How to switch an S-Corp to an LLC

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(FORTUNE Small Business) -- Dear FSB: I originally started a business and filed it as an S-Corp. However, after about two years, I want to switch it to an LLC to eliminate the filing hassles. What is the best way to change my entity status with the IRS? Or is it best to leave the business as an S-corp at this point?

- LaToya Keel, Miami, Fla.

Dear LaToya: Changing from an S-Corporation to a limited liability company (LLC) is ordinarily not difficult. The steps to follow in making the conversion vary from state to state.

In many states, you simply convert by filing a document declaring your intention to change status with the Secretary of State or appropriate state office, says tax attorney Terry Perris of the international firm Squire, Sanders and Dempsey, LLP.

Even in states that do not have such a simplified procedure, the change can be done merely by setting up a new state-law LLC. Merge the S-Corp. into the new LLC and designate the LLC as the survivor in the merger, Perris says.

However, the experts advise you to think twice about making the conversion.

Fullerton, Ca.-based CPA John Stoller says the "filing hassles" are roughly the same for and S-Corp. and an LLC.

"You'd be better keeping the S-Corp," Stoller says. That status also offers you the opportunity to easily switch to a C-Corporation in the future, should that be to your advantage, he says.

Perris says you should also note that converting to an LLC may result in significant tax liability to the shareholders of the former S-Corp.

The IRS will treat any conversion as a liquidation of the S-Corp. for federal income tax purposes, Perris says. So, if the assets of the S-Corp. have increased in value during your two years in business, the increase will be taxable to the shareholders - most likely as capital gains.

Make the LLC-conversion only if the increase in value of the S-Corp. is small or nonexistent, so that there will be little or no tax liability, Perris says.

You should also think twice about converting to an LLC if there will only be one owner, Stoller and Perris say.

Because a single-owner LLC is treated as a sole proprietorship for tax purposes, income will be reported on Schedule C of the individual owner's federal tax return, rather than on Schedule E for an S-Corp.

The experts generally believe that increasing the amount of income reported on Schedule C ups the risk of an IRS audit, Perris says.