C Corp To LLC Conversion: Everything You Need to Know
A C Corp to LLC conversion has advantages and disadvantages, and the details of how to go about it are dependent on many variables. 3 min read
A C Corp to LLC conversion has advantages and disadvantages, and the details of how to go about it are dependent on many variables. One reason to do it is to establish a pass-through entity and benefit from limited liability while eliminating the double taxation that takes place with C Corporations.
Conversion may be expensive in terms of increasing the tax burden. However, if the corporation has a significant net operating loss or heavily depreciated assets, it may be the wisest decision. Profitable corporations may have difficulty managing their corporate taxable income by shifting salaries, interest payments, and benefits, which reduce the amount of tax due.
When a C Corporation is converted to a limited liability company (LLC), the assets are liquidated and the net proceeds are distributed to the shareholders. The shareholders then contribute to the LLC, becoming co-owners. In some states, however, the liquidation step may not be necessary, and the conversion can take place by paying a processing fee and submitting a collection of forms.
Differences between LLCs and C Corporations
Small businesses often choose to form LLCs. While both LLCs and C Corporations offer protection to the owners for business obligations, they are owned, managed, and taxed differently. LLCs are more flexible and offer more choices in how they are run. LLCs do not require a board of directors. Unlike C Corporations, LLC owners can distribute profits and losses any way they choose. They also need much less in the way of documentation and record keeping.
Tax Implications of C Corporations
C Corporations must pay taxes on their profits, with federal rates as high as 35 percent. Dividends, which are distributed to individual shareholders, are taxed once more at 15 percent; the corporation cannot deduct them. The total tax rate, therefore, can range up to 44.75 percent. On the other hand, S Corporations, as well as LLCs and partnerships, are only taxed once at the level of ownership at a much lower rate.
Often, this inefficiency in taxation is offset by directing as much compensation as possible to shareholder-employees, which is deductible, unlike dividends. The tax code, however, restricts this deduction to “reasonable” compensation. In businesses that require massive operating capital, it may be difficult to defend large amounts of shareholder payments proportionate to share ownership. Such payments are also subject to payroll taxes as well as Social Security and Medicare taxes.
Why Convert to an LLC?
There are several reasons why an LLC may be the preferred entity for a given business:
- Take advantage of pass-through taxation and avoid double taxation.
- Retain limited liability protection.
- Minimize conversion costs in terms of taxation by doing so during an economic downturn when gains are reduced.
- Take advantage of losses such as net operating loss carryovers or expiring capital to reduce the tax cost of the conversion.
- Reduce the tax burden for future years, if it is anticipated that rates will increase. This also includes taxes on dividend income.
- Reduce paperwork.
An S Corporation can provide the same tax advantages, allowing profits to pass through to shareholders' returns instead of becoming a corporate tax liability. However, not every corporation is eligible for S Corporation status. To qualify, it must meet several conditions, including:
- Must have fewer than 100 shareholders.
- Shareholders must be U.S. citizens or residents, certain trusts, estates, or tax-exempt organizations.
- Can have only one class of stock.
The formal structure for corporations, which involves a board of directors, officers, and shareholders may be overkill for a smaller-sized business. Management of an LLC can be more informal and flexible.
Disadvantages to Conversion
One disadvantage of conversion is that it may increase your tax bill. Also, LLCs are not as attractive to potential investors. It's more difficult to transfer membership in an LLC than to transfer shares in a corporation. Also, if you want to reward employees by giving them a stake in the company, such as offering shares of stock, a corporation may be the better option.
There are many advantages to converting a C Corporation to an LLC, but especially considering tax liabilities, there are also drawbacks to consider. LLCs and S Corporations are more efficient with regard to taxes, but the conversion itself can prove expensive. It's best to consult with a tax advisor to find out the details of your conversion before setting plans into motion.
If you need help with C Corp to LLC conversion, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on our behalf of companies like Google, Menlo Ventures, and Airbnb.