Startups Stack Exchange Archive

tax consequences of starting as an LLC and converting to C-corp later

If you start your company as a (solo) LLC, and then decide to raise venture capital, you will probably have to convert to a C-corp.

I wonder what the tax consequences of this step would be (in California)?

If you raise, say $1M on a $10M valuation in the process of converting to a C-corp, will you be personally taxed on any of this money?

NOLO seems to suggest such a conversion might be treated as a sale. Does it mean that you’ll be taxed on $10M in capital gains?

http://www.nolo.com/legal-encyclopedia/converting-llc-corporation-s-corporation.html writes:

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].”

Answer 13464

There are a few things at play here. First, most investors like to see a company formed as a C-corp (like you said), specifically a Delaware C-corp because that’s what they’re used to dealing with.

Second: LLCs are pass-through entities. This means that you as an individual pay the taxes and assume the losses of the business. This means that the business does not get taxed, but you do (at whatever rate your income amounts to). It’s important to note that investments considered paid-in capital, and are not taxed as income. I don’t know whether this applies to LLCs because the money is technically going to the individual, not the corporation. This would require you to hire an accountant who knows much more about tax law than I do.

The catch to all this, however, is that you’d never be able to do it. No credible VC would allow you to. Therefore, you will have to convert to a C-corp before you ever raise any money. Afterwards, you probably wouldn’t pay any taxes on this money due to capital gains and paid-in capital like I said above. There are a few ways this could go down:

  1. You own all the shares. You simply form a new company with the same name, and have a lawyer draft documents showing the transfer of equity. Usually you buy these shares from this newly formed company at a nominal price (maybe $100 for 100% of x number of shares).
  2. You do not own all the shares. You would have to go through the above process, but deal with other people. This is always harder.
  3. You can sell the LLC to the corporation for the same nominal fee, or exchange equity. These all require lawyers (which is where these options are coming from) so definitely consult.

And finally: There is something called an investment tax credit (most states have these). This is where investors can claim tax-exemption for up to a certain amount of profit (sometimes up to $10M) for companies that reach a certain age. This is something investors like, and that timer does not roll over from your LLC. This is just one of the reasons they will force you to form a C-corp: they can not get these benefits if you are an LLC.

Long story short, if you are planning on raising capital, save yourself the headache and just incorporate.

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