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TLDR
- Startup founders can convert a c-corporation to an LLC. The conversion process will be specific to your startup’s state laws.
- Generally, three types of conversion exist: statutory conversion, statutory merger, or non-statutory conversion.
- Statutory conversions are relatively new in most states, allowing founders to convert your c-corporation to a limited liability company by filing forms with your state’s secretary of state’s office.
- A statutory merger is another type of conversion, although more complicated than a statutory conversion.
- Non-statutory conversions are usually more complicated and expensive than either a statutory conversion or merger.
- When deciding whether to convert your c-corporation to an LLC, founders should consider – and seek professional advice – regarding the tax implications of the conversion. One thing to consider is how will the LLC be taxed. For example, converting a c-corporation to an LLC that will be taxed as a partnership, founders can inadvertently create a large tax bill, as the transfer of assets is taxed twice. Once at the corporate level and then again for each individual shareholder.
- Founders should file a Form 8832, Entity Classification Election, identifying whether your newly formed LLC will be taxed as a partnership, a corporation, or a disregarded entity. A disregarded entity is a “type of business entity that is separate from the business owner. Even though this separation exists, the Internal Revenue Service (IRS) disregards the separation for tax purposes.” The most common form of disregarded entity is a single-member LLC.
- Some advantages of converting your c-corporation to an LLC include: Taking advantage of the LLC’s pass-through taxation, eliminating the corporation’s double taxation, and enjoying more flexibility in governance but retaining limited liability protections.
- When deciding on conversion, here are some disadvantages to consider: Conversion from a c-corp to an LLC may increase your tax bill (as well as the tax bill of your current stockholders); it’s often more challenging to transfer LLC memberships than shares of stock in a c-corporation; and LLCs often aren’t as attractive to investors as c-corporations. If you're looking for an angel investment or venture capital, a c-corp may be the way to go.
Converting a c-corporation to a limited liability company (LLC) may be beneficial under certain circumstances. However, before we jump into how and why to convert to an LLC, let’s first look at the differences between c-corps and LLCs.
An LLC is “a business structure for private companies in the United States, one that combines aspects of partnerships and corporations. Limited liability companies benefit from the flexibility and flow-through taxation of partnerships and sole proprietorships, while maintaining the limited liability status of corporations.”
A c-corporation, on the other hand, is the default designation for newly formed corporations. The Internal Revenue Service treats corporations as separate legal entities, charging them with separate corporate income taxes for any profits earned. There is no pass-through taxation.
Typically, converting from a c-corporation to an LLC would not be beneficial to startup founders. However, if you’re considering a conversion, then you’ll need to consider changes in taxation, state legal requirements, and the costs associated with the conversion itself.
Keep reading to learn more about how to convert a c-corp to an LLC.
Can You Convert a C-Corp to an LLC?
Startup founders can convert a c-corporation to an LLC. The conversion process will be specific to your startup’s state laws.
Typically in most states, there are three types of conversions from which to choose, based on your startup’s needs and goals. Let’s look at each in turn:
- Statutory Conversion. Statutory conversions are relatively new in most states, allowing founders to convert your c-corporation to a limited liability company by filing forms with your state’s secretary of state’s office. Although each state will have different rules and processes, generally statutory conversions include the following steps: (1) the startup’s directors must approve the startup’s plan for conversion; (2) have the stockholders vote on the conversion, at the recommendation of the startup’s board of directors; and (3) file the required documents with your jurisdiction’s secretary of state’s office along with any filing fees.
This type of conversion is typically the fastest. Once your c-corporation is an LLC under this type of conversion, then your stockholders are now members of your LLC, and the assets and liabilities of your c-corp now belong to your LLC. The corporation ceases to exist, and the LLC will continue as your startup’s formation, requiring you to follow all LLC management, document, and tax laws.
- Statutory Merger. A statutory merger is another type of conversion, although more complicated than a statutory conversion. Many states permit this conversion type, although you’ll need to look at the state where your startup is currently incorporated. If your state permits this type of conversion, you’ll need to specifically follow your state’s process. However, generally, this is how a statutory merger works: (1) form a new LLC; (2) have the current stockholders approve the merger both as stockholders of the c-corp and as members of the newly formed LLC; (3) have the stockholders exchange their shares of stock for membership interests in the LLC; and (4) file a certificate of merger with your state’s secretary of state’s office along with the applicable filing fees. After you merge your c-corp with the new LLC, you’ll then need to dissolve your corporation’s existence.
- Non-statutory Conversion. Non-statutory conversions are usually more complicated and expensive than either a statutory conversion or merger. Like the two above types of conversion, you’ll need to check with your state’s laws for the exact process. However, generally, the steps include the following: (1) form a new LLC; (2) transfer all of your corporation’s assets and liabilities to your LLC; (3) exchange all corporate shares of stock for LLC membership interests; (4) liquidate and terminate your corporation, including filing any forms required by your state secretary of state’s office along with the appropriate filing fees.
Unlike statutory conversions and mergers, your corporation’s assets and liabilities are not automatically transferred. Instead, you’ll need to create special legal agreements for the exchange and conversion of assets and liabilities. This can add both time and expense to your conversion process.
What to Know About Conversion Tax Consequences
When deciding whether to convert your c-corporation to an LLC, founders should consider – and seek professional advice – regarding the tax implications of the conversion. One thing to consider is how will the LLC be taxed.
For example, converting a c-corporation to an LLC that will be taxed as a partnership, founders can inadvertently create a large tax bill, as the transfer of assets is taxed twice. Once at the corporate level and then again for each individual shareholder.
Let’s look at this double-taxation in more detail.
If the c-corporation liquidates, the company must recognize gains and losses on any distributions made to the stockholders, such as when their assets are transferred to a new entity.
For the stockholders in the c-corporation, the individual stockholders will have to recognize any gains or losses on the assets being transferred, resulting in taxation for a second time on the same transaction. However, note that corporations have double taxation normally – once at the company level and then again at the individual stockholder level.
If the LLC will continue to be taxed as a corporation, and not as a partnership or disregarded entity, then the tax consequences may not be as severe. In this case, the IRS will view the transfer of assets as a straight exchange of corporate shares for LLC membership interests or, in some cases, as an “F” reorganization, which recognizes a mere change of business identity or form.
Because the tax implications can be significant, it’s best for the founder to connect with a qualified tax advisor.
What IRS Form Is Needed to Convert a C-Corp to an LLC?
In addition to filing forms with your state’s secretary of state’s office, you’ll also need to file the appropriate forms with the Internal Revenue Service.
Founders should file a Form 8832, Entity Classification Election, identifying whether your newly formed LLC will be taxed as a partnership, a corporation, or a disregarded entity. A disregarded entity is a “type of business entity that is separate from the business owner. Even though this separation exists, the Internal Revenue Service (IRS) disregards the separation for tax purposes.” The most common form of disregarded entity is a single-member LLC.
Why Would You Want to Convert a C-Corp to an LLC?
Founders may wonder, why would I want to convert a c-corporation to an LLC? What are the advantages and disadvantages of doing so?
Let’s look at the pros and cons of converting your c-corp to an LLC.
Advantages
Some advantages of converting your c-corporation to an LLC include:
- Taking advantage of the LLC’s pass-through taxation, eliminating the corporation’s double taxation.
- Enjoying more flexibility in governance but retaining limited liability protections.
- Reducing legally required paperwork.
- Reducing the tax burden for future tax years, such as taxes on dividends.
- Take advantage of carrying over new operating losses from one tax year to another.
Disadvantages
As with any corporate change, there can be disadvantages of converting a c-corporation to an LLC. Before doing so, founders need to weigh both the pros and cons of conversion, preferably with professional guidance.
When deciding on conversion, here are some disadvantages to consider:
- As we mentioned above, a conversion from a c-corp to an LLC may increase your tax bill (as well as the tax bill of your current stockholders).
- It’s often more challenging to transfer LLC memberships than shares of stock in a c-corporation.
- LLCs often aren’t as attractive to investors as c-corporations. If you're looking for an angel investment or venture capital, a c-corp may be the way to go.
Once you consider your pros and cons, you may find that converting from a c-corporation to an LLC is not ideal for your startup. However, you may find that converting the type of corporation you are is a better fit. Although that’s for another article, converting from a c-corporation to an s-corporation may be more attractive to your founders and investors.
We can help!
At AbstractOps, we help early-stage founders streamline and automate regulatory and legal ops, HR, and finance so you can focus on what matters most—your business. If you want to learn more about converting a c-corporation to an LLC, we can help you draft the appropriate documents for your startup. Additionally, we can get your documentation ready, overall shepherding this process to ensure it's done right. Get in touch to learn more!
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