Tax Implications of Converting from One Business Entity to Another

When your business grows, the structure you formed your business under may no longer be the most advantageous. Or your goals may have changed as you learned more about the industry and your community. In circumstances like these, you may wonder about business conversion—the process of changing your business’s organizational structure.

This article discusses the various business structures, their tax treatments, and how business conversion affects taxes. Next, we explore how to change your business entity type and what happens when you do.

Business Structures and Their Tax Treatment

In the U.S., businesses typically form under one of the following structures:

Sole proprietorship
Partnership
Corporation
Limited liability company (LLC)
Nonprofit organization

Most business structures require that you obtain an Employer Identification Number (EIN) from the Internal Revenue Service (IRS). This is in addition to any paperwork needed to establish a business name, pay employees, or remit sales tax. The paperwork mentioned below refers to whatever is required to legally establish and/or maintain the business entity.

Sole Proprietorships

Sole proprietorships are the least formal structure. You can create a sole proprietorship by performing business activities without filing any–or very little–paperwork with the government.

Partnerships

Partnerships come in two common forms in addition to general partnerships (GPs): limited partnerships (LPs) and limited liability partnerships (LLPs). LPs have one general partner and several limited partners, while LLPs have only limited partners. You can typically form a partnership without filing anything. However, you need to adopt a partnership agreement and file partnership tax information.

Corporations

You form corporations by filing Articles of Incorporation with your secretary of state. Those with ownership interests in a corporation are shareholders. The default corporation is a C corporation. You may elect to treat your entity as an S corporation if:

You have 100 or fewer shareholders
None of your shareholders are corporate entities
You only offer one class (type) of stock
You have no nonresident noncitizen shareholders
Each shareholder agrees to the election

C corporations involve “double taxation” because the government taxes dividends shareholders receive after the entity pays taxes. S corporations are not doubly taxed, and earnings count as personal income.

LLCs

You form an LLC by filing a Certificate of Formation or Articles of Organization with your state’s secretary of state. Those with ownership interests in an LLC are called members.

If your LLC has only one member, it defaults to sole proprietorship treatment for tax purposes. If it has two or more members, it defaults to partnership treatment. Alternatively, you may elect to treat it as a partnership or corporation.

Nonprofits

Nonprofit organizations must qualify for nonprofit status and its attendant tax exemptions. To form a nonprofit, register with your secretary of state; then apply for nonprofit status from the IRS.

Employer Identification Numbers (EINs)

Your business’s EIN identifies it for federal tax purposes. You need an EIN if you:

Have employees
Use a corporation, partnership, or nonprofit structure
File employment, excise, or alcohol, tobacco, and firearms tax returns

Essentially, you need an EIN if more people than you are involved in operating your business. Many banks also require an EIN for individuals or entities wanting to open a business bank account.

Tax Treatment by Business Structure

Different business structures bring advantages and disadvantages, especially in the tax treatment of earnings:

Taxed as self-employment—sole proprietorships and an LP’s general partner
Taxed as personal income—LP partners with limited liability, LLPs, and S corporations
Taxed at the entity level—C corporations
Tax-exempt: nonprofits

LLCs are taxed based on whether you elect to treat them differently than the default. S corporation shareholders pay self-employment tax on their salary, and the IRS may scrutinize whether the salary amount received is reasonable.

How to Change a Business Entity Type

Can I change my business type? Generally, the answer to this common question is yes. However, how to change a business entity type varies by state law, your starting structure, and your ending structure. You may use three ways to change your business entity type: direct business conversion, a cross-entity merger, or creating a new entity and dissolving the old.

Business Conversion (Statutory Conversion)

Although the specific processes vary by state, converting your business type typically involves the following steps:

Those with an ownership interest in the entity agree to convert the business
Owners create a conversion plan and vote on it
If approved, owners implement the plan
Owners file conversion documents based on their state’s processes
Owners notify other states where the entity is registered to do business and the IRS about the conversion

Each jurisdiction’s secretary of state website should provide forms and instructions explaining how to apply to convert your existing business entity to a different structure. However, certain structures cannot be converted.

Merger

You can convert one business to another by creating a new entity and then merging the old and new entities. This process may have specific requirements from state to state and typically involves meticulously drafted contracts and careful monitoring throughout.

New Entity Formation, Existing Entity Dissolution

Because different structures have different ownership and organizational structures, it may be impossible to convert the business entity directly. This limitation is particularly likely if attempting to convert to or from a nonprofit.

When conversion is not possible, you typically need to do the following:

Form a new business entity
Establish a plan to transfer the business’s assets to the new entity
Execute the transfer plan
Dissolve the initial entity

Transfer processes vary depending on the initial and final structures. Because you typically must liquidate the existing company and frequently distribute assets before transferring them to the new entity, this process can result in individual members or shareholders owing capital gains taxes.

IRS Change of Entity Classification

You might wonder how to change entity type with the IRS. Although not a proper structural change, you can request reclassification of some entity types for tax purposes. The process begins with filing a change of entity classification request. For example, you might do the following:

Revoke your election to be treated as an S corporation
Elect for S corporation status
Elect different tax treatment for your LLC

Technically, these options do not convert your business structure but can affect your tax bill.

When your business grows, the structure you formed your business under may no longer be the most advantageous.

Consequences of Business Entity Conversion

Depending on your process, you may owe a substantial tax bill. Particularly, the dissolution liquidation process may lead to a tax liability for everyone who receives an interest in the company, even temporarily. In contrast, direct conversion typically does not incur additional tax liability.

Typically, regardless of tax consequences, you’ll need a new EIN when you convert between business structures. Exceptions include:

Becoming a division of a corporation
Being a surviving corporation after a merger
Electing taxation as an S corporation
Converting at the state level without changing business structure (e.g., transitioning from an LLC treated as a corporation to a C corporation or vice versa)

In short, if your business operates the same way after conversion, you typically do not need a new EIN.

Converting Your Business Entity

How you structure a business entity conversion depends primarily on state law, your starting structure, and your ending structure. You can convert some entities directly but others only by creating a new entity. Although direct conversion is simplest, with the help of a business lawyer well-versed in your state’s law, you can minimize your tax bill.

Frequently Asked Questions (FAQs)

Can I Convert an LLC to a Corporation?

Yes, you can generally convert an LLC to a corporation. The process depends on your state’s law but may involve direct conversion, merger, or transfer from an existing entity to a new entity.

Can I Convert My S Corp to an LLC?

Yes, you can generally convert an S corporation to an LLC through direct conversion, merger, or dissolution.

Can I Change My Business Type and Keep the Same EIN?

No, you cannot generally change your business type and keep the same EIN. However, you can keep your EIN if your business organization stays fundamentally the same.

How Do I Change My Business Classification with the IRS?

To elect a new business classification with the IRS for an LLC or corporation, you complete the respective form required for the entity type. For example, you file Form 2553 to elect S corporation status. Eligible entities that are not following the default rules for type of entity also may need to file Form 8832, Entity Classification Election. For conversion between other entity types, you will have a new EIN and a new entity, so you do not have any reason to change your business classification.

Disclaimer: Bizee and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.

Resources:

26 C.F.R. § 301.7701–3 (2024), link.
IRS, About Form 8832, Entity Classification Election, link.
IRS, About Form SS-4, Application for Employer Identification Number (EIN), link.
IRS, Business structures, link.
IRS, Do you need an EIN?
IRS, Do you need a new EIN?, link.
IRS, Employer ID numbers, link.
IRS, Forming a corporation, link.
IRS, Instructions for Form 2553 (12/2020), link.
IRS, S corporations, link.
Jonathan Drysdale and Matthew Coscia, The Tax Adviser, Summary of Tax Rules for Liquidating Corporations, link.
Michael F. Lynch et al., The Tax Adviser, Now Is the Time: Converting a C Corporation to an S Corporation or LLC, link.
Sheila A. Own, The Tax Adviser, Conversion of a C corporation to an LLC, link.
T. Christopher D’Avico et al., The Tax Adviser, Converting from S corp. to C corp.: Select issues for consideration, link.
U.S. Small Business Administration, Choose a business structure, link.

Key Takeaways

Business conversion involves changing a business's organizational structure to better align with growth, goals, or industry needs.
Common U.S. business structures include sole proprietorships, partnerships, corporations, LLCs, and nonprofits, each with distinct tax treatments.
Sole proprietorships require minimal paperwork, while partnerships involve agreements and tax filings based on their type (GP, LP, or LLP).
Corporations can be C corporations (subject to double taxation) or S corporations (avoiding double taxation under specific conditions).
LLCs offer flexible taxation, defaulting to sole proprietorship or partnership treatment but allowing election for corporate taxation.
Nonprofits require state registration and IRS tax-exempt status to qualify for tax advantages.
An EIN is generally required for businesses involving employees, partnerships, corporations, or other entities beyond sole proprietorships.
Tax implications vary by structure: self-employment tax for sole proprietorships, personal income tax for S corporations, and entity-level tax for C corporations.
Business entity changes can occur through direct conversion, cross-entity merger, or forming a new entity and dissolving the old one.
Direct conversions often avoid additional tax liabilities, while dissolution and reformation may trigger capital gains taxes.
IRS reclassification of an entity’s tax treatment (e.g., electing S corporation status) does not constitute a structural change but affects tax obligations.
Typically, converting a business entity requires a new EIN, except in specific scenarios where the organization’s fundamental structure remains unchanged.