Can I Convert a C Corporation to an LLC?

by Ethan Stone, Stone Business Law

QUESTION:

I converted my startup from a California LLC to a C Corp.  Our business had changed over the past year and I’d like to convert it back.  Is this possible?

ANSWER:

First, a quick but important clarification: I’m not your lawyer and this answer doesn’t establish a lawyer-client relationship. I’m giving a generic answer to a generic question to educate the users of this site. The information below is general in nature and should not be understood as a substitute for personal legal advice.

The bad news is that it is generally not advisable to convert a C Corporation to an LLC.  The reason is taxes.  Here’s what happens:

First, the corporation is treated as if it sold all of its property to its shareholders.  The tax is on the difference between the corporation’s “basis” in its assets and the fair market value of that property at the time of the conversion.  In most startups, the valuable assets consists of intellectual property (patents, trade secrets, trademarks and, to a lesser extent, copyright) and “goodwill” (the value of a business as a going concern).  An asset’s “basis” is, to simplify, usually the cost of acquiring it.  But most startups create their intellectual property and goodwill from scratch, rather than buying them from others, so the basis is normally zero or close to it (the basis will have carried over when the original LLC was converted to a C corporation).  That means almost the entire value of the business is subject to tax.  The impact can be mitigated or, in some cases, eliminated if the corporation has significant “net operating losses” built up that it can deduct from its income.

After the corporation is taxes on the value of the assets, the shareholders are taxed again, as if the corporation sold them the assets in exchange for their stock.  Here, the tax is on the difference between the shareholders’ “basis” in their stock and the fair market value of the assets at the time of conversion.  Again, in most startups, the founders don’t contribute a lot of money for their stock, so the basis is often close to zero, making the entire fair market value of the assets subject to tax again.  If the shareholders happen to have a high basis in their stock (usually because they contributed a lot of money, relative to the value of the company, to acquire it), that can mitigate or eliminate this level of tax.

If you think your corporation and shareholders might have the rare combination of circumstances to make the taxes bearable, you should consult with a tax professional who can check your understanding and run the numbers with respect to your particular circumstances.  This is definitely not a DIY project:  The rules involved are complex, you need to assess the circumstances in detail to apply those rules properly, and the effects of a mistake are punishing.

There is another possibility, depending on your circumstances.  If you convert from LLC to C corporation and then back within the same year and little or nothing has changed in the meantime (i.e. no big distributions to shareholders, not big changes in shareholders etc.), the IRS may allow you to pretend it never happened.  The IRS has published two private rulings (here and here) in the last few years to this effect.  Bear in mind, however, that only the person receiving a “private” ruling can rely on it.  So you can only take these rulings as a general indication of recent IRS thinking.  If you think you might be eligible for this treatment, the only safe route is to get your own private ruling before you convert.  Again, you’ll need the assistance of a tax professional.

By the way, as a matter of California law, converting a corporation to an LLC is a very straightforward process.  You’ll need the other shareholders on board.  You should also take a look at any important contracts to make sure that the conversion won’t violate their terms or give the other party rights you don’t want them to have (such as a right to terminate).  That would be unusual, but it’s best to be careful.  Other than that, you just adopt some resolutions, make a few filings, pay some minor fees and you’re done.

Tip: Consider using a filing service such as Legal Zoom where they file all the documents with the state, get your record book, and more.