While many small businesses start out as limited liability companies (LLCs), business owners often find themselves facing limitations with this type of business structure when they are ready to grow their business to the next level. Converting their LLC to a corporation enables a business owner to obtain capital through selling shares to investors, providing unlimited growth potential and the possibility of becoming a publicly-traded company.
Converting an LLC to a corporation is an important decision that requires careful analysis. While the conversion can offer great potential for growth, it can also create complications and tax implications that can be disruptive and possibly even costly to the business. If you are considering converting your LLC to a corporation, or if you have legal or compliance questions about your business, contact the experienced and dedicated business lawyers at Polymath Legal PC at (833) 931-6418 to learn more about your legal rights.
Advantages and Disadvantages of Converting from an LLC to a Corporation
Understanding the advantages and disadvantages of operating as a corporation as compared to an LLC can help a business owner make an informed decision about whether a conversion is the next right step for the business.
Advantages
There are several advantages for startup companies that ultimately convert their LLC to a corporation.
Sale and Distribution of Shares
A corporation has the ability to raise capital through selling shares, while an LLC does not. This provides unlimited growth potential for the company and also allows for the company to be publicly traded. A corporation is also able to distribute its shares to employees as part of their compensation packages, which can be used as a powerful method for incentivizing and rewarding performance.
Adaptable Ownership Structure
A corporation is owned by its shareholders with their percentage of ownership being dependent on the number of shares they own. The ownership of a corporation can therefore be adapted and changed through the sale of shares, providing greater ownership flexibility than an LLC allows.
Strong Management Structure
A corporation is required to have an elected board of directors and management team that is governed by established company bylaws. Regular board of directors and shareholder meetings are also required to keep management informed of the details of the business’ operations and to ensure the company is continuously progressing towards its vision and goals. This type of management structure supports business operations and provides security and trust amongst investors.
Lower Self-Employment Taxes
LLC members are treated as being self-employed and therefore pay Social Security and Medical taxes on company profits. Owners of a corporation, on the other hand, receive compensation the same way employees do and therefore only pay self-employment taxes on their compensation, rather than on their share of the company’s profits.
Disadvantages
There are also disadvantages for startup companies that are considering converting an LLC to a corporation.
Greater Accountability and Compliance
Operating as a corporation requires greater accountability and compliance to protect shareholders’ interests. The rules and regulations imposed on corporations relate not only to holding regular board meetings, but also to the methods for issuing, transferring, and paying out shares, paying dividends, and maintaining financial records.
Higher Costs
Overall, there are higher costs involved in establishing and maintaining a corporation as compared to an LLC. Some of the main reasons for this are:
- Double taxation – While an LLC’s members pay only personal income tax, a corporation pays corporate income tax on earnings, as well as personal income tax on dividends paid to shareholders.
- Deduction of expenses and losses – An LLC owner is allowed to deduct business expenses and losses on their personal tax return, while a corporation owner (shareholder) cannot. Expenses and losses incurred by a corporation can only be deducted through the corporation’s taxes.
The experienced business lawyers at Polymath Legal PC can help you understand the advantages and disadvantages of converting to a corporation, as well as the legal implications entailed, to assist you in deciding whether or not conversion is a good decision for your business.
Methods of Conversion
There are several methods used by startups converting an LLC to a corporation. A business owner must select a tax status for their LLC when it is established, and this tax status determines the tax implications involved in each of the conversion methods outlined below. Obtaining the advice of a knowledgeable tax advisor to assist in selecting a conversion method is therefore very important.
The most common methods of conversion are:
1. Statutory Conversion
An LLC can be converted to a corporation simply by filing the required documentation with the state. Under this method, once the LLC becomes a corporation, its members become shareholders, and all assets, liabilities, and obligations of the LLC become those of the corporation.
2. Statutory Merger
Under this method, a corporation is formed separate from the LLC, and the LLC is then merged into the corporation. When the merger occurs, the LLC ceases to exist and all of its assets, liabilities, and obligations are taken over by the corporation.
3. Non-Statutory Conversion
Using this method, a new corporation is formed and the LLC’s assets and liabilities are transferred to the corporation. Once the LLC’s assets are converted to shares, the LLC is liquidated, and the shares are distributed amongst its members.
Less Common Methods of Conversion
There are two additional methods that business owners may choose for converting their LLC to a corporation however, these are less commonly used due to their complicated nature.
1. LLC Conversion into a Wholly-Owned Subsidiary of the Corporation
This method requires that a new corporation is formed, and the LLC members assign their interests to it. This method allows for the LLC to continue its operations as an LLC, which may be beneficial in cases where existing contracts and business licenses cannot easily be assigned to the corporation. As an alternative, the LLC can be liquidated under this method and all of its assets, liabilities, and obligations would then be taken over by the corporation.
2. Conversion for Tax Purposes Only
The IRS allows for an LLC to remain as such under state statute while being treated as a corporation for federal income tax purposes. Converting through this method simply requires the completion and submission of Form 8832. While this method of conversion may provide tax benefits, it can also create complications for the business since it results in the company being treated as a corporation under federal law but as an LLC under state law.
Tasks Involved in the Conversion Process
Converting from an LLC to a corporation requires dedicated time and effort from a business owner to ensure a smooth and seamless transition for all parties involved. There are many tasks involved in preparing for and completing the process of converting to a corporation, which may include:
- Filing articles of incorporation with the state
- Obtaining a new EIN and updating EIN records with banks, lending institutions, and vendors (required only for statutory mergers)
- Issuing stock certificates to shareholders
- Creating and implementing company by-laws
- Electing a board of directors and holding initial board and shareholder meetings
- Updating all references to the company name on printed and digital materials to include “Inc.” This may include business cards, marketing materials, contracts, policies, and the company website.
How the Dedicated Legal Team at Polymath Legal PC Can Help You
Startups converting an LLC to a corporation can benefit from a significant increase in their growth potential. However, business owners must consider their business’ unique circumstances to determine whether or not conversion is the right decision. If you are considering converting your LLC to a corporation, the experienced and knowledgeable lawyers at Polymath Legal PC may be able to assist you in making informed decisions and navigating the legal implications of the conversion process. Call us at (833) 931-6418 or fill out our online virtual meeting form today.