The other day, a colleague of mine (who works in an unrelated practice area) messaged me wanting to refer a client who wanted to “convert an LLC to an S-Corp”. As a Phoenix business lawyer, I frequently get this question (or some version of it) from new entrepreneurs or business partners looking into forming a new business entity, as well as business owners who formed their LLC some years ago and are now having second thoughts on the IRS’ default tax treatment of LLCs.
The difference between legal entity selection and taxable entity election
The confusion is understandable. The problem stems from the fact that LLC owners are really dealing with two separate issues; when it comes to forming a legal business entity (at least here in the United States) there is the legal side and the tax side.
Issue 1: Choice of legal entity to operate your business
The legal side revolves around the question of which form of legal business entity you want to use to conduct your business and, based upon your decision, the filing of the appropriate paperwork to have that legal entity registered with your state’s governmental agency responsible for registration. Here in Arizona, for example, the Corporation Commission is responsible for registering limited liability companies. There are many good reasons why you would want to operate your business out of a legal business entity, limited personal liability being high up on the list, and the pros and cons of each legal business entity will depend on a variety of factors, but that topic is beyond the scope of this article. Here in Arizona anyway, your legal entity could be (for example) a for-profit corporation, a limited partnership, professional LLC, etc., etc. So what, then, is an “S-Corporation” anyway? For that, we look to the second question business owners must ask themselves when forming a new business entity.
Issue 2: Tax treatment of your legal business entity
As if the choice of legal business entity weren’t confusing enough, in most cases the Internal Revenue Service also lets you choose how you want your legal business entity to be treated for tax reporting purposes (assuming you do not want to accept the default tax treatment for your particular legal business entity). This is the “tax side” of the equation. For most LLCs that qualify, one of these options is to have your LLC treated as an “S-Corp” (so named because of Subchapter S of the Internal Revenue Code).
Therefore, even though you are legally formed as an LLC, for tax purposes the IRS can actually treat your company as something else if you make that election for your LLC. It is always best to consult with a qualified CPA or tax advisor to decide which tax treatment would be advisable for your given tax situation. They can also assist you with completing and submitting the appropriate IRS form to make the selection. It is also much easier to make the appropriate election at or near the time of the legal business entity formation, rather than waiting too long, which could lead to tax complications.
While it was not clear from my colleague’s question whether their client wished to perform an LLC to S-Corp converstion for tax purposes, or an actual legal statutory merger from an LLC to a corporation under Arizona law, the takeaway is that new business owners should understand that the choice of legal business entity and the election of tax treatment of that entity are two different things.
Conclusion: Know how you want your LLC to be treated for tax purposes
While an experienced business attorney can help you evaluate your options and select the appropriate legal business entity, you should always involve your qualified CPA or tax advisor in this process, as well (the earlier the better) in order to make the right taxable entity election at the same time as, or as soon as possible following, the formal registration of your business with the appropriate governmental body in your state.
Ben Bhandhusavee is the Managing Attorney for BhandLaw, PLLC, a Phoenix business and technology law firm working with start-up companies, creative intellectual property, Internet and digital media matters, and complex corporate M&A and technology transactions. Ben can be reached at (602) 678-2970 or by e-mail at firstname.lastname@example.org