S corporation to LLC: The Path to Expansion and Appreciation
Jim Schultz, a Principal at Cendrowski Corporate Advisors, and head of the Chicago business valuation practice, discusses the benefits of switching from an S corporation to an LLC. Discover how this strategic entity structure move can revolutionize your business, reduce income taxes, attract new investors, and enhance future growth and appreciation.
Move assets from S corporation to LLC: Opening Doors to Growth
Unlocking the potential of your business begins with your S corporation creating a subsidiary LLC. Once the LLC entity is formed, the S Corp assets can typically be transferred tax-free to the single-member LLC.
The next step is to have the sole member create an operating agreement allowing new members to invest in the LLC. Even the original shareholders in the S corporation can contribute individually to the LLC to become individual members. The result creates room for entity expansion and welcomes new investors of various types. Unlike the limitations an S corporation imposes on its shareholders, the LLC offers greater freedom to explore new avenues of growth and new equity sources.
This process allows the individual members to benefit by sharing in the presumed positive growth of the expanding business. This transition to an LLC structure provides the flexibility required to foster business growth.
Tax Benefits: From Disregarded Entity to (Non-)Taxable LLC
Transferring S Corp assets to a wholly owned subsidiary LLC marks a pivotal step in the shift from S Corporation to LLC structure, and it offers a notable advantage because it does not incur a taxable event as it has a disregarded entity status.
However, when the subsidiary decides to open membership to new investors, including individual S corporation shareholders per above, the entity undergoes a shift. It becomes a “taxable LLC” since there is more than one owner, which eliminates the disregarded entity status.
This change typically does not trigger any taxable event. It simply means that you must file an actual tax return separately, but LLCs do not pay federal taxes at the entity level. Instead, they pass through the income or loss to be resolved at the member level status. This transition allows the business to adapt to new circumstances while enjoying the benefit of a non-federal tax status at the LLC level.
A key feature of an LLC is that it provides tax basis increases from certain entity liabilities to the members to allow losses to pass through to the members in excess of above their contribution basis. This is especially significant in real estate investments.
What is a Disregarded entity?
A disregarded entity is a business entity that (1) has a single owner, (2) is not organized as a corporation, and (3) has not elected to be taxed as a separate entity for federal tax purposes.
Preferred Equity Freeze: Maximizing Appreciation Potential
Another option to consider during this process is implementing a preferred equity freeze. By converting the S corporation’s membership interest in the LLC into preferred equity, the S corporation effectively locks in the value of its interest, preventing future appreciation from being attributed to that specific interest.
New members receive their distributions/profits after payments for the preferred equity interest. They can also take advantage of the LLC rules noted above and more. This allows them to avoid many limitations of being an S corporation. This approach adapts well for the individual members and applies to various transformations within the LLC.
F Reorganization: An Alternative Approach
If it’s not possible to transfer assets directly because of legal or financial limitations, an F reorganization can be another option. This three-step process involves transferring assets to qualify as a “reorganization” under federal law, accompanied by additional capital infusion. Although more complex, an F reorganization can provide the desired outcome for businesses seeking a transition from S corporation to LLC.
What is an F Reorganization?
An F-reorganization is a tax-free reorganizational structure that often involves a target company taxed as an S-corporation. The F-reorganization changes the target’s form without affecting its substance for tax purposes.
Embrace the Power of Transition from an S Corporation to LLC
Discover more strategic insights of transitioning from an S corporation to an LLC with James Schultz, a featured expert in the GGI Estate and Planning Newsletter’s 2023 Spring edition. Unlock your business’s true potential with greater flexibility, increased investor opportunities, and optimized growth potential. Trust James Schultz and the Cendrowski Corporate Advisor team to help your business grow and explore new opportunities.
Since 1983, Cendrowski Corporate Advisors (CCA) has been providing expert client service from their offices in Bloomfield Hills (MI) and Chicago (IL). Specializing in tax planning/consulting, family offices, dispute advisory, business valuation, forensic accounting, and risk management.