If you’re a business owner, you may be wondering if converting your business from an LLC to a C-corporation is the right move for you. There are a number of factors to consider when making this decision, including your business’s size, its stage of development, and its future plans. The impacts on QSBS should also be considered, but all too often are only thought about upon an exit.
What is an LLC?
An LLC, or limited liability company, is a business structure that offers both the limited liability of a corporation and the pass-through taxation of a partnership. This means that LLC owners are not personally liable for the debts and liabilities of the business, and their personal assets are protected in the event of a lawsuit. However, LLCs are taxed like partnerships (unless the entity made a “check-the-box” election to be taxed as a C-corporation or elected to be taxed as an S-corporation), which means that the profits and losses of the business are passed through to the owners and are taxed on their individual tax returns.
What is a C-Corporation?
A C-corporation is a traditional corporation that is taxed separately from its owners. This means that the profits of the corporation are taxed at the corporate level, and then again when they are distributed to shareholders as dividends. C-corporations also have more complex ownership and management structures than LLCs.
As per IRC Section 1202(c)(1), QSBS stock needs to have been issued by a C-corporation.
Pros and Cons of Converting from an LLC to a C-Corporation
There are a number of general pros and cons to converting from an LLC to a C-corporation. Some of the pros include:
- Greater liability protection: C-corporations offer greater liability protection for shareholders than LLCs. This is because shareholders of C-corporations are not personally liable for the debts and liabilities of the business.
- Ability to raise more capital: C-corporations are generally seen as more attractive to investors than LLCs. This is because C-corporations offer greater liability protection and are more familiar to investors.
- Ability to issue stock options: C-corporations can issue stock options to employees as a form of compensation. This is not possible with LLCs.
Some of the cons of converting from an LLC to a C-corporation include:
- Double taxation: C-corporations are subject to double taxation. This means that the profits of the corporation are taxed at the corporate level, and then again when they are distributed to shareholders as dividends.
- More complex ownership and management structure: C-corporations have more complex ownership and management structures than LLCs. This can make it more difficult to manage the business.
- More expensive to maintain: C-corporations are generally more expensive to maintain than LLCs. This is because C-corporations are subject to more regulations and requirements.
Key Considerations When Deciding Whether to Convert from an LLC to a C-Corporation
The decision of whether to convert from an LLC to a C-corporation is a complex one. There are a number of factors to consider, including your business’s size, its stage of development, and its future plans.
If you’re considering converting your business, it’s important to consult with an attorney and a tax advisor to discuss the pros and cons and to make sure that you’re making the best decision for your business. We can help connect you with the right resource – let us know here.
Here are some questions to consider when making the decision to convert from an LLC to a C-corporation:
- How big is your business?
- What is your business’s stage of development?
- What are your business’s future plans?
- Do you plan to raise more capital?
- Do you want to issue stock options to employees?
- Are you concerned about liability protection?
- What are the implications for QSBS? (more on this below)
Once you’ve considered these factors, you can make a more informed decision about whether to convert from an LLC to a C-corporation.
How Does Converting From An LLC to a C-corporation Impact QSBS?
Qualified Small Business Stock (QSBS) is a tax incentive that can provide up to 100% capital gains tax savings for eligible shareholders. To qualify for QSBS, the stock must be issued by a small business corporation and held for more than five years.
When considering converting from an LLC to a C-corporation, there are several impacts to QSBS to take into account, such as:
- Gross Asset Level – in order for stock to qualify as QSBS it needs to have been issued prior to the company exceeding $50M in Aggregate Gross Assets. If the company is already past this level of assets, none of the stock issued after conversion will be QSBS eligible. Also, while the gross asset level is generally measured on a tax basis, during an LLC to C-corp conversion, the assets of the LLC generally are “contributed” to the C-corp, and as per IRC Section 1202(d)(2)(B) are contributed at their fair value. As such, it is important to know the value of the assets at the time of conversion.
- Holding Period – to benefit from the QSBS exclusion, QSBS stock needs to be held for at least 5-years, and this holding period generally will not start until the stock is issued by the C-corporation (i.e. after conversion).
- Exclusion Level – the QSBS exclusion is equal to the greater of $10M or 10x the shareholder’s basis in the stock. At the time of the conversion, the shareholder’s basis is generally “stepped-up” to the fair market value (i.e. as they are contributing assets in exchange for their C-corp stock), so if the value of those assets is greater than $1M the ultimate exclusion level can be 10x that amount. Note however that the step-up in value is generally not subject to QSBS treatment at the time of the ultimate sale.
There are many factors to consider when deciding whether or not to convert from an LLC to a C-corporation. If benefitting from QSBS is one of your primary drivers, it may be best to analyze QSBS eligibility at the time of the conversion to help ensure that these benefits will be available if/when there is ultimately a gain. CapGains can help evaluate QSBS eligibility for your company – learn more and get started today here.
This article does not constitute legal or tax advice. Please consult with your legal or tax advisor with respect to your particular circumstance.