Some companies are better equipped than others for growth. The difference can come down to something as seemingly simple as business structure—not leadership vision, not go-to-market strategy, but the details of an incorporation document. Specifically, we’re talking about the distinction between an LLC and a C corporation.
If you own a startup, chances are good your business is structured as an LLC (short for limited liability company). Chances are also good your business could benefit from converting to a C corporation (AKA “C corp”).
Why Are So Many Businesses Founded As LLCs?
For a single owner or a company with a few partners, structuring the business as an LLC seems like an obvious choice. Why? Because LLCs give business owners flexibility.
An LLC is not a corporation in the legal sense. It’s essentially the same as a sole proprietorship or general partnership—an enterprise where there’s no distinction between the owner(s) and the business—with an additional shield if something goes wrong. A sole proprietor or owner in a partnership bears all financial responsibility for their business debts and losses. An LLC, on the other hand, limits the owner’s (or owners’) liability, hence the term “limited liability company.”
If an LLC gets sued, it’s the company—not the ownership—facing the lawsuit. The only money on the table is what’s already been invested in the business. By contrast, a sole proprietor or member of a partnership facing a lawsuit could lose their personal finances.
While an LLC has a legal protection mechanism in place, there’s no barrier between the organization’s income and an owner’s income. An LLC is a pass-through business, meaning profits pass through the company to the owner or owners.
This is advantageous for two reasons:
- The business is relatively easy to sell or transfer.
- An owner only pays one set of taxes every year—they don’t need to file a separate return for their business.
Despite these benefits, LLCs are not always the ideal business structure. An LLC is also limited in terms of its growth potential. In your business’s lifecycle, there may come a time—and that time may be sooner rather than later if you’re serious about scaling—when you need to convert your LLC to a C corp.
Is It Time to Convert from an LLC to a C Corp?
You should consider converting to a C corp if…
- You run a startup and want to join an accelerator. Accelerators or incubators that take equity often require their participants be structured as a corporation. That’s because C corps make it easy for owners to give others equity, which is how accelerators make their money.
- You’re aiming to attract venture capital. Venture capitalists choose to invest in C corps—many exclusively—because the structure gives them the means to create “preferred shares” of stock as well as a consistent standard for comparing companies side by side.
- You’re planning on giving 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% 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’re having serious conversations with new investors. C corp status is a key indicator that ownership takes the company seriously and has taken the time to plan ahead and get organized. Think of it as analogous to switching from cash accounting to accrual accounting. It’s that extra step that suggests you know what you’re doing. (Even better is if the company is incorporated in Delaware.)
You shouldn’t convert to a C corp if…
- You’d rather not deal with double taxation. Unlike an LLC, a C-Corp has to pay taxes. Then, when the company distributes its income (i.e. founders, employees, and investors get paid), each person has to pay their own income taxes.
- You’re not prepared for the costs and complexities of converting. The process of switching from an LLC to a corporation can be complicated. It largely depends on the state in which you formed your LLC. Some states, such as California, allow for fast-track conversions that let you switch from an LLC to a corporation in another state—usually Delaware. In other states, the process can be much more arduous.
Will Switching to a C Corp Save You on Taxes?
Changing your company from an LLC to a C Corp could reduce your tax liability—or raise it significantly. The best course for you and your company hinges on a number of business and personal financial factors.
Ready to get in the weeds a little?
Under the current US tax code, owners of pass-through companies can deduct 20% of their qualified business income (QBI)—or, if lesser, taxable income minus capital gains—from their income on their annual returns. This deduction applies “above the line,” meaning you can claim it and the standard deduction. Business owners are only eligible for this deduction if their taxable income falls under the federal threshold. Certain companies active in “specified service trade or business” categories are also excluded.
Tax liability for C corp owners, meanwhile, sits at a flat 21%. Again, however, C corp owners are taxed twice—they both the company’s returns and their individual returns.
To find out which structure is more financially advantageous for you and your business, you’ll need to crunch the numbers and weigh larger factors such as your long-term business and personal financial goals, your exit strategy, the number of owners in the business, and more. An experienced tax and accounting partner can help. Ask us about converting your business to a C Corp.