LLC Elected S Corp: Same Books or a New Accounting File?

Can I keep my LLC's books after the S election, or do I need a new file, EIN or bank account?

An LLC's books usually carry on after an S election, in the same file. The LLC is the same legal entity, and the IRS accepts any recordkeeping system that clearly shows income and expenses. What changes is the tax identity from the effective date on Form 2553: the books need a dated cutoff, new equity accounts and payroll for the owner. A business-type setting in accounting software does not make or change the election; only a Form 2553 the IRS accepts does (instructions), signed by an officer with every shareholder's consent.

A case is not simple when:

• A multi-member LLC taxed as a partnership is converting: the partnership ends and its capital becomes stock.
• The LLC already chose to be taxed as a corporation (Form 8832): this page assumes a one-owner or partnership filer. See switching a C corporation to an S corporation.
• A member is a partnership, a corporation or a nonresident alien, or members' rights to distributions differ: the IRS lists these among its tests for S status.
• The effective date falls mid-year, so the year splits between two returns.
• Unpaid invoices and bills sit at the cutoff, or the LLC reports on the cash method: the accounting method decides which return reports them.
• The IRS has not accepted the election, or accepted a later date than you asked for.
• The owner has taken draws since the effective date, because the form was filed after it.
• The LLC's debts are more than the tax basis of its assets: gain can arise on the exchange described below.
• The old books do not reconcile.

If one of these fits, see the last section for help before the opening equity is fixed.

Gather before changing anything:

• Form 2553, the IRS acceptance letter (CP261) and the LLC's EIN letter
• The effective date and each owner's ownership
• The last balance sheet before that date, and the prior-year return
• Owner contributions, loans and draws for the year, and payroll records if any

Which date do the corporation's books start?

The corporation's books start on the Item E date of Form 2553, as the IRS accepted it. The acceptance letter (CP261) confirms it, and the first Form 1120-S repeats it in the box labeled S election effective date (form). Form 2553 must generally be filed within 2 months and 15 days after the start of the tax year the election is to take effect, or at any time in the year before (instructions). With a mid-year effective date, the instructions count that period from the date entered in Item E.

That date can be earlier than the day you file: a form filed in March can take effect the January 1 before. Cash an owner took since then is booked as wages, a distribution or a loan, and pay for the owner's work is wages from that date; see S corporation payroll never run.

The tax rules treat the election as starting at the beginning of the effective date, and treat the transfer of the old business's assets and debts to the corporation as made immediately before the close of the day before. The old books therefore end the day before and the corporation's books begin on the effective date: July 1 means a June 30 cutoff.

What happens to income earned before the effective date?

The return the LLC used before reports the period before the effective date. Which return reports an unpaid invoice or bill at the cutoff depends on the accounting method and the exchange rules, not on when the work was done: a cash-method business includes income when received, an accrual-method business generally when earned. The Form 2553 instructions say not to file Form 1120-S for any year before the election takes effect, and to keep filing the old return until then.

For tax purposes the change is an exchange. A partnership is treated as contributing all its assets and debts to the corporation for stock, then distributing the stock to its partners, and a one-owner LLC's owner as contributing them for stock (regulation, paragraph (g)(1); Revenue Ruling 2004-59 reaches the same result for a state-law conversion). The tax rules, not the books, decide the result, and it depends on your numbers. See changing your business structure.

How do the equity accounts change?

The LLC's equity at the cutoff carries over as the corporation's opening equity, and owner draws stop. The IRS prescribes no account names; the Form 1120-S balance sheet shows capital stock, additional paid-in capital and retained earnings on lines 22 to 24.

Pick one method and apply it to every owner. Either way, the accumulated adjustments account on Schedule M-2, a tax record, is zero on the first day of the first S year.

Opening equity is not a plug. It must equal assets minus liabilities at the cutoff. Entering balances without matching equity leaves the difference in Opening Balance Equity; find what it is rather than pushing it into stock. See opening balance equity.

Settle each shareholder's share count before the first return. Income is allocated by shares held on each day, and all shares must carry identical rights to distribution and liquidation proceeds. Book each shareholder's actual distribution on its own line; payments that differ in timing or amount get "appropriate tax effect" under the same regulation and need a preparer's review. More in recording distributions and LLC equity accounts.

What opening balances carry over, and what does the first Form 1120-S expect?

Every balance at the close of the cutoff day carries over, because the corporation starts with the assets and debts the LLC had. The preparer needs:

• Reconciled bank and card balances
• Receivables, payables and prepaid items
• Fixed assets with cost, date in service and depreciation to date, from the old return
• Business loans, kept apart from loans between the owners and the LLC
• Tax basis and fair market value of each asset at the cutoff: if the exchange qualifies under section 351, a statement listing them goes with the owner's Form 1040 or the partnership's final Form 1065, and with the corporation's first Form 1120-S

The first Form 1120-S is due by the 15th day of the 3rd month after the corporation's tax year ends (instructions).

What changes in payroll?

From the effective date, an owner who works in the business and receives, or is entitled to, pay for it is an employee of the corporation, and that pay is wages. Publication 15 treats corporate officers who work in an incorporated business as employees, and the IRS says their payments for services are wages even when they are also shareholders.

Draws taken before the effective date stay draws.

What the corporation now runs:

• Payroll under the corporation's EIN, the same number the election uses. A single-member LLC already uses its own EIN for employment tax.
• Income tax and Social Security and Medicare withholding, with Forms 941 and 940 (IRS), and a Form W-2 for the owner (Publication 15).
• A responsible person, such as a corporate officer, who willfully fails to withhold or pay these taxes over can be personally liable for the full unpaid withheld income tax and employee Social Security and Medicare tax.
• Reasonable compensation before non-wage distributions. The IRS can reclassify payments to a shareholder-employee as wages.
• Health insurance the corporation pays for an owner of more than 2% is reported as wages on the owner's Form W-2; see health insurance for owners.
• State payroll accounts, where your state requires them. Publication 15 notes that most employers pay both a federal and a state unemployment tax; check your state agency before the first payroll.

How much pay is reasonable: S corporation owner salary. Setup: running payroll yourself. Election in effect but no payroll run: S corporation payroll never run.

How do I record owner money after the election?

Book each transfer by what it is, not by what the bank calls it. The Form 1120-S instructions treat payments to an officer as wages to the extent they are reasonable compensation, and the IRS lists court cases where payments called loans or distributions to working owners were treated as wages.

Does the election change the LLC itself, its state registration or its state taxes?

The LLC stays an LLC. Form 2553 is a federal tax election; the IRS describes an LLC as a structure created by state law that it classifies separately. State tax is a different question, and states differ. New York is one example:

• New York State does not automatically treat a federal S corporation as a New York S corporation unless the law mandates it; the company files Form CT-6 to elect (New York).
• New York City has no S corporation election and does not recognize the State one; a federal S corporation doing business in the city is generally subject to its general corporation tax (NYC Finance).

Check your state's treatment before the first state return, and before assuming the LLC's existing state filings stop. See how S corporations are taxed for states.

What if the election was late or never accepted?

Until the IRS accepts the election, the effective date is not settled, so the cutoff is not either. The deemed corporate classification applies to a timely S election; a late one needs relief. If the IRS accepted a later date than you asked for, the CP261 notice says Form 2553 was not filed on time for the requested date and relief may be available under Revenue Procedure 2013-30. Meanwhile:

• A cautious approach until the date is confirmed: keep owner pay, distributions and loans in separate accounts, and leave the old equity accounts open.
• For a period the election does not cover, the old filing status and treatment of owner pay generally continue unless relief is later granted. Settle the filing position before that period's return is due: relief for an LLC that also needs corporate status depends on every required return having been filed on time and consistent with S status, or on the first year's return not yet being due (instructions; Rev. Proc. 2013-30, section 5.03). A return filed the old way can rule relief out, so ask a professional before filing one.

How to tell whether the IRS accepted the form and how relief works: late S corporation election relief. If the election was accepted but the business kept filing Schedule C, see S corporation reported on Schedule C.

When should I clean up the old file before the switch?

Clean up the old file before the opening balances are fixed. Where Schedule L is required, the first Form 1120-S balance sheet should agree with the books; either way, an error left in the old file becomes an error in the opening equity. Bookkeeping practice, not an IRS rule, suggests this order:

1. Reconcile every bank and card account through the cutoff.
2. Move personal charges out; see commingled funds.
3. Put owner draws, contributions and loans in their own accounts.
4. List receivables, payables and prepaid items at the cutoff, and clear Opening Balance Equity.
5. Save the old file's reports as of the cutoff for the final Schedule C or Form 1065.

Then choose how to carry on. The IRS prescribes neither way.

The full choice is in clean up or start fresh and the cleanup checklist.

Example

These examples are illustrative, in US dollars.

A one-owner consulting LLC elects July 1

Assume the owner uses accrual accounting for both the books and Schedule C, with no book-to-tax differences. The LLC starts the year with no equity. From January to June it earns US$60,000 of profit, reported on the owner's Schedule C with self-employment tax, and the owner draws US$15,000 of it. On June 30 the books show cash of US$40,000, receivables of US$10,000 and payables of US$5,000, so equity is US$45,000.

On July 1 the owner's US$45,000 of equity is opened as capital stock and paid-in capital here, and draws stop. The US$10,000 owed by customers is already in the Schedule C profit, so collecting it in July only moves it from receivables to cash. On the cash method it would not be in that profit yet, and the exchange rules would decide which return reports it. From July to December the profit is the corporation's, reported on Form 1120-S, with the owner's wages on payroll.

A two-member design LLC elects January 1

The members' capital accounts are US$60,000 and US$40,000, and they become 60 and 40 percent shareholders. The partnership's last Form 1065 covers the prior year ending December 31. On January 1 the books show US$100,000 of stock and paid-in capital, one holding per shareholder. A US$20,000 distribution paid in those proportions is recorded as US$12,000 and US$8,000, one entry per shareholder, matching the actual payments.

Draws become wages and distributions

Before the election the owner took US$4,000 a month in draws. After it, suppose payroll records US$2,500 of gross wages a month and takes income tax and the employee share of Social Security and Medicare tax out of that amount, while the employer share is a separate company cost. The other US$1,500 is a distribution recorded in equity. The wage is only for illustration: reasonable pay depends on the work.

Different for you?

• The election is filed but the effective date, the opening balances or your wage-and-distribution split are unclear, a partnership is converting, or a return was already filed the old way for a period you meant the election to cover: the cutoff, the opening equity and whether payroll and the first Form 1120-S can be built from the existing books depend on your documents, not on a rule of thumb. Get bookkeeping help before payroll or a return is built on them.
• You are still deciding whether to elect: see should you elect S corporation status.
• Form 2553 was late, rejected or never confirmed: see late S corporation election relief.
• An owner is a nonresident alien, or you are unsure of an owner's US tax residency: see should you elect S corporation status for who can elect, and cross-border tax help.
• The LLC already chose to be taxed as a corporation (Form 8832): see switching a C corporation to an S corporation.
• You want the full S corporation accounts and entries: see S corporation bookkeeping, and how S corporations are taxed for the return.
• The books are months behind or mixed with personal spending: see S corporation catch-up books and bookkeeping help.
• You own more than one LLC: see books for several companies.
• You paid yourself W-2 wages from a single-member LLC before the election: see wages from your own single-member LLC.