Why Convert an LLC to a Corporation
Before the Tax Cuts and Jobs Act of 2017, it made sense to form a Limited Liability Corporation. The main reason for doing so was that LLCs avoid the double taxation that happens when you own shares in a corporation, which pays a business tax on its profits at a 35% rate (now 21% under the Tax Cuts and Jobs Act of 2017). On top of that, you then pay a dividend.
If that all sounds expensive, that’s because it was, and the whole thing could be avoided by forming an LLC instead of a corporation.
The other reason to form an LLC was the structure’s ability to allow founders to invest their own capital into the LLC and generate ordinary losses from the LLC up to the investment. If the same investment was made into a corporation, there would only be a basis on the shares, which would be recouped when they are sold (which could be many years in the future).
So LLCs as a business structure made sense, and then the new tax law went into effect in 2018. Corporations are now taxed at 21%, which is a lot lower than the previous 35%. Dividends are still taxed, but most startups do not pay dividends anyway because they reinvest their profits into growth and acquisitions. Investors prefer reinvested profits because they want the upside of a fast-growing company rather than clipping coupons with received dividends.
All of this really means that owning an LLC is not as advantageous anymore. Plus, there are other issues that arise once an LLC has investors:
- The business needs to file the annual K-1 tax forms for each and every investor, an expensive and time-consuming task
- When investors want to sell their units in an LLC, the LLC needs to amend their Operating Agreement, which is also, you guessed it, expensive and time-consuming
- Allowing investors to trade their units on an Alternative Trading System, such as the upcoming StartEngine Secondary, would not be viable because of the Operating Agreement paperwork, mentioned above
The best structure for a company and for investors is the good old corporation, the best of which is the Delaware C-Corporation, which is used by millions of corporations. It is cost-effective to set up and very flexible.
Converting an LLC to a Corporation is a simple and straightforward matter for the states that permit the statutory conversion, a list that includes both California and Delaware. This is a great 50-state guide to converting an LLC to a Corporation. A statutory conversion is a matter of filing a few forms with the Secretary of State’s office.
You will need approval from all of the members of the LLC (not a big deal), then you will need to file the certificate of conversion and the other documents required by the state your business is in.
And Voila! All of the members are now shareholders in your corporation. The low tax rate of 21% is in effect, and the company does not need to file anything every year for shareholders. Time and money, both saved.
The company can now offer shares to investors via a public method like equity crowdfunding and then subscribe the company to an Alternative Trading System (such as StartEngine Secondary if they are raising on StartEngine), so investors can trade their shares at some point down the line if they choose to. This conversion can help bring in new capital and create liquidity for investors. This is as good as it gets.
For the states that do not offer the statutory conversion allowing the business to convert from an LLC to a corporation, a good securities attorney is required to handle the magic. In effect, that lawyer will help enact a plan that involves constituting a new Delaware Corporation and merging the LLC into it, and sometimes filing to dissolve that LLC once the merger is done. This represents a lot of work and really requires an attorney to pull off.
In 2019, it’s clearer than before that entrepreneurs should incorporate their startups as Delaware Corporations and convert their LLCs into corporations if they did not original form as such. The appeal of raising capital from the general public, low taxes, the low cost of maintenance, and the ability to create liquidity for investors trump any benefits of an LLC.
