The details of how to convert your small business from a corporation to an LLC will vary based on multiple factors. While we can’t look at every possible scenario, here are a few basic facts about the general process.
First, it’s important to understand that there is not just one kind of corporation, one tax status for an LLC, or one kind of conversion. On the contrary, there are:
With these variables in mind, it’s important to understand that, for example, converting a C corporation to an LLC taxed as a partnership through a statutory merger is fundamentally different, both in terms of tax consequences and in terms of required paperwork, from converting an S corporation to an LLC taxed as a corporation through a statutory conversion. Here we’ll try to simplify matters, and look mainly at closely-held C corporations converting to multi-member LLCs (the most common scenario).
1. Statutory conversion is a relatively new, streamlined procedure, available in many states, that allows you to convert your corporation to an LLC 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:
While there are important technical distinctions between a statutory conversion and other types of conversion, the practical effects are the same: People who previously were corporate stockholders are now members of your new LLC, the assets and liabilities of your corporation are now assets and liabilities of your new LLC, and your corporation 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 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 a corporation to an LLC. 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:
Like statutory conversion, a statutory merger automatically transfers your corporation’s assets and liabilities to the new LLC by operation of law. However, unlike statutory conversion, you have to create your new LLC as a separate business entity before that transfer can occur (a process that itself involves multiple steps and fees), as well as formally exchange corporate shares for membership rights through a merger agreement. You also likely will have to file a form that formally dissolves your corporation.
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:
Unlike the two preceding conversion methods, under nonstatutory conversion your corporation’s assets and liabilities are not automatically transferred to the new LLC. Instead, along with first forming a new LLC, in a nonstatutory conversion you will need special agreements to both exchange corporate shares for LLC membership interests, 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.
Example 1: California has a conversion statute that allows corporations to convert to California LLCs by filing state form LLC-1A. While this won’t allow you to skip certain other steps in the process, such as holding a required shareholder vote to approve the conversion, deciding how the LLC will be managed, and preparing your new LLC’s operating agreement, it will allow you to avoid many of the steps required for a nonstatutory conversion or statutory merger.
Example 2: Arizona does not have a conversion statute. As stated on an Arizona Corporations Commission FAQ page, “Conversion is not allowed under Arizona law. A corporation can merge with or into an LLC, but cannot simply convert to an LLC. You should consult with an attorney so that you can receive appropriate legal advice for your particular needs.” If you want to convert your corporation to an Arizona LLC, you will need to complete either a statutory merger or a nonstatutory conversion.
Before you undertake a conversion from a corporation to an LLC, you should check your state’s conversion and merger laws.
Converting a C corporation to an LLC taxed as a partnership often results in a large tax bill. This is largely because the corporation is taxed in conjunction with the sale or transfer of its assets (“liquidation”), and the shareholders, too, are taxed on the assets distributed to them. In other words, there is double taxation. While there may be exceptional circumstances that will substantially reduce the taxes involved in this type of conversion, such as the corporation having no built-in gain or appreciation of assets, or having significant net operating losses (“NOLs”) that can offset gains on its distribution of assets during liquidation, in many cases the taxes will outweigh any potential advantages of conversion.
Converting a corporation to an LLC that will continue to be taxed as a corporation generally does not have the same degree of adverse tax consequences as when converting to an LLC taxed as a partnership. The IRS will look at this kind of conversion in one of two ways: as a straight exchange of shares for LLC membership falling under Internal Revenue Code (IRC) Section 1036, or, in some cases, as a largely tax-free “F reorganization” (meaning a transaction falling under IRC § 368(a)(1)(F)). However, while the tax bill may be lower, the details of how that bill is calculated are not especially straightforward, particularly for an F reorganization. Also, as this type of conversion will not change the basic elements of how your business will be taxed going forward, you should investigate closely how it would benefit the business, other than by providing a more flexible management structure.
Converting a C corporation to an LLC that has “disregarded entity” tax status could involve such variations as:
For many small businesses, the second and third of these variations may seem rather exotic. Each of the three variations has its own particular tax consequences. The first option, which may be most relevant to smaller businesses, will be treated by the IRS as a liquidation of the corporation, with the usual associated taxes.
Converting from an S corporation to an LLC is fundamentally different from converting from a C corporation, because an S corporation has only one level of taxation; as a rule, an S corporation itself does not pay tax, only its shareholders do. Therefore, the tax consequences for this type of conversion are often more limited than conversions from a C corporation. At the same time, because both an S corporation and an LLC have pass-through taxation, you should examine carefully what advantages you expect to gain by making this kind of conversion.
In general, the tax consequences associated with converting from a corporation to an LLC will be complicated. You can find detailed additional guidance in Federal and State Taxation of Limited Liability Companies, by David J. Cartano (CCH). Ultimately, however, for any kind of corporation-to-LLC conversion you should consult with an experienced tax adviser.