A business that starts as an LLC may later need to convert to a C corporation. Although converting to a corporation subjects an LLC to double taxation, some startups must do so to attract investment from venture capital funds or other institutional investors.
Bootstrappers or other founders that are unsure about funding may take the wait-and-see approach to business formation, forming as an LLC to keep things simple while preserving the possibility of converting to a corporation later.
As with most business law issues, the decision of whether to convert from an LLC to a corporation includes both state-law and tax considerations.
State-Law Consequences of Converting an LLC to a Corporation
Most states have statutory conversion laws that provide a relatively straightforward process for converting an LLC to a corporation. These laws automatically transfer all the old LLC’s debts and assets to the new corporation and treat the new corporation as a continuation of the old LLC. The general process for completing a statutory conversion is described below.
Tax Consequences of Converting an LLC to a Corporation
From a tax perspective, converting from an LLC to a C corporation is relatively painless. The IRS treats a statutory conversion as an assets-over transfer where the LLC contributes its assets to the corporation in exchange for stock, then immediately liquidates and distributes the stock to the members. Under the rules governing contributions to corporations, the transaction is not a taxable event, as long as the former LLC members control the new corporation. In this context, “control” means that the former LLC members must own stock in the new corporation that is at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.
The Flipside: Converting from a Corporation to an LLC
Although converting from an LLC to a corporation is usually not a taxable event, conversion from a corporation to an LLC is not so easy. When a corporation converts to an LLC, the IRS treats the transaction as though the corporation liquidated its assets (in a taxable sale), then distributed the net proceeds to its shareholders (in a taxable dividend).
Under these rules, each step of the transaction triggers the double taxation characteristic of corporations. The corporation pays tax on the deemed sale of its assets, and the shareholders pay tax on the deemed distribution to the shareholders.
How to Change an LLC’s Tax Classification Using Tax Elections
Although LLCs are taxed as pass-through entities by default, an LLC can elect to be treated as a corporation for tax purposes while remaining an LLC for state-law purposes. If the conversion is being done solely for tax purposes, the business may remain as an LLC and file an election to be taxed as a corporation. Remaining as an LLC preserves flexibility and saves attorneys’ fees and filing costs associated with conversion.
To elect to be taxed as a corporation, the LLC need only file the appropriate form—Form 8832 for C corporations or Form 2553 for S corporations—with the IRS. After the election is filed, the LLC is taxed as a corporation but treated as an LLC for all other purposes. No state-law filing is required.
How to Convert an LLC to a Corporation
Sometimes changing the tax classification is not enough. Some businesses must actually change the state-law form of the business to a corporation for business reasons, such as to meet investor requirements.
An LLC may convert to a corporation by following the “statutory conversion” requirements of the state of formation. Texas law, for example, requires the following general steps:
- Review State Law to Determine Steps for Conversion. Although most jurisdictions permit statutory conversions, the exact steps may differ depending on state law. If multiple states are involved—for example, if a Texas LLC is converting to a Delaware corporation—the laws of both states must be considered.
- Review the LLC Documents to Be Sure They Permit Conversion. The LLC certificate of formation and operating agreement should be reviewed to determine whether there are any restrictions on or special approvals required for conversion.
- Run a Preliminary Name Check. If the corporation will use a different name from the LLC, the corporation’s intended name must be checked for availability. If the corporation name is the same as, deceptively similar to, or similar to the name of an existing business, or any name reservation or name registration filed with the Secretary of State, Secretary of State will not accept the conversion. The Secretary of State will not reject the name of the corporation for conflicting with the name of the LLC that is being converted to the corporation.
- Determine Franchise Tax Status. Converting a Texas LLC to a corporation requires a certificate of account status from the Texas Comptroller of Public Accounts. The certificate must state that all franchise taxes have been paid and that the LLC is in good standing for conversion. The certificate of account status must be obtained from the Comptroller’s office—a printout of the online account status is insufficient. Alternatively, the certificate of conversion (discussed below) may provide that the corporation is responsible to pay the LLC’s franchise taxes.
- Prepare the Corporation’s Certificate of Formation. The corporation’s certificate of formation must be filed with the certificate of conversion (discussed below). If the plan of conversion is attached to the certificate of conversion, the certificate of formation should be included as part of the plan of conversion or as an exhibit to the plan. If the LLC summarizes the plan instead of providing the complete plan of conversion, the corporation’s certificate of formation must be attached to the certificate of conversion. The certificate of formation must include a statement that the corporation is being formed as part of a plan of conversion and provide the LLC’s name, address, date of formation, and the jurisdiction of formation.
- Draft a Plan of Conversion. A plan of conversion must either be attached to or summarized in the certificate of conversion (discussed below). The plan of conversion must include the LLC’s name and place of formation, the corporation’s name, and a statement that the LLC is continuing its existence as the corporation. The corporation’s certificate of formation should be attached to the plan of conversion.
- Approve the Plan of Conversion. Unless the certificate of formation or operating agreement provide otherwise, Texas law requires the plan of conversion to be approved by a majority of the members. The certificate of conversion must include a statement that the plan of conversion has been approved as required by Texas law.
- Prepare the Certificate of Conversion. The certificate of conversion must include either the plan of conversion or a statement certifying that all required information is included. The certificate of conversion must also state that the plan of conversion has been approved by Texas law and as required by the LLC’s governing documents. It must also include the corporation’s signed certificate of formation.
- File the Certificate of Conversion with the Texas Secretary of State. The LLC must file the certificate of conversion with the Texas Secretary of State. The Texas Secretary of State will usually process the filing within five to seven business days from the date it is filed. (We maintain an account with SOSDirect and can usually have the filing processed within a day or two.)
- Pay Filing Fees. Filing fees are $300 for filing the certificate of formation and $300 for filing the certificate of conversion, for a total of $600.
Other states—including Delaware—have similar processes, but the end result is the same. Once all requirements are satisfied, the original business continues to exist in the form of the new corporation instead of in the form of the old LLC. All the old LLC’s property becomes the new corporation’s property and all the old LLC’s debts and obligations become the new corporation’s debts obligations. The rights of creditors of the old LLC remain and may be enforced against the new corporation. The equity (membership interest) in the old LLC becomes stock in the new corporation.