Why Should a Startup Convert an LLC to a C-Corporation?
Startups that plan to raise venture capital will almost certainly have to convert to a C-corporation if they’re formed as an LLC. Venture capital funds won’t invest in entities with pass-through tax structures like an LLC taxed as a partnership. One structural reason they usually won’t do this is that some of the venture capital fund’s own investors (LPs) are likely tax-exempt organizations (e.g., pension funds, endowments, and foundations), and these organizations can’t receive unrelated business taxable income (UBTI) that flows through an LLC to its owners without jeopardizing their tax-exempt status. This makes LLCs a no-fly zone for many VCs.
VCs are also familiar with and prefer the well-established body of corporate law governing management, fiduciary duties, etc., especially in Delaware, where most startups incorporate. This is especially significant if one or more investors will take a seat on your startup’s board of directors, in which case the investor will have fiduciary duties to the company. Investors will feel more comfortable knowing what their duties entail with a Delaware C-corporation.
Related Post: Where Should I Incorporate My Startup?
Qualified small business stock or “QSBS” is stock issued by a C-corporation that’s eligible for a sizable exclusion from federal capital gains taxes. While there are a number of eligibility requirements for stock to receive favorable QSBS tax treatment, the important one here is that the stock must be issued from a C-corporation. An LLC taxed as a partnership can’t issue QSBS.
Related Post: QSBS: The Basics of Tax-Advantaged Startup Stock
For founders and early investors, QSBS is a huge incentive to ensure that the company is either formed originally as a C-corporation or converted from an LLC to a C-corporation early on. Doing so has the potential to save millions of dollars of gain from capital gains taxes. And in fact, there’s actually an opportunity to do some advanced QSBS planning by starting as an LLC and converting to a C-corporation at a strategic point, which we’ll get into in more detail later in this post.
Familiar Compensatory Equity Structures
To scale, startups need to lure stellar employees away from their cushy jobs with tech incumbents in startup hubs like San Francisco, Seattle, New York, etc. But startups can’t compete on cash compensation. Instead, they have to offer equity and the upside that brings to help make up the gap in cash compensation. Early stage startups typically grant stock options to employees.
LLCs can grant compensatory equity. But LLC compensatory equity structures tend to be less well understood and, as a result, a harder sell than stock options in a corporation. Also, there are tax-advantaged types of compensatory equity, like incentive stock options (ISOs), that are only available for C-corporations.
Related Post: Startups and Stock Options: ISOs vs. NSOs
What is an LLC to a C-Corporation Conversion?
Now that you know why a startup may want to convert, let’s take a closer look at what a conversion actually entails. The language used to describe conversions can be confusing.
Converting an entity typically refers to changing the form of the entity, for instance, from an LLC to a corporation. For example, a Washington LLC might convert to a Washington C-corporation. However, conversion can also refer to changing the form of the entity and moving the entity to a different state. For example, a Washington LLC might be converted to a Delaware C-corporation, or a California LLC might be converted to a Delaware C-corporation.
There’s another term–-”domestication”–-which technically refers to moving an entity to a different state, but this term is less commonly used than “conversion.” Since each state has different statutes dealing with conversion and/or domestication, the language used can differ. This makes it especially important for startups to work with a competent startup lawyer to ensure the change of entity form and/or state they’re planning is, in fact, authorized by the state or states involved.
Tip: When startups convert from an LLC to a C-corporation, they’re often also moving the entity to Delaware, as Delaware is where most startups are incorporated. In that sense, this is both a conversion and a domestication, but often it’s just referred to as a conversion.
For a traditional statutory conversion, where an LLC (taxed as a partnership) converts to a C-corporation, it is really just a changing of the form of the entity. For all practical purposes, the converted entity continues on as before with the same assets, liabilities, rights, obligations, etc. The minimally disruptive nature of the statutory conversion is one of its main appeals, particularly for more established businesses with existing contractual obligations to third parties.
However, as we’ll see later on, traditional statutory conversions aren’t always an option depending on the state or states involved. And even where a traditional statutory conversion is available, in certain circumstances non-statutory conversion structures may yield a better tax outcome. So, sometimes a startup will need to explore alternative conversion structures.
How to Convert an LLC to a C-Corporation
There are a number of different ways a startup can convert from an LLC to a C-corporation. The easiest and by far the most common way is via statutory conversion. However, where statutory conversion isn’t available, or where other considerations (e.g., tax structure) outweigh the convenience of statutory conversion, other methods can be used.
For startups pursuing a statutory conversion, the first step is to verify that statutory conversion is available in your state. If you’re converting from an LLC in one state to a C-corporation in another state (e.g., a California LLC to a Delaware corporation), then you have to verify that statutory conversion is authorized in both states. This may not be a simple task, and so working with a good startup lawyer is important.
Tip: The good news is that Delaware, which is where most startups converting from an LLC to a corporation will end up, does authorize statutory conversion. And so for most startups, they’ll just need to verify that the LLC’s state of formation permits statutory conversion, though they should also work with counsel to ensure that a statutory conversion is the best structure for their situation.
If statutory conversion is available, then typically the next step will be for the converting LLC to obtain the necessary consents at the organizational level to authorize the conversion. To do this, both the LLC operating agreement and the relevant conversion statute of the LLC should be consulted to ensure appropriate consents are obtained. This usually includes preparing and adopting a plan of conversion spelling out in some detail how the conversion will be structured, how LLC units will convert into shares of the corporation’s stock, management composition in the converted corporation, and more.
Once the conversion has been approved by the LLC, then it will be time to file documents with the secretary of state in each relevant jurisdiction. For example, a Washington LLC converting to a Delaware corporation would file Articles of Conversion with the Washington Secretary of State and a Certificate of Conversion and a Certificate of Incorporation with the Delaware Secretary of State. In our example, once the conversion is completed, the Delaware corporation is for all purposes the same Washington LLC that existed before the conversion. Hence, the Washington LLC doesn’t need to be dissolved.
From there, the converted Delaware corporation should take customary post-conversion corporate action including to adopt bylaws, elect the board of directors, appoint corporate officers, execute board and shareholder consents, and related tasks.
One last thing to keep in mind: If, in our example, the converted Delaware corporation operations are still based in Washington, then it should file with the Washington Secretary of State to qualify the Delaware corporation to do business as a foreign entity in Washington.
Related Posts: 4 Steps to Register an Out-of-State Business in Washington State and 5 Steps to Register an Out-of-State Business in California
Statutory conversion won’t be available or appropriate in every circumstance. One alternative structure is what’s known as a statutory merger. In a statutory merger, a new Delaware corporation would be formed and the existing LLC would be merged into the new corporation, terminating the existence of the LLC. The new corporation would then take on all of the rights and obligations of the LLC.
This is certainly a viable structure and it leads to effectively the same result as the statutory conversion. The main downside is increased complexity, paperwork, and legal fees. All other things being equal, a statutory conversion will be faster and cheaper to do than a statutory merger.
There are a number of types of non-statutory conversions. A startup might rely on one of these methods if statutory conversion is unavailable, or if an alternative method could yield a better tax outcome than a traditional statutory conversion.
The first is known as an “assets-over” transfer, where the LLC transfers its assets to a newly formed C-corporation in exchange for stock, followed by a distribution of the stock to the members in dissolution of the LLC. Note that the tax treatment for a statutory conversion is deemed to be an “assets-over” transfer, and so the main reason to use this structure would typically be if statutory conversion wasn’t permitted under state law.
The second is known as an “assets-up” transfer, where the LLC distributes its assets to its members in liquidation and the members contribute the same assets to the new C-corporation in exchange for its stock.
The third is known as an “interests-over” transfer, where the LLC members transfer their LLC interests to the new C-corporation in exchange for stock and the new C-corporation dissolves the LLC.
The decision to use one of these structures over another is often driven by tax planning goals, as each method can lead to different tax results. This underscores the importance of working with qualified legal and tax professionals when converting.
The final form of conversion, which is somewhat of a misnomer, is a check-the-box election, meaning that an LLC taxed as a partnership elects instead to be taxed as a C-corporation for federal tax purposes. To be clear, this does not convert the LLC into a C-corporation for state law purposes. It simply means that, for federal tax purposes, the IRS will treat the LLC as a C-corporation.
In general, startups should not rely on this method. Potential investors will expect to see a Delaware C-corporation, not an LLC taxed as a C-corporation.
Will Converting an LLC to a C-Corporation be a Taxable Event?
One of the most common questions we hear from startups is whether a conversion from an LLC to a C-corporation will be a taxable event. The short answer is no, provided that the conversion is structured correctly. However, there are a number of traps for the unwary here, and many startups have unwittingly exposed themselves to harmful tax events based on shoddy conversion structuring.
It’s important to emphasize here that, particularly with tax structuring, each conversion scenario must be analyzed individually and with the help of experts. The general information provided here is meant to help direct startups toward asking the right questions to qualified legal and tax service providers, not as a DIY toolkit.
With that said, as a general rule, an LLC to C-corporation conversion will be tax-free under Section 351 of the tax code. This makes sense in most conversions where the purpose is merely to change the form of the entity.
However, there are numerous exceptions to this general rule. For example, when the converting LLC’s debt is greater than its basis in its assets. In that scenario, any excess debt would be treated as taxable gain under Section 357(c) of the tax code. This example is meant to illustrate one particular risk. But there are multiple other exceptions that aren’t covered here. It bears repeating: there is no one-size-fits-all conversion approach when it comes to tax structure. Each situation needs to be analyzed and an approach designed to ensure the conversion will not be a taxable event.
QSBS Eligibility in a Conversion
The good news on the tax front is that in general the C-corporation stock from an LLC to a C-corporation conversion can be structured to be qualified small business stock, assuming of course all the other QSBS requirements are met. It should be noted that, in general, the 5-year holding period will commence on the date of conversion. So unless there’s a strategic reason for waiting to convert, like the reason we’ll explore in the next section, usually it’s prudent for startups that are LLCs to convert as soon as possible to maximize the chance that the holding period can be met.
Keep in mind that while QSBS eligibility may be achievable in a variety of different conversion structures, depending on the specific circumstances, there may be strategic reasons to pick one type of conversion structure over another to optimize for QSBS gain exclusion. For example, there can be reasons to structure a conversion as an “interests-over” transfer, where the LLC members transfer their LLC interests to the new C-corporation in exchange for stock, rather than as the default “assets-over” transfer structure deemed to apply to a typical statutory conversion, as explained in more detail here.
Conversion Pro-Tip for Maximizing QSBS
When converting to a C-corporation, the initial objective with QSBS should be to ensure that the new C-corporation stock is eligible for QSBS treatment. But there is also an opportunity to use conversion as a way to increase the QSBS exclusion cap, potentially up to 50x the $10 million cap! This is an advanced planning strategy and isn’t for every startup, but it has massive upside if deployed in the right situation.
As a refresher, the federal capital gains exclusion for QSBS is limited to the greater of either $10 million or 10 times the amount of the stockholder’s basis in the stock. For most startups that form as a C-corporation, the focus is on the $10 million cap. That’s because the founder’s basis in their shares (i.e., the original cost of their stock) is usually quite low, and so the $10 million cap tends to be the higher number.
But there’s a neat trick that startups can use that can potentially increase the cap from $10 million to $500 million. To do this, a startup would strategically form an LLC (taxed as a partnership) with the intent of converting to a C-corporation at a later date. When the startup converts, the basis of property contributed in exchange for QSBS from the newly formed C-corporation will be the fair market value of the property when it’s contributed. If an LLC is converted to a C-corporation, the value of the business will be the fair market value of the contributed property for QSBS. So, if an LLC has a high enterprise value at the time it converts, there’s potential to exceed the $10 million cap because the enterprise value will be multiplied 10x. Let’s consider an example to illustrate this strategy.
Example: If Dave and Betty form an LLC and convert it to a C-corporation when the fair market value of the business is $20 million, then the maximum QSBS gain exclusion for them would be a whopping $200 million. If they sold the company for $200 million and their stock met all the QSBS requirements, they would have to pay capital gains on the first $20 million in proceeds, but the remaining $180 million in gains would be excluded.
It’s important to note that this only works if the conversion takes place when the assets of the LLC are valued at not more than $50 million. That’s why the maximum gain exclusion is $500 million, i.e., $50 million multiplied by 10.
While this example shows the huge potential for effectively deploying this strategy, in reality it’s often not the right choice for startups. A few reasons for this are listed below.
As we learned above, most startup investors won’t invest in LLCs, and so the company may not be able to raise its fair market value meaningfully enough to make this strategy worthwhile while still an LLC.
The startup really has to have a big exit for this strategy to pay off. Looking at the example above, the founders would have to pay capital gains on the first $20 million in proceeds before the QSBS exclusion kicks in. So if the company only sold for $20 million or less, this strategy would actually backfire and the founders would pay capital gains on all their gains.
Realistically, this strategy would be ideal for startups that can bootstrap to a healthy valuation before needing investment from venture capital, but that still anticipates having a big exit. The number of startups that can pull this off is fairly small. So this should strategy should be used sparingly.
Entity Conversion FAQs
Do founders need to make an 83(b) election after converting an LLC to a C-corporation? Yes, startup founders will need to make a timely 83(b) election covering their shares in the converted C-corporation, even if they made a previous 83(b) election covering their LLC units.
Do I need a new EIN after converting an LLC to a C-corporation? The answer may depend on the specifics of the conversion. The IRS has provided guidance here.
Do I need to shut down the LLC after converting to a C-corporation? The answer here likely depends on the conversion structure. If a statutory conversion, then the LLC won’t need to be dissolved. But in an “interests-over” conversion, for example, the LLC may need to be dissolved, unless the business has continued use for it.
While the process of converting an LLC into a C-corporation can initially seem easy, it can hide complex legal and tax issues. If these are not handled properly, they could significantly harm the converting startup and its founders. Hence, the choices of whether, when, and how to convert should be made with the input of legal and tax experts.