In this article, we examine some of the reasons that might motivate a conversion from a California Limited Liability Company (LLC) to a California S-Corp, as this is a significant decision that can have profound implications on the taxation, liability, and overall structure of your business entity.

We also examine the mechanics of converting a California LLC into a California S-Corp with a summary of the steps required.

Introduction to a California LLC and a California S-Corp

Before we explore further, we first must understand what is a limited liability company and S Corporation in California.

California LLC

A California Limited Liability Company is a business structure allowing owners, also known as members, to limit their personal liabilities while enjoying the flexibility benefits of a partnership and the ability to choose the tax benefits of either a sole proprietorship or partnership by default or corporate taxation or S Corporation taxation by making an election.

California S-Corp

On the other hand, a California S-Corp is a California Corporation that has elected to be taxed in accordance with Subchapter S of the Internal Revenue Code. S Corporation taxation in California provides the tax benefits of being singularly taxed at the shareholder level, thereby avoiding double taxation, and not being subject to self-employment tax.

Differences between LLC and S-Corp in California

There are several key differences between a California LLC and a California S-Corp.

Tax Differences Between an LLC and S-Corporation in California

By default, an LLC in California is a pass-through entity, meaning the profits of a California LLC are passed through to the individual tax returns of the owners, and owners then pay personal income tax on those profits. However, an LLC in California may elect corporate taxation if it desires to be subject to double taxation, or S Corporation taxation as well.

An S-Corp, however, allows business owners to be treated as employees and they can draw salaries from the profits of the California Corporation, which can lead to significant payroll tax savings without subjecting the California Corporation to double taxation.

Management Differences Between an LLC and S-Corporation in California

Both entities differ in how they are managed.

California LLCs tend to have a more flexible management structure. The owners can manage the California LLC themselves or opt for managers to run it.

California S-Corps, on the other hand, have a more rigid structure, mirroring that of a traditional corporation with a board of directors and officers.

Profit Distribution Differences Between an LLC and an S-Corporation in California

The distribution of profits varies between an LLC and an S-Corporation in California.

In an LLC, the division of profits amongst the members is quite flexible and can be outlined in the operating agreement. In contrast, an S-Corp has a set rule that profits and losses must be allocated in accordance with the proportion of shares owned by each shareholder.

When to Convert from an LLC to an S-Corporation in California

There are several scenarios where it might make sense to convert your LLC to an S-Corp in California.

Increasing Profitability

If your business entity is increasingly profitable, converting to a California Corporation taxed as an S-Corp may allow you to save on self-employment taxes without subjecting the California Corporation to double taxation. As a California S-Corp, you can pay yourself a reasonable salary and take the remainder of your income as distributions, which are not subject to self-employment taxes. This can result in significant tax savings if managed well.

Need for a More Formal Structure

As your business grows, you may find the need for a more structured management system. A California S-Corp, being a California Corporation electing to S Corporation status, has a traditional structure with a board of directors and corporate officers, which may be more suitable for businesses that have grown beyond a small number of members.

Planning to Raise Capital

If you are planning on raising capital from investors, you may want to consider transitioning to a California S-Corp. Many investors prefer to invest in corporations due to the clarity of the ownership structure, and the ability to receive dividends, which are not subject to self-employment tax. However, other business entity choices for investors would be a California Corporation or a California Limited Partnership.

Profit and Loss Distribution

If California LLC members want to have profits and losses distributed in line with ownership percentages, the transition to a California S-Corp could be beneficial. Unlike with a California LLC, California S-Corp shareholders must receive distributions (and bear tax implications from profits and losses) in proportion to their ownership share.

How to Convert a California LLC into a California S-Corp

Converting a California LLC into a California S-Corp involves a series of steps. To convert your LLC to an S-Corp, you first need to convert your LLC to a corporation before electing your corporation to be taxed as an S Corporation.

Before beginning the conversion process, consult with a trusted corporate attorney and accountant to understand all tax implications of the conversion on your business.

Determine if LLC Members are Permissible S-Corp Shareholders

California S-Corps are subject to certain restrictions on who may be shareholders.

S-Corps are limited to a maximum of 100 citizens or permanent residents of the United States, all of whom must be individuals, certain trusts, or estates, (California S Corporation shareholders cannot be partnerships, corporations, limited liability companies, or non-resident alien individuals), and S Corporation taxation limits the California S-Corp to only having one class of stock.

It is imperative to ensure all California LLC members qualify under these restrictions before proceeding with the conversion.

Obtain a Majority Vote from LLC Members

The California LLC members must vote in favor of the conversion. Depending on the provisions of the California LLC Operating Agreement, a simple majority or a unanimous vote may be required.

This vote should also approve a written Plan of Conversion, which should detail how the rights of the members in the LLC business entity will translate into the rights of shareholders in the S-Corp business entity.

File Articles of Incorporation Conversion with the California Secretary of State

The filing process to convert a California LLC to a California S-Corp, the filing of Articles of Incorporation Conversion must be filed with the California Secretary of State and accompanied by a filing fee. Under California law, this means the filed Articles of Incorporation must include a statement of conversion indicating that it is converting an LLC to a corporation and not the formation of a new corporation in California.

These Articles of Incorporation containing a statement of conversion, when approved by the California Secretary of State’s office, officially changes your business structure from an LLC to a corporation.

Complete All Remaining Incorporation Steps, Including Filing Internal Revenue Service Form 2553

After the conversion, draft corporate bylaws (which outline how your corporation will be run), hold an initial meeting of your board of directors (to approve the initial corporate matters), and issue shares of stock to the former LLC members (and be sure not to forget the federal and/or California securities filings that will be required!) according to the ownership percentages of the former LLC members.

Next, file Form 2553, “Election by a Small Business Corporation,” with the IRS. This form officially elects your company to become an S-Corp for federal tax purposes. Remember to file this within two months and 15 days of the beginning of the tax year when the election is to take effect.

If the converted LLC was not previously taxed as an S Corporation, it may be necessary to obtain a new Employer Identification Number (EIN) from the Internal Revenue Service.

Please note that this is a generalized guide and individual circumstances can vary.

Get Expert Guidance from San Diego Corporate Law

Ready to convert your California LLC to a California S-Corp, but unsure where to start? The experienced attorneys at San Diego Corporate Law are equipped to guide you through every step of the process, ensuring a smooth transition that suits your business needs. Do not navigate this complex process alone; contact San Diego Corporate Law today for a consultation.