Converting from LLC to C Corp: Benefits, Process, and Tax Implications

Many organizations start as a limited liability company (LLC) before converting to a C corporation (C corp), often to attract venture capital and eventually go public. There are many advantages to changing your business structure, but to make the right moves at the right time, you need to understand the legal process, its tax implications, and the financial planning that comes with this critical transition.

Before looking at the how and why of converting from an LLC to a C corp, it's important to first ask, "What is an LLC?" and "What is a C corp?"

Understanding the LLC Structure

The LLC is a common business structure popular with small companies and start-ups. Owners are referred to as members. They are either single- or multi-member, with a management structure that's either member-managed or manager-managed. Every LLC has an Articles of Organization that is filed with the Secretary of State. The details differ based on the state where the LLC is formed, but generally, this document contains:

• LLC name
• Statement of purpose
• Address of principal place of business
• Management structure (member-managed or manager-managed)
• Registered agent’s name and address
• LLC’s organizers’ names

In addition, many LLCs also have a formal operating agreement that details roles and responsibilities, tax plans, and rules for adding and removing members. Once an LLC is formed, it can only be closed by an event specified in the operating agreement, the members' agreement, or a court order. Members can leave for any reason without causing the LLC to dissolve.  

Advantages of LLCs

There are many reasons to form an LLC, especially when compared to business structures like sole proprietorships, general partnerships, and other types of corporations.

Limited Liability

One of the most important advantages of an LLC is right in the name - "limited."

The LLC business structure provides its members limited liability by separating business assets and finances from personal assets and finances. On paper, the LLC is a juridical personality through the legal notion of corporate personhood, which means – just like a natural person – it can hold property, enter into contracts, and even sue or be sued. That means the people who own the LLC are not responsible for the business's debts, and creditors cannot pursue members' assets if the LLC owes them money.

The limits are not absolute, and it's possible for the courts to "pierce the veil," closing the LLC and opening up its members to liability. It's rare, according to Cornell Law School, and "typically require corporations to engage in fairly egregious actions ... abusing the corporation (e.g. intermingling of personal and corporate assets) or having undercapitalization at the time of incorporation."

Pass-Through Taxation

The other big advantage is that an LLC allows pass-through taxation, so business income and losses are passed through to members, who report everything on their personal tax returns. At the business entity level, the LLC itself has no tax obligations, so any taxes owed are paid by the members at likely lower personal rates.

How much of the gains, losses, income, deductions, and credits does each member assume? Everything can be established in the operating agreement, and members do not have to allocate tax items based on ownership stakes. Also, they can allocate the items in different proportions.

Disadvantages of LLCs

It takes longer to set up an LLC than a limited partnership or a sole proprietorship because there are more administrative requirements. There's just more paperwork. For example, in some states, part of the process is publishing a letter of intent in the local newspaper.

There can also be more taxes, and the filing process can be more complex. Again, it depends on the state, but you might have to pay a franchise tax, also known as a capital values tax, to benefit from limited liability. States typically charge a flat fee or a percentage of profits and revenues. To understand what tax liabilities might be present, talk to a tax expert to create the ideal tax plan.

Introduction to C Corporations (C Corps)

It's helpful to start with a broader definition of a corporation before focusing on C corps. Although synonymous with "big company," a corporation as a legal structure is not defined by its size. Instead, according to Forbes, it's "a company or group acting as a single entity and has shareholders, directors and officers working in association." Just like an LLC, a corporation is separate from its shareholders, so they are not personally responsible for its debts.

A C corp is the most common type of corporation. Its defining characteristic is its tax designation. In fact, the name comes from subchapter C of the Internal Revenue Service (IRS) Code. All corporations are subject to a lot of oversight and regulation, and C corps have to follow a set of operating rules called corporate formalities to keep their corporate protections. A C corp must also establish a board of directors, have a president and a secretary, hold regular meetings, and have at least one shareholders meeting annually – complete with recorded minutes.

Key Differences Between LLCs and C Corps

While both legal entities protect business owners from personal liability from the company’s debts and lawsuits, they differ in ownership structures and tax consequences.

Required Roles

While an LLC can have one or multiple members, a C corp requires a board of directors, a president, and a secretary.

Equity

Members can receive a percentage of the LLC's profits based on the size of their investments. Unlike a C corp, an LLC cannot issue stocks. Shareholders in a C corp can usually sell their shares.

Taxes

The LLC does not pay taxes. Instead, with pass-through taxation, members pay for their share of the LLC's profits on their personal tax returns. At the C corp, the federal government taxes profits at the corporate level. Then, shareholders pay taxes on their salaries, dividends, or profits from selling shares.

Reasons to Consider Converting from LLC to C Corp

If you're currently structured as an LLC, it might make sense to convert to a C corp, but there are pros and cons to transitioning. One of the best ways to decide is by looking at your current management style and future goals, balancing the legal considerations and tax implications.

How You Manage the Business

Remember, an LLC gives you many more options for ownership and management. Sole owners have the responsibility but also the freedom to make all the decisions. You can run things exactly how you want. Even with multiple members, as a team, you have the collective latitude to assign and share responsibilities in whatever way works best.

Switching to a C corp means accepting a set structure with built-in oversight. You need to get a board of directors, hold regular meetings, and have at least one meeting a year for shareholders. There's just more on your plate, from handling extra paperwork to dealing with investors. The upside is you're growing your brain trust and increasing funding opportunities. 

Where You Raise Future Funds

One of the key considerations is the changes in fundraising and financing options after conversion, which is why start-ups looking to attract venture capital and angel investors or go public in the next 5 years are encouraged to seriously consider switching to a C corp. Because your LLC won't have an initial public offering (IPO) or likely go through many acquisitions, investors can see your business as more of a risk. Or they might simply have a harder time understanding it. With a C corp, you can offer stocks, an instrument investors already have a lot of experience with.  

In order to raise funds successfully, investors will want to understand the financial health of the business. Keeping up with ongoing bookkeeping as well as deploying strong expense management & bill pay strategies help streamline the process. 

However, even when they're comfortable with the level of risk and taking convertible promissory notes instead of stock, other barriers remain. For example, many venture capital funds cannot invest in LLCs because their tax-exempt partners don't want active trade or business income.     

How You Attract and Retain Talent

Switching to a C corp opens up new ways to compensate current employees and draw new talent. You can choose between different types of equity, including employee stock options and restricted stock units (RSU). With an LLC, you can still offer something called a profit interest unit, but the administration is complex, and you likely face a hard time explaining the value to both staff and applicants.

In the end, part of the value of an offered stock option is that people already know what it is and generally how it works. It’s just easier to be able to tell an applicant your company offers stock options than having to have them sit through an explanation of the intricacies of LLCs. 

Legal Process of Converting an LLC to a C Corp

Depending on where you've registered your LLC, you can do either a statutory conversion or a statutory merger. Regardless of the process you use, the results should be the same: members of the old LLC are now shareholders in the new C corp, all assets and liabilities are moved to the corporation, and the LLC is dissolved.

Statutory Conversion

If your state offers it, it's likely your best option. The process is more streamlined and straightforward than other methods. All you have to do is send some paperwork to the secretary of state's office.

Every state has its own specific rules, but they all tend to require you to:

• Create a formal plan of conversion
• Have the LLC members approve it
• Submit a certificate of conversion, article of incorporation
• File associated documents

Statutory Merger

Although the results are the same, the process here involves more steps. First, you have to form a new corporation that has your LLC members as stockholders. The members and the stockholders, who are the same people, then approve the merger. They then get shares for their membership rights. Finally, all the associated paperwork needs to be submitted to the secretary of state along with the certificate of merger.

There is also a non-statutory conversion, but because it's the most complicated, it's also the most expensive.

It's best practice to go back and double-check your business contracts once you've converted to a corporation. For example, your bank documents, loans, leases, permits, and insurance policies. You might also need to get a new employer identification number (EIN) from the IRS.

Tax Implications of Changing Business Entities

The conversion itself is likely not a taxable event according to U.S. Code 351, but you need the help of a tax expert to make sure.

Double Taxation

Speaking in broad generalities, the biggest difference after conversion from an LLC to a C corp is the addition of "double taxation." With an LLC, all tax liabilities pass through to its members' tax returns. The LLC itself is not taxed. With a C corp, however, there are taxes for both the corporation and the shareholders, meaning more taxes overall. At the same time, a corporation enjoys opportunities for tax breaks and write-offs an LLC does not, which you need to consider when weighing the relative drawbacks of being taxed twice.

Speaking more specifically, the amount of increase or decrease can also depend on how your LLC is currently taxed. For example, an LLC with only one member is treated by the IRS as a disregarded entity. But one with multiple members is taxed as a partnership. It doesn't matter how many members are in the LLC when it comes to Social Security and Medicare taxes, though; everyone in every LLC pays them because the IRS considers members self-employed.

Because there are so many factors involved and even small variables can have a large effect on the decision-making process, it pays to be methodical and consult with experts. Once you understand the differences between LLCs and C corps, the pros and cons of the business structures, including the tax implications and effects on your financial planning, you can choose the one that best matches everything from your management style to where you see your company in the near and distant future.

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