Should you convert your corporation to an LLC?

Depending on your state, the process of converting a corporation into an LLC can be quite easy. But access to an easy conversion process shouldn't be the driving factor behind a decision to convert a corporation into an LLC.

LLCs offer certain advantages over corporations and vice versa. In deciding whether to convert your business structure, it's important to look specifically at why you want to convert and the practical consequences of such a change.

Why go from inc. to LLC?

LLCs offer a number of features that make them a popular choice for many small business owners. If you've been considering changing your corporation into an LLC, one or more of these features is likely what makes the idea of conversion attractive.

The following are just some reasons a business owner might decide to convert their corporation into an LLC.

Tax advantages

Corporations taxed as C corporations (which is the situation for most corporations) face what's known as double taxation. This means you're taxed twice: first at the corporate level, with tax being levied on the corporation's profits, and then again on an individual level, with shareholders being taxed on dividends they've received from the corporation.

Many small businesses that start out as corporations don't run into the double-taxation issue immediately since they often don't make enough profit to distribute dividends to shareholders. However, as your corporation grows and begins to generate greater profits, you may be concerned about how this double taxation will affect you. At this point, the conversion into an LLC might start to look attractive.

This is because LLCs are taxed on a pass-through basis, meaning the LLC's profits are “passed through" to the individual LLC members, to be taxed in their hands only. By converting your corporation into an LLC then, you gain the advantage of pass-through taxation and don't have to worry about double taxation.

Flexible management options

Corporations must be managed according to a fairly rigid structure, with a board of directors to direct overall operations and officers to oversee the day-to-day operational details. Certain decisions require the formal approval of the board and/or the shareholders, evidenced in the form of corporate resolutions and shareholder resolutions. These requirements can add to the challenges of managing a corporation, particularly a smaller one that has only a handful of shareholders.

An LLC, on the other hand, lets you run your company without having a rigid management structure. You have the flexibility to decide how your business will be managed, and these rules are then outlined in detail in your LLC's operating agreement.

If you've been finding the management requirements of running your corporation too onerous—for example, the need to draw up corporate resolutions to document certain decisions may be adding too much to an already overwhelming workload—the increased management flexibility of an LLC may be a better option for your business.

Flexible profit-and-loss distribution

Corporations use shares to distribute ownership interests. The main drawback to share-based ownership is that each share in a particular class of shares is weighted equally, and profits are received based on the proportional ownership of the shares issued.

LLCs, on the other hand, have the flexibility to allocate profits differently. While many LLCs do allocate profits based on ownership interest, an LLC also has the option of structuring an alternate profit-allocation arrangement.

Depending on your particular situation, this may make the conversion from corporate status into an LLC an attractive option. For example, with an LLC, you can allocate a higher percentage of profits to someone who makes a higher cash contribution to the company without altering the ownership percentage. Once the cash contribution has been paid back through profit allocations, the profit-allocation arrangement reverts back to a percentage-ownership basis.

How do I change my business from inc. to LLC?

How you go about converting your corporation to an LLC depends on the rules and regulations of the state in which your business is registered.

Streamlined conversion

Many states offer a streamlined conversion process that lets you make the change without certain formalities, such as forming a new LLC, dissolving the old corporation, and transferring the corporate assets and liabilities to the new LLC. If this option is available in your state, it will usually be the fastest and most cost-efficient way to convert to an LLC.

Merger option

A merger option may be available in your state if no streamlined option is offered. Under this method, you will have to form a new LLC, create a merger agreement to implement the transfer of ownership rights from shares to LLC membership units, and, depending on your state's rules, dissolve the corporation. Unlike the traditional method below, however, your corporation's assets and liabilities will automatically be transferred to the new LLC.

Traditional conversion

A traditional conversion is the most onerous of the three methods. As with the merger option, you'll have to create a new LLC and exchange shares for LLC membership interests. You'll also have to do all the paperwork necessary to transfer corporate assets and liabilities to the new LLC, as well as dissolve the old corporation.

What are the practical consequences of converting my corporation into an LLC?

Practically speaking, converting your corporation into an LLC will eliminate the need to hold directors' meetings and shareholders' meetings and draw up resolutions documenting certain decisions. Overall, it will enable you to run your company without having to adhere to the more rigid requirements of managing a corporation.

Transferring ownership interests is more difficult with an LLC than with a corporation. With an LLC, you have to transfer the LLC membership interests, while the transfer of ownership interests in a corporation is as easy as transferring shares.

However, the most important consequence of converting a corporation into an LLC lies in the potential tax impact. Regardless of the method you use to convert into an LLC, from a tax perspective, the transfer of corporate assets is seen as a liquidation or sale of the corporation's assets. If any gain has been accumulated in the value of these assets—a likely scenario for most corporations—it will be taxed at both the corporate level and in the hands of the shareholders.

These potential negative tax consequences are an important consideration in deciding whether to convert a corporation into an LLC. In many cases, the costs of this additional tax burden vastly outweigh any benefits you may receive from the conversion.

It's worth consulting with a tax expert before deciding to convert so you can evaluate whether conversion is the optimal choice for your business.

You may have many reasons to convert your corporation into an LLC and, depending on your particular state, the actual formal conversion process may be streamlined and cost-effective. However, the tax consequences of a conversion should be an important factor in your decision.