Have you been wondering whether it’s time to explore converting your LLC into a corporation? When you first started your business, you were probably convinced that the many benefits of being an LLC (Limited Liability Company) were exactly what your new venture needed: pass-through taxation, liability protection, and simple governance.
Now, maybe your business has gained momentum and expanded quickly. If so, congratulations! It might be time to consider converting your trusty LLC into a corporation so you can take advantage of a new set of benefits. If you decide to go this route, here’s what you need to know:
LLC vs. Corporation
First of all, let’s consider some reasons why you may want to convert your company from an LLC to a corporation.
LLCs and corporations have different ways of being taxed. An LLC has pass-through taxation, which means that profits or losses are reported on the members’ personal tax returns. If you reincorporate as an S Corp, you can choose pass-through taxation just like with your LLC. With a C Corp, though, the company is considered a separate entity; it must submit a tax return and pay income taxes on its profits.
Depending on your company’s size and income, the potential for double taxation could be a determining factor when choosing your entity type. With pass-through taxation, LLCs and S Corps are only taxed on the amount reported on the individual’s income tax return. But with a C Corp, the company reports income and the owners and shareholders also report their earnings…hence “double taxation.”
For a smaller business, this could be a costly expense. However, if your company is growing exponentially, a C Corp can provide the advantage of being able to leave some of the profits in the company. This would allow you to allocate your business’s profits to claim a lower income tax bracket.
Social Security and Medicare
LLC members are not considered to be employees, so they don’t pay into Social Security or Medicare taxes. Instead, those who actively work in the business need to pay self-employment taxes on their income, which includes a reasonable salary plus any part of the profits they receive.
In a corporation, only those paid a salary are subject to Social Security and Medicare taxes. Profit distribution isn’t subject to these taxes. This means that you can classify some of your income as “salary” and some as a “distribution” to lower your tax burden. Incfile’s Tax Calculator is a helpful tool to use in crunching these numbers and making your decision!
LLC members who actively work in the business (along with S Corporation shareholders) are allowed to deduct operating costs that the business incurs on their personal tax returns. A net operating loss means a company has a negative taxable income because their allowable tax deductions are greater than its taxable income. The IRS has a great list of business expense deductions for you to consider when you’re preparing your tax return!
C Corporation shareholders cannot deduct operating costs because a C Corp files its own tax return and reports those deductions there. However, if your stock drops, shareholders can deduct up to $3,000 from their other income and even carry the losses over into future years.
Employee Perks and Benefits
There are some important differences in benefits to understand if you are deciding to change your LLC to become a corporation. In an article on Entrepreneur.com, Nellie Akalp says it like this: “First, certain retirement plans, stock option, and employee stock purchase plans are only available for C corporations.” If you’re planning on offering benefits like this, make sure you convert your business to an entity that allows it.
Akalp continues: “In addition, LLC members (as well as S corporation shareholders who own more than 2 percent of the business) need to pay taxes on certain employee benefits like health benefits, employer contributions to HSAs [Health Savings Accounts] or FSAs [Flexible Spending Accounts], and life insurance benefits. Shareholders of a C corporation do not have to pay taxes on these benefits.”
How to Transition Your LLC to a Corporation
Typically, there are three different ways you can convert your LLC to an S Corp or C Corp.
1. Statutory Conversion
Most states have streamlined this process so you can just fill out a few forms and submit them to your secretary of state to quickly alter your entity status. For example, in California, you can access a copy of the “Conversion of a California Limited Liability Company into a California Stock Corporation” requirements.
As with most states, you’ll need to include your company name, address, EIN and registered agent’s information. The document must be signed and acknowledged by all members agreeing to transfer the entity from an LLC to a corporation. In California, this service costs $150, but check with your secretary of state for requirements, forms, and fees (which can range from $50-$300).
2. Statutory Merger
If your state doesn’t allow statutory conversions (Arizona, for example), this will be the method you most likely will use. Just as the name implies, you won’t be converting your LLC to a corporation, but rather merging your existing LLC with a new corporation that you will create.
This process includes several steps:
- Form a new corporation
- LLC members vote to approve the change from members to stockholders
- LLC members legally change their membership rights for agreed-upon shares in the corporation
- File a certificate of merger and/or other legal document(s) required by your secretary of state
3. Nonstatutory Conversion
This is the most complicated and expensive way to change entities because it involves liquidating and dissolving the existing company to form a new company. Assets and liabilities of the former LLC are then transferred to the new corporation. The LLC members still need to agree upon becoming shareholders, but the owners must buy their interests in the new entity.
Additional Steps to Complete an LLC Conversion
Once you’ve decided which type of entity conversion is best for you, remember that there are some specific paperwork and filing requirements involved with your new corporation status. You’ll need to write your articles of incorporation, compose corporate bylaws, elect officers, appoint a corporate director, schedule future board meeting and create stock certificates.
If all of this seems overwhelming, you’re not alone! It can get complicated when you start to consider whether your business should be an LLC vs. an S Corp or an LLC vs. a C Corp. This process needs to be completed correctly and meticulously to ensure you don’t have any problems or legal ramifications down the road.
At Incfile, we have a team of experienced, knowledgeable professionals who can guide you through this legal maze to get your business entity changed. Contact us today if you’re interested in learning more about how you can complete this process simply without the hassle and stress of doing it on your own.