There are many reasons a startup should begin its life as a C corporation, and yet it is not uncommon for founders to start their companies as LLCs. Founders often believe it is simpler to begin operations as an LLC and that they can always, when the time is right, convert the business to a corporation, and not infrequently, this is the right approach.
Often, though, a time comes when various factors may either compel the conversion of an LLC to a corporation or prompt the founders to evaluate whether converting is in the best interests of the business and its owners. This post assumes that the LLC being converted is treated as a partnership or a disregarded entity for federal tax purposes.
When Is the Right Time to Convert to a Corporation?
Most often, the decision to convert to corporate status is driven by investors who require that the entity convert prior to making the investment. However, if founders have time to plan and schedule the conversion, then the administrative burden associated with the conversion can be reduced by making the conversion effective on the first day of the entity's taxable year, generally January 1.
This will avoid the need to file a final partnership tax return for the part of the year prior to conversion and a separate "stub" year return for the corporation for the remainder of the year, which in turn requires additional accounting work to determine the portion of the income or loss for the year that is allocable to the pre- and post-conversion periods. In short, converting effective as of the beginning of a taxable year reduces the administration, expense, and time involved in dealing with two different entities in a single year.
The same is true for payroll and other employment tax filings. Because the corporation is a different entity than the LLC for tax purposes, employees will become employees of the corporation at the time of the conversion. However, if the conversion occurs mid-year and the "alternate procedure" described in Revenue Procedure 2004-53 is elected, the LLC is relieved of the obligation to furnish W-2s to the employees and the corporation instead has the responsibility, thereby relieving the employees from receiving separate W-2s from the LLC and the corporation.
Similarly, a single FICA wage base will apply to the compensation paid to each employee. Finally, the conversion often can be structured in a way so that the corporation can continue to use the EIN of the LLC, although this can add additional steps in the conversion.
If a startup does not have the option of converting as of the first date of the entity’s taxable year, then it should consider a conversion date that for accounting purposes is simple to track. For instance, it may be easier to convert at the end of a month when the startup would have a better idea of its inventory should that be an issue.
What Do You Need to Consider When Converting an LLC Into a Corporation?
Tax issues can be paramount in considering a conversion from an LLC to a corporation. While the conversion usually will not trigger gain, the conversion can be taxable.
This will often occur where the LLC has spent borrowed money and deducted the expenditures, which (depending on the facts) can cause the LLC's members to recognize gain on the conversion. The company's accountants should always be engaged to calculate the tax effects of the conversion prior to undertaking the conversion.
What Are the Ways to Convert an LLC to a Corporation?
There are four commonly used ways to convert an LLC to a corporation and one much less common way.
- 1. Statutory conversion to a corporation. Most states allow LLCs to be converted to a corporation by the simple filing of documents with the state. At the time of the conversion the LLC by operation of law becomes a corporation and, therefore, the owner of all the assets, liabilities and obligations of the LLC.
- 2. Form a new corporation and then merge the LLC with and into the new corporation. Here, the separate legal existence of the LLC will terminate on the merger, and by operation of law the new corporation will succeed to all of the rights and obligations of the LLC.
- 3. Form a new corporation and then have all of the LLC's assets contributed to the new corporation in exchange for the stock in the new corporation. Following the contribution the LLC can be liquidated and dissolved and its only asset, which would be the stock of the corporation, distributed to the members of the LLC.
- 4. Form a new corporation and then have the LLC's members assign their LLC interests to the new corporation. The LLC will be a wholly owned subsidiary of the new corporation following the assignment of the LLC interests.
There is some flexibility with this structure because future operations can either continue under the LLC or the LLC can be liquidated with all of its assets and liabilities being assumed by the corporation. Continuing to operate the business (either in whole or in part) through the subsidiary LLC can be a good option if the LLC has contracts that are not easy to assign to the new corporation, or if the founders would prefer not to set up new bank accounts, business licenses, etc.
The least common method is more of a tax strategy that is generally not acceptable to investors. This method allows an LLC to convert to a corporation for federal income tax purposes (but not state law purposes) by "checking the box" and filing Form 8832 to treat the LLC as a corporation. While this method changes the tax treatment of the LLC, it remains an LLC for state law purposes, which can result in a number of complications.
These different approaches to conversion can have differing tax consequences. Again, the company's tax advisors should be consulted as to the best alternative from a tax perspective.
What Are the Ways to Convert an LLC to a Corporation?
In addition to the state legal filings and entity level actions required to complete the conversion, there are other third-party actions that must be taken into consideration in preparation for and in connection with the conversion. Among these are the following:
- 1. Obtaining the approval of the members of the LLC.
- 2. Reviewing agreements including loans, leases, and supplier and vendor agreements to see if the conversion requires any third-party approvals or notifications. Material agreements with banks and landlords often include provisions requiring the approval of the bank or landlord before completing a conversion or changing the entity's name.
- 3. Reviewing licenses and permits to ensure they are changed to reflect the new entity.
- 4. Notifying the company's bank and other third parties of the corporation's new employer identification number (EIN) if the corporation does not, or is not able to, use the LLC’s EIN, and change of name (from Acme LLC to Acme Inc.). This can require establishing a new bank account with the new EIN. Vendors who pay the company and issue the company a 1099 will need to issue the 1099 to the corporation and list the corporation's name and EIN.
- 5. Changing labels, business cards, purchase order forms, contracts, policies, etc., that reference the LLC to reference the corporation (Inc.).
Although converting to a corporation can be a fairly simple, straightforward, and mostly administrative task, there are important things to consider. If they are done wrong, you can end up with a big tax bill, and if done right, you may just end up with a big investment!