Navigating the change from LLC to Delaware C Corporation

At Anomaly CPA, we often get asked when is the best time for a new company to convert from an LLC to a C Corporation.  While the answer may seem straightforward, there are usually multiple considerations.  As the CEO of Anomaly CPA, I've had the privilege of guiding various entrepreneurs through this intricate journey, particularly within the SaaS landscape. The motivation behind such a transformation often stems from the pursuit of venture capital, the desire to issue stock options, or the preparation for an IPO. 

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The decision has multiple legal and tax complexities but it can also lead to substantial growth and opportunities. In this post, we'll dive into this process and make the technicalities more relatable including some examples we have worked through with clients. 

Why consider the conversion from LLC to Delaware C Corporation?

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So why do investors, founders, and startups even consider this conversion and all the complexities that come with it? LLCs are lauded for their operational flexibility and tax benefits, offering a straightforward pass-through taxation mechanism that benefits their members in early years, while there are losses. However, when businesses, particularly those in the technology sector, reach a certain scale, the need for external investment becomes apparent. C Corporations attract a wider pool of investors thanks to their familiar equity structure and potential tax advantages upon exit.

The typical steps to follow

While Delaware is the most popular state to incorporate your C Corporation, you can incorporate in nearly any state.  Delaware's reputation as a business-friendly state is well-earned, offering a streamlined process for LLCs to convert to C Corporations. 

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The journey involves several important steps:

1. Plan of conversion drafting: The first step is having your counsel draft the official plan on conversion.  This is a foundational document that outlines how the LLC's member interests are translated into shares of the new C Corporation.  Depending on the type of LLC interests (capital, profit, etc) this may be complex and involve your tax counsel as well.  
2. Gaining member approval: You can’t do this conversion on your own, unless this is a single member LLC!  This member approval step is a critical step that often requires a majority vote, but this can vary based on the LLC's operating agreement.
3. Certificates of conversion and incorporation: These documents, filed with the Delaware Secretary of State, mark the official legal conversion of the entity from an LLC to a C Corporation.  Further, it is important to work with your advisors to see if you will be required to obtain a new IRS EIN or the existing EIN will survive.  From a practical standpoint, we always recommend that companies get ahead of this if their advisors inform them the entity will need a new EIN.  This could cause significant operational headaches.
4. Adopting corporate bylaws and other formalities: This final step solidifies the new entity's internal governance and operational framework.  Bylaws are a necessary document for your new corporation and will replace the operating agreement that your former LLC had.  Without a doubt, an attorney who is familiar with Delaware (or the state you incorporate in) should be drafting this. 

Tax implications: A closer look

The tax landscape undergoes a significant transformation post-conversion:

1. End of pass-through taxation: The LLC's pass-through status is replaced by the C Corporation's subjectivity to corporate income tax.  It is important that you work with your tax advisor to understand how you’ll be taxed from both a corporate and personal standpoint after this conversion.  
2. Understanding your tax basis: The conversion officially ends the pass-through partnership taxation and all members are not shareholders of the corporation.  It is important to understand how your former adjusted basis in the partnership has translated into the stock ownership of the new corporation.  This will ultimately affect a future gain or loss on disposition.  
3. The double taxation dilemma: A notable drawback of C Corporations is the double taxation on profits and dividends, a stark contrast to the LLC's tax treatment.  Smart planning can reduce or mitigate these effects.  Further, if you have losses, the losses will no longer pass through the members and will be treated as Net Operating Losses at the corporate level. 

CoffeeTech Innovations: A case study

Let’s review a practical example that mirrors a client conversion we recently navigated.  CoffeeTech Innovations, while a hypothetical entity, mirrors the challenges and opportunities faced by many companies contemplating this transition. Initially thriving as an LLC, CoffeeTech's ambition to scale and attract significant venture capital necessitated a shift to a C Corporation structure. When the big VC players came to town, staying as an LLC became a nonstarter as the VCs did not want to deal with the complexities of passthrough taxation.

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However, this move was not merely about legal and tax preparation but a strategic realignment of their business model to fit their growth aspirations.

Navigating CoffeeTech's conversion

1. Strategic planning: The initial phase involved thorough planning, ensuring that every member's stake was equitably converted into shares of the new corporation.  The company had multiple series of “profits interests” which further complicated the process and involved outside counsel.  The process is not always straightforward and pre-conversion equity maneuvers may be needed.
2. Ensuring compliance and approval: Transparent communication facilitated unanimous member approval, a testament to the importance of alignment and clear vision.
3. Tax Strategy and Execution: Addressing the tax implications was important to the founders who wanted to ensure they could maximize their IRC 1202 benefits. We deployed certain 1202 strategies to maximize their future benefit on the disposition. 

Wrapping up changing from a LLC to a Delaware C Corporation

The decision to convert your company from an LLC to a Delaware C Corporation should be carefully considered as you scale.  Work with experienced tax and legal counsel early on to educate yourself on the pros, cons, and future complexities of such a decision.   

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LLCs by nature are quite flexible and the conversion to a corporate structure can come as a shock for some founders, given the rigidity and complexity of corporations.  However, if the long-term economic benefits outweigh these complexities, this can be a prudent move for some startups. 

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