Should You Convert a Corporation to an LLC?

why change from inc to llc

 

Why change from Inc. to LLC? Learn the key tax and management benefits you’ll enjoy if you convert your corporation into an LLC.

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If you’re thinking of changing your business structure, then you might be wondering: why change from Inc to LLC? Is it worth the hassle to get your shareholders’ consent, file all the paperwork, and create an operating agreement for a new LLC?

Depending on your corporation’s unique needs, your business might actually benefit from transforming into an LLC. But it’s not the right choice for every business. In this guide, we’ll discuss what LLCs and corporations are, the benefits of converting into an LLC, and some of the drawbacks of converting.

What is an LLC?

A limited liability company (LLC) is a business entity type created by state statute. To create an LLC, a small business owner files the Articles of Organization. LLCs are owned by members, who can run the business themselves or hire managers to do so as they wish.

From a practical standpoint, an LLC is like a combination of a sole proprietorship or general partnership and a corporation. It’s like a sole proprietorship or partnership because it’s flexible and simple to manage. But it’s like a corporation because it’s a separate legal entity that affords the owners personal asset protection. That means there’s a corporate veil that shields the owners from the business’s debts and lawsuits. In most cases, a member of an LLC can’t lose their personal assets if the LLC defaults on a loan or is sued.

What is a corporation?

A corporation is a business entity that’s created by filing the Articles of Incorporation (or a similar form). Corporations are owned by shareholders, who receive profits from the business in the form of dividends. Every corporation is governed by a board of directors, and the directors appoint officers to manage it, such as a CEO, a CFO, and a president.

Like LLCs, corporations have a corporate veil and personal liability protection. The shareholders usually don’t have personal liability for business obligations like debts and legal issues.

Convert Corporation to LLC: Pros

There are quite a few advantages to converting a corporation into an LLC: tax benefits, flexible management, fewer reporting requirements, and more.

Pass-Through Taxation

One of the biggest drawbacks to a C corporation is double taxation. “Double taxation” is a term used to describe the two layers of taxation that corporations go through. First, the corporation pays the corporate income tax before distributing profits, and then the shareholders pay personal income taxes on the profits they receive from the corporation.

LLCs, however, are taxed as pass-through entities by default. Under pass-through taxation, the business itself doesn’t pay taxes at the corporate level (although multi-member LLCs have to file an informational return). The LLC passes its tax burden through to its members, who report any income they receive on Schedule C of their personal tax returns. So, the LLC’s income is effectively taxed only once, usually causing a lower overall tax burden.

Tax Options

Corporations can’t do much to change their taxation structure (only certain ones can elect S corp status). LLCs have a bit more flexibility, with up to 3 options for how they’re taxed. By default, single-member LLCs are taxed like sole proprietors (also referred to as a disregarded entity). Multi-member LLCs are taxed like general partnerships.

But LLCs can also elect to be taxed like a C corporation or an S corporation if they meet the IRS criteria for doing so. Being taxed as a type of corporation can allow the LLC’s members to reduce their self-employment tax burden by paying themselves like employees. Being taxed as a C corporation also allows a wider range of tax deductions.

Knowing which tax structure is most beneficial for you can be complicated. We highly recommend consulting with a tax attorney to discuss what’s right for your business.

Less-Rigid Management Structure

The management of a corporation is set in stone: the board of directors appoints officers to manage the day-to-day affairs for the business, and they’re accountable to the shareholders for the decisions they make. State laws might vary a little bit about how many officers or directors the corporation must have. But by and large, every corporation has the same management structure.

LLCs, however, are a bit more flexible. LLCs may be member-managed or manager-managed, as set out in its operating agreement. In a member-managed LLC, each member helps run the day-to-day operations of the business. But in a manager-managed LLC, the members appoint managers — who can be some of the members or third parties — to run the business. This flexibility benefits members who might want to invest in the LLC but not run it.

Less Reporting and Paperwork

Business corporations have a lot of corporate formalities they must uphold: drafting and adhering to bylaws, sending an annual report to shareholders, filing an annual report with the state, maintaining meeting minutes, and more. While these requirements aren’t impossible to keep, they can be tedious, especially for small businesses.

LLCs are generally much simpler. In most states, LLCs have to file an annual report, and that’s the primary paperwork step after formation. LLCs can provide reports for their members or keep minutes for member meetings, but they aren’t strictly required to like corporations. Additionally, an LLC’s operating agreement isn’t a requirement in most states — although we highly recommend drafting one.

More Options for Distributing Profits

In a corporation, ownership is evenly divided between shares of stock, and each share has a set value. All shares have the same value (unless there are different classes of stock). So each shareholder receives the corporation’s profits in direct proportion to the number of shares they hold.

LLCs, however, have more options because the operating agreement can dictate how much of the profits goes to each member. By default, each member receives a distributive share that matches the percentage of their initial contribution. For example, if two members both gave an initial capital contribution of $5,000, then they’d each receive 50% of the profits by default.

But that same LLC could also elect to split profits in a 75/25 split if one member does more of the work and the other primarily invests. Ultimately, the LLC can set out a profit distribution structure that works best for their needs. The only catch: profit distributions and membership interests should be clearly set out by the LLC’s operating agreement.

Convert Corporation to LLC: Cons

As with any big decision, there are a few drawbacks you should be aware of if you’re going to convert your corporation into an LLC.

LLCs aren’t recognized outside the U.S.

The limited liability company business structure is created by state statute, and the federal government upholds it. Other international governments, however, don’t recognize LLCs. You can’t, for example, qualify as a foreign entity as an LLC in France.

If your business has aspirations of setting up an international presence, then you’ll need a corporation. Other countries outside the U.S. recognize the corporation, meaning you’d have ample opportunity for international expansion.

Note: normally, “domestic entity” refers to a business that’s formed in one state and qualifies as a foreign entity in another state. However, in the context of international business, a domestic entity refers to businesses formed in the U.S. Be sure not to confuse these different areas. 

LLCs can’t raise money by selling shares

Raising capital as an LLC is challenging because LLCs can’t sell shares. For the most part, an LLC can only raise additional capital if its members make additional capital contributions. They can also get loans, but those come with expensive interest and financial obligations.

On the other hand, corporations can more easily raise funds by selling shares.

LLCs have less prestige than corporations

When you ask someone to name a big, successful business that they admire, there’s a good chance they’re going to name a corporation. That’s because the small qualifier “Inc.” adds a lot of weight to a business. In the public eye, corporations enjoy a lot of prestige.

By comparison, LLCs aren’t as highly regarded. They’re still perfectly legal, but often they don’t have the same public recognition. Additionally, venture capitalists generally prefer to invest in corporations over LLCs.

LLCs are harder to sell

It’s very common for business owners to sell their business, perhaps because it’s time to move on to a new endeavor or they’re ready to retire. It’s actually somewhat complicated to sell an LLC, especially for multi-member LLCs. The sale of an LLC (or part of an LLC) is strictly governed by the LLC’s operating agreement or the state’s default rules. In some states, unless the operating agreement explicitly provides for a sale, the LLC has to dissolve completely when a member wants to leave or sell.

In contrast, with a corporation, an owner can just sell their shares as a relatively simple transaction.

We can help!

Managing your business can feel like a solo endeavor, but it doesn’t have to. Here at ZenBusiness, we handle the red tape so you can focus on what matters: your business. Whether you need help forming your corporation or LLC, a template to create your first operating agreement, or anything in between, we’ve got your back.

Disclaimer: The content on this page is for informational purposes only, and does not constitute legal, tax, or accounting advice. If you have specific questions about any of these topics, seek the counsel of a licensed professional.

Why Change from Inc to LLC FAQs

  • Converting a corporation into an LLC (or vice versa) can be a complicated or relatively straightforward process depending on your state’s conversion statutes. Some states allow for a statutory conversion, which lets you change your business type with a single, simple form (often called the Certificate of Conversion). In other states, you’ll need to conduct a statutory merger. In a merger, you’d create a new LLC, draft merger agreements to transfer your corporate assets to the new LLC, and then dissolve the corporation.

    Each state has different forms and procedures for converting a corporation. And no matter what form you file, you’ll need to create a plan of conversion and get it approved by your shareholders.  We highly recommend getting legal counsel to navigate the conversion process.

  • There are lots of reasons you might change a corporation into an LLC: easier management, fewer corporate requirements, flexible taxation, pass-through taxation, and more. There’s no one-size-fits-all answer to whether a corporation or LLC is better for your business, though. Each business has unique needs. If in doubt, consult with a business attorney for personalized advice.

  • If you’d like to have your C corporation taxed like an S corporation, you first have to meet all the IRS criteria for an eligible entity. This includes being a domestic corporation, having fewer than 100 shareholders (who are all individuals or qualified trusts), and only issuing one class of stock. As long as you meet the criteria, you can submit IRS form 2553, Election by a Small Business Corporation, to elect S corp status.