Should we convert our LLC to a C-Corp?
We've reached a point where we need either hard capital or strategic hire capital and as an LLC it seems like it is much harder to grant capital (either immediately or in a vesting process).
Also, the pass through tax situation (we filed a 2553 for the LLC) really hurts us because we tend to drain the bank account at the end of the year so that we're not hit with huge personal tax on money we don't receive. Then the business suffers cash flow issues in January.
It seems that a c-corp -- with it's double taxation issue -- might have been a better choice for us.
So, the options as I see it are to convert the entity to a c-corp (how?) -- or start a new c-corp that becomes a holding company for the llc. Due to the pain in setting up vendor agreements with the majority of our clients, I lean toward the latter plan. It also allows us to "buy" the assets of our individual companies (we all had individual companies before we started this business) in order to use them as tools for exploiting different markets.
Any thoughts or experiences to share?
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If you start a new C-corp you may be subjected to taxes on transfer of assets, so be careful. – Henry The Hengineer 13 years ago
3 Answers
A third option, which would solve your pass-through tax issue, and would be much easier than the other two options you describe, is to simply change the tax structure of your LLC. You can convert your LLC from a pass-through entity to a corporate entity by filing a form with the IRS. This allows you to keep your company as an LLC, so you don't have to deal with the complexities of owning a C-Corp, while letting you take advantage of corporate taxation. This option won't solve your capital concerns, but it's worth considering.
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That's an option our accountant has given us. We're still struggling to figure out if we even want to grant stock/shares to anyone at this point (and it's another question on here). Thanks for the reply! – Sean 13 years ago
Are you doing your LLC taxes correctly?
The LLC pass through actually makes it easy to NOT drain the bank account at the end of the year. A C-corp with its double taxation makes this a problem.
For example, if you have a C-corp, you need to pay out all of the profits of the corporation at the end of the year or else you will have to pay corporate taxes on that profit. And then if later you pay that money to yourself, you will pay income tax on it (double tax). Because of depreciation and other ways that you spend money that are not full expensable, you can end up having to pay out more money than you have in your bank account.
An LLC fixes this because the profit the LLC made is "assigned" to the partners in a specific way on their personal returns via a K-1. Then the individuals only need to pay the taxes on this money and they can take a fully expensable distribution from the company to pay this. There is no difference between the money in the company's bank account and your bank account. That money can be distributed both ways without and tax implications.
I'm not an accountant, so there may be some complications I'm glossing over but I've been handling our corporate taxes for the last ten years and for one of our related companies which was an LLC and converted to a c-corp in order to take investments. But @Dana's original answer is correct in that you will need to be a C-corp to take an investment. 99% of venture capital will require that you convert, and the conversion is relatively painless.
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"For example, if you have a C-corp, you need to pay out all of the profits of the corporation at the end of the year or else you will have to pay corporate taxes on that profit." - What do you mean by "pay out all the profits"? – Henry The Hengineer 13 years ago
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@NeoTycoon Let's say you look at your P&L sheet and it shows you had a profit of 1 million. If you write a bonus check of 1 million to your employees (or to yourself) then you can make the company have a profit of $0 so you owe no tax and that money doesn't get double taxed. But then your bank account is at $0 and its hard to pay your expenses. This is the problem at the end of the fiscal year for C-corps. – Michael Pryor 13 years ago
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Michael, it's the same issue with an LLC (pass through taxation). Let's take your case where you have 1mm in profit on your books. In an LLC, that is passed on to you as basically unreceived distributions on your personal taxes, and you're responsible for your 25%+ tax, even though you've not received the money -- which is exactly what we're getting hit with [although not 1mm in profit :)] – Sean 13 years ago
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@Sean It's not the same issue. The LLC is much preferable because you can write a distribution check which debits from the capital account and has no tax implications for you to pay the taxes. For example, let's say your LLC makes 1mm in profit. You can write that whole 1mm profit out as a check to yourself without paying income tax. It's just a distribution. Or you could write a check to yourself for just enough to pay the taxes. In a C-corp, you'd have to write a paycheck to yourself in order to get rid of the profit. That's not the case in the LLC since the LLC's "profit" is just yours – Michael Pryor 13 years ago
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I said the exact same thing you said... but I'll say it again. If I take a $300k distribution (or my capital account is credited 300k), then I must pay taxes on that 300k. OUCH. Sure I don't have to drain the account, but I'm paying 30% on that. And I can't *really* use that to pay payroll and the like as that's my money. This strategy puts you at a large personal risk since if the business goes under you've paid tax on money you'll never see... – Sean 13 years ago
If you will be seeking investment from sophisticated investors, your company will need to be a corporation rather than an LLC, and the corporation will need to own all of the relevant assets (customer contracts, intellectual property, etc.).
You did not disclose the state in which your LLC was formed but, as a general proposition, conversion from LLC to corporation is a straightforward legal process. The major potential gotcha is a tax hit - your accountant can advise whether this would be a problem in your situation.
Disclaimer: This answer does not establish an attorney-client relationship.
