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TLDR
- 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 in most states, there are three types of conversions from which to choose, based on your startup’s needs and goals, including a statutory conversion, a statutory merger, or a non-statutory conversion.
- C-corporations are taxed twice. The startup must pay taxes at the business level. Then, when the corporation distributes income, then the founders, investors, and employees must pay tax on those distributions.
- Founders will also need to file the appropriate forms with the Internal Revenue Service. Founders should file a Form 8832, Entity Classification Election, identifying that your newly formed c-corporation will be taxed as a corporation.
- When converting your LLC to a c-corporation, you’ve increased your opportunity to raise venture capital. Most larger angel investors and VCs prefer to invest in c-corporations, not LLCs. Additionally, with a c-corporation, you can also offer employees equity, tying them to the success of your startup while increasing their financial portfolio.
As a startup, you may have decided to form your business as a limited liability company (LLC). From the flexible management structure to the limited liability protection, LLCs are convenient forms of business structure. However, as your startup grows and matures, you may need to convert your startup from an LLC to a c-corporation.
Converting your LLC startup to a c-corporation can attract investors and larger investments. However, just like any business entity conversion, becoming a c-corporation can be a tedious and frustrating process. Here we break down the steps of converting your LLC to a c-corporation.
However, before we jump into conversion, let’s first explore the basics of LLCs and c-corporations.
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.
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 an LLC to a c-corporation.
Can You Convert an LLC to a C-Corp?
Startup founders can convert an LLC to a c-corporation. 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 limited liability company to a c-corporation 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 LLC is a c-corporation under this type of conversion, then your LLC members are now stockholders, and the assets and liabilities of your LLC now belong to your c-corp. The LLC ceases to exist, and the c-corp will continue as your startup’s formation, requiring you to follow all corporate 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 formed. 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 c-corporation; (2) have the current LLC members approve the merger both as members of the LLC and stockholders of the newly formed c-corp; (3) have the LLC members exchange their membership interests for shares of stock; 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 LLC with the new c-corp, you’ll then need to dissolve your LLC’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 c-corporation; (2) transfer all of your LLC’s assets and liabilities to your c-corp; (3) exchange all LLC membership interests for corporate shares of stock; (4) liquidate and terminate your LLC, 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 LLC’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.
Post-conversion, founders will need to take the following steps to start operating as a c-corporation:
- Create corporate bylaws
- Elect a board of directors
- Schedule and hold board of director and stockholder meetings
- Issue stock certificate to all owners
This can often seem overwhelming, especially with so much else on your plate. Don’t hesitate to reach out to a qualified advisor to help you create the documents you’ll need.
What to Know About Conversion Tax Consequences
When deciding whether to convert your LLC to a c-corporation, founders should consider – and seek professional advice – regarding the tax implications of the conversion. One thing to consider is how the c-corporation will be taxed.
It’s true that limited liability companies enjoy favorable taxation. It has flow-through or pass-through taxation, meaning that the profits and losses pass through to the members’ individual tax returns. In other words, LLCs enjoy one level of taxation, not two like corporations (once at the corporate level and once at the stockholder level).
However, how do your taxes change when you convert your LLC to a c-corporation?
As stated above, c-corporations are taxed twice. The startup must pay taxes at the business level. Then, when the corporation distributes income, then the founders, investors, and employees must pay tax on those distributions.
Depending on the type of conversion you choose, you may be able to convert all of your LLC’s assets and liabilities over to your new c-corporation. If you meet certain requirements, then that conversion of assets and liabilities may be treated as a tax-free contribution under Section 351 of the Internal Revenue Code.
But, consider this. When transferring your debt over to the c-corp, you may create additional taxation for the final tax reporting for the LLC. For example, say you transfer $100,000 in assets and $50,000 in liabilities from the LLC to the c-corporation. In the eyes of the Internal Revenue Service, that debt relief created $50,000 in additional income to the LLC. And, of course, this income is passed through to the LLC’s members.
Additionally, here’s something else to keep in mind. As soon as the LLC ceases to exist, the Internal Revenue Service wants you to pay any final taxes 3 ½ months after ceasing to exist, often referred to as a short tax year. If this final tax return is not filed timely, the LLC’s members can face tax penalties. And, remember, this “final return” appears on the individual members’ Form 1040.
Because the tax implications can be significant, it’s best for the founder to connect with a qualified tax advisor to make sure all paperwork is prepared and filed timely.
What IRS Form Is Needed to Convert an LLC to a C-Corp?
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 that your newly formed c-corporporation will be taxed as a corporation.
Why Would You Want to Convert an LLC to a C-Corp?
Let’s look at the pros and cons of converting your LLC to a c-corp.
Advantages
When converting your LLC to a c-corporation, you’ve increased your opportunity to raise venture capital. Most larger angel investors and VCs prefer to invest in c-corporations, not LLCs.
Additionally, with a c-corporation, you can also offer employees equity, tying them to the success of your startup while increasing their financial portfolio.
Disadvantages
As with any corporate change, there can be disadvantages to converting an LLC to a c-corporation. 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. First, c-corporations require more management and documentation than LLCs. In this way, they have more formal requirements and less flexibility. And, of course, there's double taxation.
Because of these reasons, it’s best to seek advice from a tax professional before making a decision to convert.
What to Consider Before Converting Your LLC to a C-Corp
In addition to weighing the tax consequences and other pros and cons of converting your LLC to a c-corporation, consider the following:
- What are your startup’s goals? Do you want to attract larger investments? Are you considering going public one day? If so, converting to a c-corporation would be beneficial.
- What is your management style? Could your startup transition to a more regimented, formal management style? With a c-corporation, you lose the flexibility of running your startup completely on your own terms. You’ll now have a board of directors to answer to.
- What is your communication style with current investors? When converting to a c-corporation, you’ll have more formal requirements for reporting to investors on a regular basis. This includes explaining your progress towards achieving your key performance indicators (KPIs). At the same time, you have access to various professionals' skillsets, experience, and connections.
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 an LLC to a c-corporation, 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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