Best of Both Worlds: Converting Your Startup From a LLC to a Corporation

Entrepreneurs often ask my opinion on which type of entity is best for a startup or small business and, while I have written about this before, I generally say that one size never fits all.  That choice is made by each company depending on founder structures, short- and long-term planning, and, of course, tax.  I have seen companies start as corporations and as LLCs and both can be successful depending on your circumstance.  But are you stuck with that form once you make that choice?  That requires a bit of explanation. C-Corporations as Default? Many lawyers and entrepreneurs will tell you that all new startups must be Delaware corporations, and more explicitly, C-corporations.  This is the result of a common view that Delaware law is more friendly to your business than your state's, the courts are specialized and prepared to deal with business law issues that your company may face, and that a C-corporation is the structure that you will need in the event you take on investors (which you will certainly need if you are going to be taken seriously).

Without rehashing my previous post, I don't automatically subscribe to that line of thinking.  There are some startups that have very valid reasons for starting as, say, a limited liability company.  Those are mostly attributable to the flow-through tax structure and the flexibility of management and with allocations and distributions to the members. In other words, a company can take advantage of the tax savings of not having to pay corporate tax like a C-corporation during the early years of operation, the flexibility of adjusting the amount of distributions it gives to its members, and the freedom to customize management and ownership structures.

Can you Change your Entity? And if your LLC needs to be corporation later in life - for, say, investment or tax reasons - state laws provide mechanisms that vary by state for conversion from a LLC to a corporation (note: converting from a corporation to a LLC results in a much different, and less favorable tax treatment).  In Delaware, it is as simple as filing a conversion form.  In other states, such as Massachusetts, the same thing is accomplished through a somewhat more complicated conversion process or by enacting a full merger of your company into a newly-created Delaware entity.

What's it Going to Cost? Yes, there are both legal fees and filing fees associated with this type of conversion that will dissuade some companies from going down this route.  Your company needs to weigh the savings of flow-through tax treatment it will enjoy as a LLC with the cost of going through the conversion later.  And in addition to the legal fees, there are certainly some additional tax issues to consider (there we go again with the tax issues) particularly if you have passive members or hold certain types of debt.  But for many small and growing companies, you could accomplish a conversion without breaking the bank.  The key will be to make sure that your lawyer and accountant are involved early in the process.

Have you converted?  What was your experience?