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Tax Consequences to Avoid When Converting from LLC to C Corp

Posted by Melissa Hollis to Taxes, Business Advice

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Many entrepreneurs get their business off the ground as a limited liability company (LLC).

This can make a lot of sense if you are the single owner of a company or if you only have a few partners. Operating as an LLC gives business owners flexibility.

From a tax perspective, an LLC couldn’t be better: The business’ income is treated as the income of the owners. That’s right—you don’t pay separate business taxes if your company is an LLC. Instead, the company passes taxable profits and deductible losses through to the owners, who are all considered partners by the friendly folks at the IRS.

Pretty straightforward, right?

But there may come a time when you need to convert your LLC to a C Corporation. There are a few indicators that you should think about converting to a C Corp.

Social Sharing Image - Converting your business from LLC to C Corp? Here's how you can avoid costly penalties.

 

Converting from an LLC to a C Corp is an Excellent Idea Under 3 Circumstances

Social Sharing Image: Converting from an LLC to a C Corp is an excellent idea under these 3 circumstances.

1. You are a startup and you’d like to join an accelerator

Accelerators or incubators that take equity often require their participants incorporate as a corporation. That’s because it makes it easy for you to give others equity, which is how accelerators make their money. Also, incorporation shows accelerators that you have your business ducks in a row.

 

2. You’d like to attract venture capital

Venture capitalists want to invest in C Corps, which allow investors to create “preferred shares” of stock and provide a consistent legal structure that makes it easy for them to compare companies side by side. But they really want to invest in Delaware C Corps because that state is particularly friendly to corporations and their investors. More than 60% of Fortune 500 companies are incorporated in Delaware.

 

3. You want to give your employees some equity

In a corporation, it’s easy to reserve shares that your company can later distribute to employees. In an LLC, the partners own 100 percent of the company, so if you want to give equity to a non-partner employee, you’ll have to make that person a partner.

 

A Few Downsides for C Corp Businesses LLC Partners Should Consider

Unlike an LLC, a C Corp has to pay taxes. When the company then distributes its income (to pay its founders, employees, and investors), each person has to pay income taxes on those funds. That can feel like a big shift if your company has been operating as an LLC—suddenly, you’ll be paying taxes twice.

The process for converting from an LLC to a corporation can be complicated. It all depends on the state in which you formed your LLC. Some states, such as California, allow for fast-track conversions that let you convert an LLC to a corporation in another state—usually Delaware. In other states, the process can be much more arduous.

There's one more thing to be aware of: a tax penalty that you can easily avoid by filing your paperwork on time.

 

Avoid the Tax Penalty: Converting Your Business from LLC to C Corp

If you find yourself ready to switch from a partnership to a corporation, your partners are going to want to pay attention to a particular requirement:

The IRS wants you to file a tax return for the LLC as soon as it stops existing.

LLC partners have three and a half months to file what’s known as a short tax year return and pay up. Otherwise, the partners will be on the hook for $195 per month each, in addition to the income taxes.

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You may be able to simply convert all of your LLC’s assets and liabilities over to your new C Corp. Under IRS Code Section 351, this is considered a tax-free contribution, and there may be no gains or losses. If that’s the case, you won’t have to pay taxes.

But you will have to pay taxes if your LLC contributes more liabilities than assets to the new C Corp. For example, say your LLC contributes $50,000 in assets (cash, inventory, accounts receivable) and $70,000 in liabilities (accrued expenses, debts). Your LLC partners will essentially have just unloaded $20,000 in debt onto the new C Corp.

To the IRS, that $20,000 is income, and the LLC partners will need to pay income taxes on it as soon as possible.  

$195 per month is a lot to pay for forgetting your paperwork. Don’t let it happen to you!

 

Before You Convert Your Business From an LLC to a C Corp...

No matter what, you’ll want to consult a lawyer who specializes in corporate law (have you met our friends at LawTrades yet?). From there, if you’re an inDinero client, we can help you file the paperwork on time. If not, make sure you have a tax expert on your side to help you cover your tax filing bases. Our financial experts are happy to talk to you about your tax needs and see if we can help.

 

To help businesses like yours understand their tax responsibilities and save time and money by  preparing year-round, inDinero’s tax experts have put together a 3-piece resource pack designed specifically for business owners. Download your copy of The Entrepreneur’s Business Tax Pack pack now:

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About the author
“Melissa

Melissa Hollis

Melissa Hollis is a content marketer and lover of all things West Coast. She enjoys waking up every day and getting the chance to rethink the obvious and enable the dreams of aspiring entrepreneurs.


Disclaimer: The inDinero blog provides general information about tax, accounting, and business-related topics. It is not intended to provide professional advice. Read more in our Terms of Use.