporation, or no more than 75 days from the start of the current tax year. For example, if you launched your Corporation on September 21, 2014, you must file by December 5th in order to have it apply to your 2014 taxes. Otherwise, you will need to file the form by March 15 to have S Corporation status apply to your 2015 taxes.
Not everyone can form S Corporations. The IRS requires that all S Corporation shareholders be individuals (not LLCs or partnerships) and legal residents of the U.S.
If you are not eligible for S Corporation status, and you still want to change your C Corporation status, the steps are more involved and will vary state-by-state. In many cases, you will first need to dissolve the C Corporation and then form a new LLC for your company. You should speak with a tax advisor before undergoing this process.
Scenario 3: LLC to a Corporation
Samantha launched a software company several years ago. At the time, she was just looking to minimize her personal liability and keep things as simple as possible. As a result, she was advised to form an LLC. Years later, her business grew and she started considering VC funding. For numerous reasons related to stock ownership and taxation, investors prefer to deal with Corporations rather than LLCs.
Before Samantha began courting outside investors, she switched her LLC to a C Corporation. She made the change before she got the funding, since it would be more complicated to switch business structures after others are involved in the company ownership.
If you are interested in converting an LLC to a corporation, keep in mind that the exact steps involved vary based on the corporate laws of your LLC’s state. In Samantha’s case, she created a new C Corporation and then made the original LLC a subsidiary of the Corporation. However, many states now offer a more streamlined conversion process that lets you convert your LLC to a corporation by filing forms with the secretary of state’s office.
When Your Needs Change, so Can Your Business Structure
The bottom line is there is no reason to stick with a business structure that doesn’t work for your situation any more. It’s possible to convert your structure once your needs change, and in most cases, the process is easier than you think.
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