Converting an LLC to a Corporation: An Overview
Learn about the legal and tax issues involved when you convert a limited liability company to a corporation or S corp.
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The process for converting your small business from an LLC to a corporation will vary depending on multiple factors. While we can’t cover every possible variation, here’s a quick look at some of the more basic issues for this type of conversion. For the rules in each state, see 50-State Guide to Converting an LLC to a Corporation.
Variable Elements of Conversions
First, there isn’t just one tax status for an LLC, one kind of corporation, or one kind of conversion. On the contrary, there are:
- LLCs taxed as partnerships, LLCs taxed as corporations, and LLCs taxed as “disregarded entities”
- C corporations (which pay corporate taxes) and S corporations (which have pass-through taxation, so that only the shareholders pay tax); and
- multiple methods for converting your business—including statutory conversions, statutory mergers, and nonstatutory conversions
With these variables in mind, it’s important to understand that, for example, converting an LLC taxed as a partnership to a C corporation through a statutory merger is fundamentally different, both in terms of tax consequences and in terms of required paperwork, from converting an LLC taxed as a corporation to an S corporation through a statutory conversion. Here we’ll try to simplify matters, and look mainly at multi-member LLCs taxed as partnerships converting to closely-held C corporations.
Three Types of Conversion
1. Statutory conversion is a relatively new, streamlined procedure, available in many states, that allows you to convert your LLC to a corporation by filing a few forms with the secretary of state’s office. Each state that permits statutory conversions has its own specific forms and rules. However, generally speaking, steps for a statutory conversion include:
- prepare a plan of conversion and have it approved by the LLC members;
- file a certificate of conversion, and, as necessary, also an LLC certificate of formation and other legally required documents with the secretary of state.
While there are important technical distinctions between a statutory conversion and other types of conversion, the practical effects are the same: People who were LLC members are now stockholders in your new corporation, the assets and liabilities of your LLC are now assets and liabilities of your new corporation, and your LLC ceases to exist. A key point about statutory conversions is that all these effects occur automatically by operation of law rather than through separate, formal agreements regarding exchanges of LLC interests for stock and transfers of assets and liabilities, and without additional filings with the secretary of state. Statutory conversion is usually the quickest and most inexpensive way to convert from an LLC to a corporation. In those states where it’s available, it will generally be your best option.
2. Statutory merger is more complicated than statutory conversion. However, if your state does not allow for statutory conversions, you will likely use this method. While specific details will vary from state to state, basic steps of a statutory merger usually include:
- form a new corporation (which means your LLC members will now also be corporation stockholders)
- have the LLC members vote to approve the merger both in their roles as LLC members and as corporation stockholders
- have the LLC members formally exchange their membership rights for shares in the corporation; and
- file a certificate of merger and/or other legally required documents with the secretary of state.
Like statutory conversion, a statutory merger automatically transfers your LLC’s assets and liabilities to the new corporation by operation of law. However, unlike statutory conversions, you have to create your new corporation as a separate business entity before that transfer can occur (a process that itself involves multiple steps and fees), as well as formally exchange membership rights for corporate shares through a merger agreement. You also likely will have to file a form that formally dissolves your LLC.
3. Nonstatutory conversion is generally the most complicated and expensive way to convert from an LLC to a corporation. Very briefly, the main steps are:
- form a new corporation
- formally transfer your LLC’s assets and liabilities to the corporation
- formally arrange the exchange of LLC membership interests for corporation shares; and
- otherwise formally liquidate and then dissolve the corporation.
Unlike the two preceding conversion methods, under nonstatutory conversion your LLC’s assets and liabilities are not automatically transferred to the new corporation. Instead, in a nonstatutory conversion, you will need one or more special agreements to both exchange LLC membership interests for corporate shares, and to transfer assets and liabilities. There are multiple methods for handling these transfers and exchanges. If you need to go through a nonstatutory conversion, you will need expert legal assistance. However, in most cases, you should be able to avoid using this approach.
While we are mainly concerned with conversions to C corporations, the same conversion methods will be available if you want to convert to an S corporation. However, as part of a conversion to an S corporation, you will also need to file IRS Form 2553.
Regardless of which method you use to change the legal form of your LLC, you will still need to take care of all the tasks normally associated with creating a new corporation, such as:
- filing a set of articles of incorporation or equivalent document with the secretary of state’s office, including an indication that you are converting from an LLC (in some states, the articles of incorporation may serve as the conversion form)
- drafting corporate bylaws
- electing corporate officers and appointing corporate directors
- holding an initial board meeting; and
- issuing stock certificates.
Also, although various IRS guidance is not entirely clear, you may well need to obtain a new Employer Identification Number (EIN) as part of the conversion process.
It’s important that you follow all the required formalities for creating and maintaining a corporation in order to ensure that your business continues to have limited liability. For a more complete discussion of the steps involved in forming a corporation, consult Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State, by Anthony Mancuso (Nolo).
Finally, you will also need to make sure that no business contracts or agreements, such as bank documents, leases, licenses, and insurance, will be nullified by changing your business entity from an LLC to a corporation.
Arizona. Arizona law does not allow for statutory conversions. As stated on an Arizona Corporations Commission FAQ page, “Conversion is not allowed under Arizona law. An LLC can merge with or into a corporation, but cannot simply convert to a corporation. You should consult with an attorney so that you can receive appropriate legal advice for your particular needs.” Arizona does, however, have a merger statute for LLCs. Therefore, if you have an Arizona LLC and want to convert it to an Arizona corporation, you will likely rely on a statutory merger.
California. California law does allow for statutory conversions. As stated in a California Secretary of State instructional document, “A California limited liability company can be converted into a California stock corporation by filing Articles of Incorporation containing a statement of conversion.” To convert your Callifornia LLC to a California corporation, your main tasks will be preparing and approving a plan of conversion, and then filing slightly specialized articles of incorporation with the secretary of state.
The IRS’s Approach to Transfers of Assets and Interests
In Revenue Ruling 84-111, the IRS briefly describes three more specific methods of converting an LLC to a corporation when using nonstatutory conversion. Each of these three methods has a shorthand name, as follows:
- “Assets-over” conversion: the LLC transfers all of its assets and liabilities to the newly-formed corporation in exchange for all outstanding stock of the corporation, and the LLC is terminated by distributing all of the corporation’s stock to the LLC members (“assets-over” because assets are transferred “over” to the new corporation)
- “Assets-up” conversion: the LLC distributes all of its assets and liabilities to its members to terminate the LLC, and then the members transfer all the assets received from the LLC to the corporation in exchange for all outstanding stock of the corporation plus the corporation’s assumption of all of those LLC liabilities that previously had been assumed by the LLC’s members (“assets-up” because, after LLC assets are transferred “down” to LLC members, they are ultimately transferred “up” to the new corporation)
- “Interests-over” conversion: the LLC members transfer their LLC interests to the newly-formed corporation in exchange for all the outstanding stock of the corporation, which terminates the LLC, with all of the LLC assets and liabilities becoming assets and liabilities of the corporation (“interests-over” because LLC members transfer their “interests over” to the new corporation).
Revenue Ruling 84-111 does not address how the IRS views statutory conversions or statutory mergers. However, a 2004 IRS bulletin clarifies that, for federal tax purposes, the IRS will treat these types of conversions as essentially equivalent to the first conversion method listed just above (“assets-over”). More specifically, as stated in the 2004 bulletin, the IRS will assume that LLC members contribute “all [LLC] assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the [LLC] liquidates distributing the stock of the corporation to its [members].”
Each of the three transfer methods described by the IRS has its own particular tax consequences. You can find more detailed information in Federal and State Taxation of Limited Liability Companies, by David J. Cartano (CCH). Ultimately, however, you should consult with an attorney.
Change in Tax Status (“Check-the-Box”)
Our main concern here is converting the legal form of your business from an LLC to a corporation. However, if you’re seeking to convert your LLC’s tax status from partnership to corporation without changing the LLC’s legal form, you only need to file IRS Form 8832 (to be taxed as a C corporation) or IRS Form 2553 (to be taxed as an S corporation). (By default, the IRS taxes a multi-member LLC as a partnership and a single-member LLC as a so-called “disregarded entity.” There is no separate IRS tax category for LLCs.)
While the IRS forms for changing tax status are fairly straightforward, this procedure—known as “Check-the-Box”—involves special eligibility criteria. You can find those criteria in the instructions included with the forms. Generally speaking, your LLC should be eligible to file either Form 8832 or Form 2553, but you should consult with a tax expert for more details.
The tax implications of converting an LLC to a corporation can sometimes be significant. Therefore, for any kind of LLC-to-corporation conversion, you should consult with an experienced tax adviser.