The limited liability company, or LLC for short, is one of the most commonly used business entity types. This legal structure offers a unique set of benefits that grows in importance as your enterprise matures and expands its operations. For many businesses forming an LLC provides significant benefits including flexible ownership arrangements and governance along with strategic tax planning. However if you find yourself faced with major decisions about how to best facilitate future growth it may be time to consider converting from an organization type like this into something more powerful- such as switching over to a corporation.
When considering whether to convert your LLC into a corporation, it is vital to reevaluate ownership structures, governance needs, tax needs, and the organization’s goals for the future. Here are a few critical questions to help you evaluate the best choice for your company:
What is the entity’s state of formation?
The first thing to understand is whether your state of formation allows conversion. As of this writing, state law varies so it’s important you do your research beforehand. There is also no consensus on the exact process for effectuating a conversion if it is allowed. LLC owners must look to their state law to understand what steps to take and how much a conversion would cost. If your state does not require a fixed conversion method, you may consider workarounds that produce the same outcome. One of the most common alternatives is a statutory merger. A statutory merger involves creating a new company—in this case, a corporation—that merges with the original LLC. After the merger occurs, the LLC is completely absorbed and ceases to exist. Contractual and statutory tools are used to create the new entity and dissolve the original one.
What are the organization’s ownership requirements?
LLCs and corporations differ significantly with respect to ownership, so this is an important factor that LLC members must consider. Drafters can contractually restrict ownership by corporate shareholders, which is usually easily transferable, and make ownership by LLC members, which is typically subject to restrictions on transfers, more flexible. However, careful drafting is required to modify these characteristics, which are often not part of the standard operations for each of these entities. LLC members may decide to convert the business to a corporation if they would like the option of offering equity to investors, or in some cases, to employees. Gauge what ownership structure your company requires to be profitable and successful.
What tax-saving strategies are available to the organization?
Weighing the tax implications of a potential conversion is extremely important because the LLC and the corporation may produce significantly different results. For instance, unless an LLC has elected to be taxed as a C corporation, it is a pass-through tax entity, meaning that LLC members report information about their business on their personal income tax returns, and the LLC is not responsible for paying its own taxes. This differs from the C corporation, which is subject to double taxation—at both the owner (shareholder) and the entity levels. However, it is essential to keep in mind that the LLC does allow its members to elect for the LLC to be taxed as a corporation. In contrast, a corporation may not elect to be taxed as a partnership. The only way for a corporation to enjoy pass-through taxation is if the corporation chooses to be taxed under subchapter S, better known as an S corporation election.
In addition to potential changes to ongoing tax requirements, there may also be a one-time tax cost to factor into your decision. If you receive cash or property as a result of the conversion, there may be tax liabilities, so having a tax professional assist you in the process is critical.
The decision to convert from an LLC to a corporation should not be made lightly. Businesses interested in obtaining significant funding from outside investors through venture capital or providing stock options to employees benefit the most from taking this leap.
If you are trying to determine the best course of action for your organization, we can help you identify the pros and cons of each option and support you in implementing your choice. Please contact us to schedule a consultation.
This article is a service of Greg Gordillo, Family Business Lawyer™. We offer a complete spectrum of legal services for businesses and can help you make the wisest choices on how to deal with your business throughout life and in the event of your death. We also offer a LIFT Start-Up Session™ or a LIFT Audit for an ongoing business, which includes a review of all the legal, financial, and tax systems you need for your business. Schedule your LIFT Session today!