Growing Out of Your LLC
While a limited liability company (LLC) structure may fit your business initially, it may not suit your company forever. After a while, you may find operating as an LLC hinders your business growth for one reason or another. This is not uncommon, and, if you face this situation, you can transition your business from an LLC to a corporation. However, you should consider several important factors and options before you make this change. Read on for more information to help you decide if converting from an LLC to a corporation is the right next step for your company.
Reasons to Convert From an LLC to a Corporation
Business owners might consider converting from an LLC to a corporation for a variety of reasons. Here are some of the most common:
- You want to raise money from investors. Investors typically prefer to invest in corporations. Why? Because it’s easier to buy and sell stakes in corporations given their defined and transferable ownership shares. Corporations also have the ability to issue a separate class of shares called “preferred stock,” which investors often find attractive.
- You want to undertake a public offering. If you plan to someday conduct a public offering of common stock, you must first form a corporation.
- You want to issue stock as compensation. Whether you want to issue stock as compensation to initial investors or organizers, or you want to regularly issue it to employees as part of their regular compensation, it’s much easier to do so as a corporation than an LLC.
- You want to join a startup accelerator. Startup accelerators or incubators often take equity and therefore require companies to be incorporated.
- You want to lower your self-employment taxes. As an LLC, members must pay Social Security and Medicare taxes on their share of the entire company’s profits. In a corporation, owners receive payment like other employees and only have to pay these taxes on the amount of their compensation. Importantly, an LLC can choose to be taxed as a corporation without actually converting into one.
When Is The Right Time to Switch?
It’s difficult to pinpoint the right time to convert your LLC into a corporation, but a few general guidelines can offer some help. For example, you need to make the switch if you’re considering a public offering of stock in the future. Another factor to consider is the point at which the amount of owners’ self-employment tax exceeds the amount of corporate tax your company would pay as a corporation. Once you cross that threshold, you have one less reason to keep an LLC structure. However, remember that LLCs can opt to be taxed as a corporation without converting from the LLC structure.
S Corporations vs. C Corporations
Another important consideration is that S corporations and C corporations offer two distinct business structures. While they have many similarities, they also have some significant differences.
- Limited Liability Protection: Like LLCs, both S corporations and C corporations offer business owners personal liability protection.
- Formation Process: Both require business owners to file formation documents with the company’s home state.
- Basic Structure: Both have shareholders, officers, and directors, and the company can issue a share of its profits to shareholders in the form of dividends based on the number of shares owned.
- Rules and Regulations: Both must hold shareholder and director meetings, keep minutes of those meetings, issue stock, create bylaws, and file annual reports.
- Taxation: This is the most significant difference between S corporations and C corporations. At the federal level, C corporations must pay taxes as separate entities with their own corporate tax returns while their shareholders must pay taxes on any dividends they receive from the company’s stock. In contrast, S corporations are subject to “pass-through” taxation. That means an S corporation itself does not pay taxes on its income and its shareholders pay a tax on their portion of the company’s profits. This can often result in a much lower tax payment for owners of an S corporation. In addition, state taxes vary widely and S corporations do not receive the same tax treatment everywhere.
- Ownership Restrictions: S corporations have much stricter regulations regarding ownership. For example, they may have a maximum of 100 shareholders and their owners cannot include non-U.S. citizens, C corporations, other S corporations, LLCs, partnerships, and certain other entities. In addition, S corporations may only issue one class of stock while C corporations can issue multiple classes of both common and preferred shares. The tighter restrictions on S corporation ownership can make it more difficult to gain additional capital or sell the business.
Qualifications Needed to Switch From an LLC to a Corporation
The primary qualifications needed to convert your LLC into a corporation relate to ownership restrictions. Given the restrictions for S corporation ownership, you’ll have to meet the below qualifications if you choose this structure:
- Be a domestic company
- Have no more than 100 shareholders
- Have only one class of stock
- Have no non-U.S. citizens, corporations, or certain other entities as owners
Three Ways to Transition Your LLC to a Corporation
If you decide you want to convert your LLC into a corporation, there are several ways to complete the transition — depending on your state. They include:
Probably the simplest and least-expensive method, statutory conversion also is the newest option and not available in all states. While the process varies slightly within the states offering statutory conversion, it generally includes preparing and approving a conversion plan and filing relevant forms with the appropriate state regulatory office. A key characteristic of a statutory conversion is that the transfer of all business assets and liabilities from your LLC to the new corporation — along with the status conversion of LLC members to corporate shareholders — happens automatically as part of the process. That means you can skip the additional, separate actions and paperwork required by the other two methods.
In a statutory merger, you must first separately form a new corporation. Next, the LLC members (now also shareholders of the new corporation) must approve a merger of the two companies and give up their LLC membership rights. Then, the companies must file a certificate of merger and other paperwork with the appropriate state regulatory office. Finally, you’ll need to dissolve the LLC. While this method also automatically transfers assets and liabilities as in a statutory conversion, it’s significantly more complicated and time-consuming because of the added steps associated with first creating a new corporation. However, it may be the best option in states that don’t offer statutory conversions.
This is the most complex and, generally, the most expensive option for converting an LLC into a corporation because it's used for certain rare situations and requires legal assistance. Like a statutory merger, you must first form a new corporation. Next, you must formally transfer assets, liabilities, and ownership interests with separate agreements between the LLC and new corporation. These transfers don’t happen automatically as in the other two methods. Finally, similar to a statutory merger, you will need to officially dissolve the LLC.
IMPORTANT NOTE: The above options are the same for both C corporations and S corporations, but you’ll also need to file Form 2553 with the Internal Revenue Service if you convert to an S corporation.
New Responsibilities With Incorporation
So you’ve decided the best next step for your company involves converting to a corporation. In addition to the advantages this new business structure brings, you’ll face new responsibilities you didn’t have as an LLC owner. Your incorporated company must now elect directors from its group of shareholders and those directors then need to select the company’s officers. By law, the directors must hold regularly scheduled meetings and take minutes at each of those meetings. The new corporation also must issue stock and potentially comply with additional financial reporting requirements.