LLC to C-Corp. Conversion: Pitfalls to Avoid

LLC to C-Corp. Conversion: Pitfalls to Avoid

In looking at the issue of limited liability company (“LLC”) to C-corporation conversions, there are often two critical questions that are raised by founders and their advisors:

1) How do we ensure that the transaction is not a taxable event; and, related
2) How do we maintain economic equivalency between the securities held by members in the LLC, and the securities distributed to them in the C-corporation.

Why Convert?

Many entrepreneurs form new businesses as LLCs. Many founders prefer LLCs for two reasons:

1) They are tax “flow-through” structures – namely, they can offset LLC losses against other income they may have;
2) Tax treatment upon sale of an LLC may be relatively favorable. A good overview of these advantages can be found here.

It’s typical for many services companies to be founded as LLCs, as well as companies that are founded by serial entrepreneurs or founders with diverse business interests and holdings. The personal tax flow-through benefits in particular could not be achieved through a C-corporation structure.

If you formed your company as an LLC but then seek institutional venture capital or angel funding, venture capitalists will typically, and angel investors will sometimes, require you to convert your company into a C-corporation. If you are a startup and wish to join an accelerator, it may also require conversion into a C-corporation, and if you wish to adopt a capital structure that allows the issuance of conventional stock options, you may wish to convert the LLC into a corporation.

Conversions of LLCs to C-corporations in other instances, including for friends and family financing rounds, are less common among emerging-growth companies, and conversions of LLCs into other entities, such as S-corporations and partnerships, are even rarer. Conversions into business forms other than C-corporations will be discussed in a later article.

Conversion Mechanics

Delaware has relatively simple requirements for conversions of Delaware entities. Once the conversion of a Delaware LLC into a Delaware corporation has received majority member approval (or whatever applicable approval is specified by the LLC’s operating agreement), conversion involves filing a certificate of conversion and a certificate of incorporation (for the post-conversion corporation) with the Delaware Secretary of State, and paying applicable fees.

While some states, like Delaware, have “fast-track” procedures for conversions, different states’ requirements vary, and converting an LLC formed in one state into a corporation incorporated in another state may be especially complex. For example, due to requirements of some states other than Delaware, non-Delaware LLCs may need to be merged into Delaware corporations, which is a more complex process than the one described in the preceding paragraph.

Upon the effectiveness of the conversion as described above, all of the LLC’s property and liabilities are transferred to the new corporation, including rights of creditors against the entity. The LLC should also adopt a plan of conversion agreement that provides for this transfer and other conversion-related matters.

As will be discussed below, this is typically NOT a taxable event.

Additional Conversion Requirements

Regardless of the states that are involved with the conversion, there are few additional steps that are generally required for conversions:

(1) confirming pre- and post-conversion capitalization of the company,
(2) confirming the valuation of the LLC prior to the conversion and “booking up” capital account balances; and
(3) organizing the new corporation, such as by appointing directors, approving bylaws and other customary matters for new corporations.

Capitalization and Valuation Matters

In order to convert an LLC into a corporation, confirming the LLC’s capitalization, its members’ capital account balances and the LLC’s valuation is required.

Pre-Conversion Capitalization

First, it is essential to ensure that the LLC’s capitalization is clear. If it is unclear how much LLC equity is outstanding or who owns it, then it will be difficult to confirm who needs to approve the conversion and what equity will be issued upon conversion, and the corporation could be subject to claims by former LLC members that they received incorrect amounts of equity in the new C-corporation.

To ensure clear capitalization, ownership of all securities issued by the LLC, such as membership interests and profits interests, should be correctly documented. The LLC’s capitalization table should be cross-checked against correct equity issuance documents, such as subscription agreements, and they should match.

Capital Account Balances and Post-Conversion Capitalization
Second, it is critical to ensure that capital account balances of the LLC’s members are updated until immediately before the conversion. This is required in order to confirm the capitalization of the corporation after conversion.
Economic Equivalency – A Critical Test
One of the key requirements in a conversion, to maintain the non-taxable status of the transaction, is that there must be economic equivalency between the securities held by a member of the LLC and the securities that each member receives in the form of C-corporation stock.

A fundamental rule of conversions is that an LLC’s equity interests do not necessarily convert, on a 1:1 basis based on numbers of securities outstanding pre-conversion, into similar numbers of shares of stock in the corporation. Rather, an LLC’s equity is converted on an “economic equivalency” basis, meaning that equityholders in the LLC receive equity of equivalent value in the corporation.

The Need for a Valuation
Internal Revenue Code Section 704(b) requires that an LLC maintain capital accounts for its members. The number and type of shares issuable by the corporation upon conversion need to be based on those relative capital account balances, but only after the capital accounts have been booked up to reflect the current fair market value of the LLC and its assets immediately prior to the conversion. To properly book up capital accounts, it is necessary to obtain a valuation of the LLC immediately prior to the conversion. The valuation will typically be necessarily for both the equity as well as separably identifiable assets of the LLC to show the current fair market value.

Further, an LLC’s “profits interests”, which are a type of membership interests often issued to employees, advisors and consultants , do not generally convert into stock options, which are equity issued by corporations for similar purposes. Rather, if there has been an increase in value of the LLC between the profits interests’ grant date and the bookup date, they may typically be converted into restricted stock. The rationale for this is a function of how profits interests work.

When profits interests are issued, there is a “hurdle rate” attached to them which is equal to the value of the company on the date they are granted. This hurdle rate is important so that the issuance of these interests are not taxable as immediate income. If the LLC has increased in value since the date the profits interests were granted, then they would have an unrealized paper gain, which is recognized by the IRS. If you convert these into options of a C-corporation, on an economic equivalency basis, they would be “in the money” options and you would fall afoul of IRC 409A – namely, you would be creating an immediate tax event for all recipients of those options. External expertise can be useful in navigating these nuanced LLC valuation pitfalls.
Post-Conversion

Once the LLC has been converted into a C-corporation, the corporation will need to undertake organizational steps similar to those of any newly-incorporated corporation, such as approving bylaws, ratifying officers and issuing stock certificates. You may also need to notify your bank and the IRS of the conversion and the corporation’s name.

If the corporation is issuing options, you may need a valuation to establish the strike price of those options under the new corporate structure.

Taxes

An in-depth analysis of the tax treatment of LLC conversions is beyond the scope of this article. However, please note that conversions of LLCs into C-corporations are usually not taxable events. There are circumstances in which the transaction may be taxable however, and a rigorous analysis of the facts surrounding the conversion should be made by a tax expert. For example, if the LLC has third-party debt outstanding (other than trade creditor debt), including convertible notes, the transaction may be taxable.

Further, you may need to file a tax return for the LLC as soon as it is converted into a corporation; otherwise, tax penalties may accrue.