Many entrepreneurs get their business off the ground as an LLC, or limited liability company.
This can make a lot of sense if you are the single owner of a company or if your startup only has a few partners. 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 an LLC.
Instead, taxable profits and deductible losses are passed 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—and that time may be sooner if you’re a startup—when you need to convert your LLC to a C Corporation.
Converting from an LLC to a C-Corp is a great idea if:
- You are are a startup and you’d like to join an accelerator, like Y Combinator or Dreamit.
Accelerators or incubators that take equity often require their participants be incorporated as a corporation. That’s because it makes it easy for you to give others equity, which is how accelerators make their money. Also, being incorporated shows accelerators that you have your business ducks in a row.
- 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.
- You want to give equity to your employees.
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.
- You want to meet investor expectations. If you’re a newer company or a startup, it’s in your best interests to look like you know what you’re doing for potential lenders or investors. These are people who don’t like surprises.
The Cons of Converting to a C-Corp
There are some downsides, though. Unlike an LLC, a C-Corp has to pay taxes. Then, when the company distributes its income (ie, founders, employees, and investors get paid), each person has to pay income taxes on their paychecks. 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 huge thing to be aware of—a tax penalty that can easily be avoided, but only if you file your paperwork on time. More on that tomorrow!
No matter what state you’re in, you’ll definitely want to consult a lawyer who specializes in corporate law! From there, if you’re an inDinero client, we can help you file the paperwork on time—just get in touch with us at [yourcompanyname]@indinero.com.
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