Should You Convert Your Corporation to an LLC?

Should You Convert Your Corporation to an LLC?

by Jane Haskins, Esq., March 2015

Limited liability companies, or LLCs, are a popular choice for small businesses. But what if you didn’t form an LLC when you started your business, and instead established a corporation?

Can you now convert a corporation to an LLC? And more importantly, should you?

Many states now offer a simple conversion procedure that makes it easy to change a corporation into an LLC. But the tax aspects of conversion are not so simple, and you may end up with a hefty tax bill. Before converting a corporation to an LLC, it’s important to understand the advantages of doing business as an LLC and the cost of changing from a corporation.

Difference Between LLC and Inc.

Whether you do business as a corporation or LLC, you have the same protection from personal liability for business obligations. However, there are differences in the way LLCs and corporations are owned, managed and taxed.

In general, LLCs are much more flexible and offer their owners more choices than corporations. For example, corporations must have a board of directors, while LLCs can have any management structure they want. Corporate shareholders allocate profits and losses according to the number of shares they own, while LLC owners (known as “members”) aren’t required to distribute profits and losses in any particular way. And LLCs have fewer recordkeeping requirements and greater tax flexibility than corporations.

LLC vs. Inc.: Reasons to Convert

There are several reasons why a corporation might choose to convert to an LLC. Among them:

  • To take advantage of pass-through taxation. If your corporation is taxed as a C corporation, you are taxed twice: there’s a corporate tax on profits, and shareholders are then taxed on dividends that are paid from those profits. Some corporations can avoid this by choosing to be taxed as S corporations. S corporation profits pass through to the shareholders’ personal returns, avoiding the corporate tax. If a corporation doesn’t qualify as an S corporation, the only way to get this pass-through taxation is to convert to an LLC.
  • To gain flexibility in the way that profits and losses are split. Corporations issue shares to their shareholders. The holders of a particular class of shares receive profits in proportion to the number of shares they own. LLC members can divide profits in any way they choose, and don’t necessarily have to allocate them according to ownership percentages.
  • To gain management flexibility. Corporations have a set structure that involves a board of directors, officers, and shareholders. This may seem overly rigid for a small business. An LLC allows for more informal and flexible management.
  • To avoid paperwork. Corporations must file annual reports with the state, and they generally have more recordkeeping requirements than LLCs. Converting to an LLC may allow you to avoid these administrative chores in the future.

LLC or Inc.: Disadvantages of Converting to an LLC

There are also some drawbacks to becoming an LLC.

  • You may pay additional taxes. When you convert a corporation to an LLC, the Internal Revenue Service treats that transaction as though you had sold the assets of the LLC. That means that you are taxed on any built-in gains on assets that have appreciated in value. You must pay this tax even though you never actually received any money. When you convert a C corp to an LLC, you may pay that tax at both the corporate and the individual level. When you convert an S corp to an LLC, you only pay this tax at the individual shareholder level.
  • LLCs are less attractive to investors. Outside investors, including angels, investment groups and venture capitalists, like to invest in corporations. If you change your business to an LLC, you’ll likely have to switch back to a corporation to pursue this type of funding.
  • It’s harder to transfer membership in an LLC than it is to transfer shares in a corporation.
  • Corporations tend to be a better choice if you plan to reward employees with a stake in the company.

Converting a corporation to an LLC can have important advantages for a business, but there are also drawbacks, particularly when it comes to taxes. Before converting, consult an accountant or tax lawyer who has experience with small business taxation. A good tax advisor can evaluate the tax you can expect to pay as a result of converting as well as the future benefits to your business. He or she can also advise you on alternatives to converting, such as choosing S corporation taxation.

If you want to convert a corporation to an LLC, LegalZoom can help. We'll help you file your certificate of conversion, as well as create your new operating agreement.