Can You Convert An LLC To A Corporation?
Yes, you can convert your Limited Liability Company (LLC) to a corporation. However, understanding the income tax consequences of such a conversion is essential.
Why Should You Consider Converting Your LLC To A C-Corp?
Some of the reasons to convert an LLC to a C-Corp are listed below:
- Corporations can implement share option agreements making it easier to offer employees equity with share options as incentives;
- Most investors prefer investing in corporations due to receiving equity in return and thus attractive for potential investors;
- Ownership of shares is more straightforward to transfer than interests held in an LLC; and
- Certain states, such as Delaware, provide corporations with additional tax benefits.
LLCs And Corporations: Similarities And Differences
LLCs and Corporations both provide their owners with limited liability protection, and each can own assets and take on obligations.
LLC owners are referred to as “members” and can elect member management, or third parties can be brought in to manage the day-to-day operations. This option provides members with more flexibility. Some states may require the filing of annual reports.
Corporation management is more rules bound and includes appointing a board of directors who must have regular meetings, create minutes, ensure record-keeping and file annual reports. State laws may require filing annual reports, including detailed financial information of the corporation.
By default, an LLC is taxed as a pass-through entity, meaning that the owner/s file and pay taxes on the LLC profits in their personal tax returns. Members could choose to be taxed as a corporation; however, such an election is not a common practice due to the double taxation of a C-Corp.
C-Corps are not disregarded for tax purposes; therefore, a taxpayer is separate from its shareholders. The C-Corp pays corporate tax on the business profits made, and if dividends are declared to the shareholders, dividends tax applies. (This double tax may not be applicable for Delaware corporations where the shareholders live outside of Delaware).
S Corporations vs. C Corporations
- Both entities are created by filing Articles of Incorporation with the relevant state agency and provide their owners with limited liability protection.
- They are owned by shareholders who appoint directors and corporate officers.
- They are required to file annual reports, have annual meetings and pay annual fees.
- Both require bylaws.
- The pass-through laws apply when taxing an S-Corp, meaning that the shareholders pay tax on business profits in their personal capacity. For a C-Corp, the business profits are subject to corporate tax, while the distributions made to shareholders are further subject to dividends tax. Effectively, corporate profits are double taxed.
- S-Corps have additional restrictions imposed regarding ownership. There may only be a maximum of 100 shareholders, and these individual shareholders must be US persons.
- S-Corps may only issue one class of shares, while a C-Corp is permitted to issue multiple classes of shares – e.g., ordinary and preferred shares.
Understanding The Different Types Of Conversions
The methods to convert your LLC are briefly described below.
This method is relatively new and is available in most states.
LLC members must file a few forms with the secretary of state’s office requesting approval for the conversion.
All assets and liabilities of an LLC are transferred to the newly formed corporation, and the conversion occurs by operation of law rather than through formal agreements and additional filings – a significant difference between this method and others.
A statutory merger requires the registration of a new corporation, drafting additional agreements, and filing additional forms.
Perhaps the most expensive and complex type of conversion, assets and liabilities of the LLC are not allowed to be automatically transferred to the newly formed corporation. Multiple special agreements may be required to affect this transfer and exchanges.
Advantages Of Converting To A C Corporation
- LLCs cannot issue stock to its members, and therefore c-corps are more attractive investment opportunities for venture capitalists, corporation accelerators, and other investors looking to invest in startups via equity;
- Stocks can be reserved to be issued to employees as performance benefits;
- C-Corps can continuously offer equity to investors when capital injections are required.
Disadvantages Of Converting To A C-Corporation
- Corporate tax and dividends tax;
- Conversion costs could be expensive;
- Corporations may have additional annual filing requirements and fees.
Qualifications Needed For Switching From An LLC To A Corporation
To qualify for the conversion of an LLC to a corporation, the ownership restrictions should be considered. This is especially the case when the LLC elects to be taxed as an S-Corp.
How To Convert An LLC Into A Corporation?
The following are three major directions to consider when transitioning an LLC into a corporation:
- LLC members need to prepare and approve a conversion plan;
- Submission of a certificate of conversion and an LLC certificate along with other legally required documentation
- Form a new corporation with the LLC members as corporation shareholders;
- The LLC members will vote to approve the merger – both in their capacity as LLC members and corporation shareholders;
- The LLC members will formally exchange their membership rights for shares in the new corporation;
- A certificate of merger is filed along with other legally required documentation; and
- Formally liquidate and dissolve the LLC by submitting the necessary forms
- Form a new corporation;
- The assets and liabilities belonging to the LLC are to be formally transferred to the new corporation;
- Arrange for the formal exchange of the membership interests of the LLC for the shares in the corporation; and
- Formally liquidate and dissolve the LLC by submitting the necessary forms.
- The following methods described by the IRS in Revenue Ruling 84-111 need to be considered as well, namely:
- “Assets-over” conversion:
- The LLC assets are transferred to the corporation for all the authorized stock. Terminate the LLC by distributing all the stock in the corporation to the members.
- “Assets-up” conversion:
- The LLC is terminated by distributing all the assets and liabilities to the members. The authorized stock in the new corporation is then transferred to the members in exchange for the assets.
- The corporation will also assume all the liabilities previously adopted by the members.
- “Interest-over” conversion:
- The LLC members transfer their interests in the LLC in exchange for all the corporation’s authorized shares. The corporation will then hold the assets and liabilities, and the LLC will be terminated.
- “Assets-over” conversion:
The conversion from an LLC to a C-Corp would be most advantageous in the following circumstances:
You are a startup and are interesting in joining an accelerator:
Incorporation is an additional selling point for accelerators or incubators who might purchase equity in the company.
You’d like to attract venture capital:
Venture capitalists and angel investors favor investing in corporations as they will receive equity in exchange for their investment (statistically, venture capitalists prefer Delaware C-Corps).
You want to give your employees some equity:
The ownership structure of LLCs does not permit them to incentivize employees with share options without the employees becoming partners/members – this is possible with a corporation as shares can be reserved for employee share options.
Do You Need A New EIN When Converting LLC To C Corp?
Since an LLC is created utilizing state statute, the IRS has not established an income tax classification for these entities.
- A corporation receives a new charter from the secretary of state.
- You are a subsidiary of a corporation using the parent’s EIN, or you become a subsidiary of a corporation.
- You change to a partnership or a sole proprietorship.
- A new corporation is created after a statutory merger.
- You are a division of a corporation.
- The surviving corporation uses the existing EIN after a corporate merger.
- The corporate name or location changes.
- A corporation chooses to be taxed as an S corporation.
- The reorganization of a corporation changes only the identity or place.
- Conversion at the state level with business structure remaining unchanged.
Tax Consequences From Changing An LLC To A Corporation
When converting an LLC to a corporation, it is crucial to understand what type of tax status already exists in the LLC. The tax status of the LLC determines how the company will be converted.
A conversion of an LLC to a corporation can have significant tax consequences based on the transactions deemed to occur due to your conversion.
Suppose an election is made in terms of Form 8832 to change classification from a disregarded entity to a corporation. In that case, it’ll be considered as if the disregarded entity’s owner provided all assets and liabilities to the corporation in exchange for stock.
When a business entity experiences a transition in elective classification status from a disregarded entity to a corporation, the change ought to be treated as a transfer of all assets and liabilities kept by the owner of a former disregarded entity to a newly formed corporation. The disregarded entity’s owner will also be treated as the transferor, potentially resulting in unforeseen tax implications.
Changing The LLC’s Tax Status
As LLCs are not recognized as taxable entities, single-member LLCs are taxed as sole proprietors, and multimember LLCs are taxed as partnerships by default.
Members can elect to change the tax status of LLCs by using the “check-the-box” classification. LLCs are eligible entities, and IRS Form 2553 needs to be filed to be taxed as an S-Corporation, while an IRS Form 8832 needs to be filed to be taxed as a C-Corporation.
The instructions on the forms need to be followed, completed, and submitted to the IRS. The election is effective from the date specified on the forms. The effective date cannot be more than 75 days prior, too, and not more than 12 months after the election is filed.
The change in tax status from a multimember LLC can trigger a taxable gain if the liabilities transferred to the corporation exceed the assets.
New Responsibilities With Incorporation
When considering the conversion of the LLC to a Corporation, the following actions need to be taken to ensure that the newly formed corporation complies with the statutory requirements:
- Corporate bylaws need to be created;
- The shareholders need to appoint a board of directors and corporate officers;
- Hold an initial board meeting;
- Share certificates need to be issued to each shareholder
- When should you convert LLC to C Corp?
- You should convert LLC to a C Corp when considering share options as incentives for employees or when there is a need to raise capital.
- Can I switch from an LLC to a corporation?
- Yes, it is possible to convert an LLC to a corporation.
- Do you need a new EIN when converting LLC to C Corp?
- It depends on the type and method of conversion used. If a new corporation was formed due to a statutory merger, the corporation would need to apply for a new EIN.
- How does an LLC elect as C Corp?
- The LLC can complete Form 8832 and follow the steps on the form. The tax implications of the election need to be considered carefully due to the different tax treatment of a C-Corp.