Plenty of small businesses operate as a limited liability company (LLC) when they first set up shop. In fact, a big portion of LLCs operate as single-member companies with a sole owner. This sounds appealing in the beginning because LLCs are easy to establish, and they provide flexibility and protection for your personal assets. But it gets more and more complicated as your business grows.
An LLC configuration might have worked for your startup when it was just you in your garage. But as you get bigger, you’re probably going to want (read: need) to share equity in your business. That can make LLC status a problem. In fact, as an LLC, you won’t be able to issue shares in your company.
All told, operating as a limited liability company isn’t right for most startups as they scale. But if you founded as an LLC, don’t worry. You can convert to a C-corp. (This means tackling a statutory conversion, statutory merger, or non-statutory conversion, which is a topic we’ll dig into on another day.)
Before you make that change, though, there are some things you should know. We’ll give a brief overview of big-picture things to consider, then drill down into the tax implications.
Big changes that come with C-corp status
It’s worth doing some research yourself and talking with your accountant and lawyer if you’re considering converting to a C-corp. But to help you ask the right questions, we teed up a few quick overviews of the biggest changes that come with establishing a C-corp.
- Ability to IPO. LLCs can’t IPO. And that can make it challenging to attract investors who look forward to that liquidity event. To become publicly traded, you’ll need to be a corporation. In other words, converting to a C-corp can help you take your startup to the next level — and attract the investors you need to get there.
- Ability to create and sell/grant shares. Only corporations can issue stock certificates. If you want to offer shares as a way to loop in investors or incentivize employees, you’ll need to move away from an LLC structure.
- Limitless shareholder opportunities. But wait, you might be thinking, isn’t there more than one type of corporation? You’re right. You could also explore becoming an S-corp. But if you want to have the ability to sell shares to foreign investors or you want to have more than 100 shareholders, you’ll need to be a C-corp. To learn more, check out our blog comparing these two corporate structures.
- Business structure. C-corps are required to have a board of directors and an agreed-upon set of bylaws.
- Access to incubators and accelerators. A lot of them require you to issue them equity (it’s how they make their money). But you’ll only be able to do that if you can issue shares, which requires your startup to be a corporation.
A C-corp can open up new opportunities for your startup, but it also comes with new requirements. That includes tax ramifications, so let’s look more closely.
What converting to a C-corp does to your taxes
Converting from an LLC to a C-corporation changes your taxation long-term, but it also has ramifications in the first year. To help you get a good handle on what to expect, let’s look at the lasting change first, then the specific consideration right after you convert.
No more passthrough
As an LLC, profits and losses pass straight through to members (i.e., owners), which means you needed to pay income tax on your portion of those profits. As an LLC member, the IRS considers you self-employed and will consequently expect you to pay Social Security and Medicare taxes on your company’s net earnings. That can feel like a drag, but it means you’re only paying the taxes once: on a personal level.
C-corps come up against something called double taxation, which basically means they’re responsible for taxes on a corporate level and their shareholders need to pay taxes on a personal level, too.
With a C-corp, the P&L stays with the business and you pay corporate taxes on profits. That said, you’re still subject to income tax on your salary and applicable taxes on any shares you sell or dividends you earn from your shares.
There are ways to minimize double taxation. By distributing earnings in the form of salary, those become tax-deductible for your company. That means you won’t need to pay taxes on that money on a corporate level, just at the personal level.
Ultimately, double taxation is the biggest hurdle startups have to navigate after converting to a C-corp. Fortunately, our team at ShayCPA has extensive experience helping tech startups streamline this change and avoid double taxation whenever possible.
Final tax return for your LLC
Once you complete your conversion to a C-corp, you might need to file one last tax return for your LLC. Failing to do so can land each of your former LLC members with a steep penalty for every month that the return is late.
Long story short, talk to your accountant before you make the switch to a C-corp. The paperwork required will depend on the type of conversion you use and how much you’re moving to the C-corp in assets and liabilities. If you transfer more in liabilities than in assets, the IRS sees that as profit for the LLC members since they’re essentially unloading those liabilities into the corporation. Be ready to pay taxes on that amount.
Clearly, it can get complicated, but your accountant will know what filings are required to keep you penalty-free. We may also recommend converting toward the end of the year to avoid the need to file two separate returns.
Qualifying Small Business Stock (QSBS) Implications
To qualify for QSBS tax benefits, which we discuss in this article, the stock must be originally issued stock from a domestic C-Corporation, not an LLC. Care must be taken in the setup of the C-Corporation so that as a founder, you don’t lose this precious tax benefit. This will take a combination of work from your general counsel and tax counsel to ensure you don’t lose QSBS status.
Most tech startups that found as LLCs end up converting to C-corps. But it’s all about finding the right time to make the change — and finding the time to understand the process before you dive in. To discuss the steps and the tax ramifications with someone knowledgeable, don’t hesitate to reach out to our team. Here at ShayCPA, we specialize in accounting for tech startups. What’s more, we exclusively work with C-corps, so we have extensive experience in this arena. To chat with us, get in touch today.