Companies make the conversion from limited liability company (LLC) to C corporation status for a number of reasons. One major reason is to attract venture capital (VC) funding, or to respond to specific requirements outlined in a VC term sheet. Keep in mind that if you are seeking external funding, a C corp conversion is much less complicated when undertaken before outside investors become involved. Other reasons companies and their owners opt for this conversion include a better retention of earnings, increased opportunities for the reinvestment of capital, and greater flexibility in terms of ownership structure, as well as reduced filing and administrative burdens. Despite the benefits, and the typically "tax-free" nature of the actual conversion, there are tax burdens sometimes associated with this change that you may not expect.
A "Tax-Free" Conversion
Incorporation is done in a number of ways. For example, some LLCs opt for a "check the box" election, whereby they simply choose to be taxed as a corporation. Others may choose an entity conversion under a state law formless conversion statute. In both of these methods, the LLC is deemed to contribute all of its assets and liabilities to a newly formed corporation in exchange for its stock. A deemed distribution of the stock is then made to the members in complete liquidation of the LLC. Under Internal Revenue Code Section 351, the deemed contribution of assets and liabilities to the corporation is considered a tax-free contribution, and therefore the transaction itself generally results in no gain/loss. This typical outcome is the reason why many business consultants often tell their clients that this type of conversion is entirely tax free.
The Tax Burdens You Might Not Anticipate
The reason we say "generally" in the paragraph above is that there are circumstances in which gain may be recognized and tax owed. Pursuant to IRC Section 357(c), an LLC may be potentially exposed to taxation during a conversion when aggregate liabilities assumed by the new corporation exceed the aggregate tax basis of the assets contributed. All assets and liabilities contributed to or assumed by the corporation are taken into account in determining total liabilities, tax basis and, ultimately, recognized gain. For example, upon conversion, an LLC which contributes $80,000 of assets (including cash, accounts receivable and fixed assets) and $100,000 of liabilities (including accounts payable, accrued expenses and notes payable) will recognize a gain of $20,000 (excess of liabilities over adjusted tax basis of the assets) and the gain will be reported on the partnership’s final tax return.
Preparation is Key
For many companies, especially smaller companies seeking growth, an unexpected tax burden can sometimes have a major financial impact on their entity conversion. Depending on your company's situation, certain tax considerations may mean that an LLC to C corp conversion is best left to a later date, or that a change in entity is not advisable before certain other changes occur. For more specific guidance regarding the tax implications of your expected conversion, feel free to contact me directly.