Should You Convert Your LLC to a Corporation?

Should You Convert Your LLC to a Corporation?

by Jane Haskins, Esq., March 2015

If you’re an owner of a limited liability company, you probably chose an LLC because of its flexible structure and liability protection.

But now you may be questioning that decision. Perhaps you want to raise some money or give employees a stake in the business, and people are telling you that you need to form a corporation. Or you may have heard that a corporation can help you save money on taxes.

Converting LLC to corporation is a relatively simple process in most states. But before you decide to convert, you need to understand the differences between the two entity types and the benefits of converting. It’s also essential to get tax advice to ensure there are no unpleasant surprises when you file your annual return.

Difference Between LLC and Inc.

Whether you choose LLC or corporation, your personal liability protection will be the same. But there are differences in the way corporations and LLCs are owned, governed and taxed.

Corporations have been around a long time, and they have an established ownership and management structure. Corporations issue shares to their owners, or shareholders, who are entitled to company dividends based on the number of shares they own. Corporate shares are relatively easy to transfer from one owner to another, and this is one of the reasons that investors like corporations.

An LLC is a newer type of business. LLCs don’t have a set management or ownership structure, and they don’t have as many reporting and recordkeeping requirements as corporations. It is more difficult to transfer LLC ownership than it is to transfer corporate shares, meaning that owners can usually choose who to let into the business. These characteristics have made LLCs a popular choice for small business owners.

Corporations have a more rigid tax structure than LLCs. Many corporations are taxed as C corporations, meaning that they pay corporate tax on their profits, and the shareholders pay personal taxes on any dividends they receive. Some corporations qualify to be taxed as S corporations. S corporations do not pay corporate taxes, but all their profits pass through to the shareholders’ personal tax returns. This often results in an overall tax savings.

LLCs can choose to be taxed in the same way as corporations. Or, they can be taxed as a sole proprietorship or partnership, with profits and losses flowing directly to the owners’ personal tax returns.

LLC vs. Inc. – Why Convert?

There are several common reasons for changing an LLC to a corporation:

To attract investors. Because LLC ownership can be difficult to transfer from one owner to another, professional investors vastly prefer to invest in corporations. And if you think you might eventually seek venture capital or have a public stock offering, you will have to be a corporation.
To compensate people with stock. Startups without a lot of cash sometimes use company stock to compensate people who helped get the business going. Established businesses sometimes give certain employees a stake in the company. This is easier to accomplish through corporate stock than through membership in an LLC.
To minimize self-employment taxes. LLC owners are treated as self-employed individuals and must therefore pay Social Security and Medicare taxes on the full amount of the company’s profits. Owners of an S corporation that are involved in running the business are paid as employees, and while they must still pay Social Security and Medicare, they only pay these taxes on their reasonable salary, not on all the company’s profit.

LLC or Inc. – Tax Issues

Before you change an LLC to a corporation, it’s important to seek advice from an accountant or tax lawyer who has experience with small businesses. Usually there are no taxes associated with the conversion itself. But the tax laws are confusing and there are exceptions that could lead to a large tax bill at the end of the transaction.

In addition, if your business doesn’t qualify to be taxed as an S corporation, your newly converted corporation will be taxed as a C corporation and will pay corporate income tax. Depending on your business, this could mean a larger tax bill in future years. You should know what to expect before you convert.

Convert LLC to Corporation

If you’ve consulted with a professional and feel that conversion is best for you, your LLC’s members should formally approve a plan of conversion. After that, the conversion procedure will depend on the state where your LLC was formed.

Many states allow a simplified process known as a “statutory conversion.” With a statutory conversion, you can automatically transfer the LLC’s assets and liabilities to a corporation without having to separately form a corporation and dissolve the LLC. You’ll need to file a certificate of conversion and any other required documents with the state and pay a filing fee. Forms are usually available on the website of your state’s business filing agency.

If your state doesn’t allow statutory conversions, you will most likely complete a more complicated statutory merger. You will need to form a corporation with your LLC’s members as shareholders. Your members must approve a plan of merger. They will exchange their membership interests for shares in the corporation and then you will file a certificate of merger and any other required documents with your state. You may also need to file documents formally dissolving your LLC. Because of the potential complexity of a merger, it’s a good idea to work with a small business attorney.

Completion of either of these procedures will convert your LLC to a C corp. If you want to convert an LLC to an S corp. to take advantage of pass through taxation, you will also need to file form 2553 with the Internal Revenue Service.

If you think your LLC may benefit from converting to a corporation, it’s important to seek professional advice. Getting the right advice can help you avoid taxes and ensure that you don’t make costly mistakes in the conversion process.

If you're ready to convert your LLC to a corporation, LegalZoom can help. We'll file your certificate of conversion, as well as create your new corporate bylaws and resolutions.