Incorporating an LLC

LLC TO INCBy Joe Wallin and Scott Usher of Bader Martin, P.S.

It is not uncommon for founders to start their companies as LLCs and then want to or need to incorporate or convert to a corporation later. Incorporating an LLC does not have to be a difficult or expensive process. It may be, because of exceptional or unusual facts, but frequently it can be quite straightforward.

There are essentially three different ways (well, four, but more on that later) to convert an LLC to a corporation:

  1. You can form a new corporation, and you can merge the existing LLC (via a state law statutory merger) with and into the new corporation. If you use this method, the separate legal existence of the LLC will terminate on the merger and by operation of law the new corporation will succeed to all of the rights and obligations of the LLC.
  2. You can form a new corporation, and then have the LLC contribute its assets to the new corporation in exchange for the stock in the new corporation, and then you can liquidate the LLC.
  3. You can form a new corporation and then have the LLC’s owners assign their LLC interests to the new corporation. Immediately afterward, the LLC will be a wholly-owned subsidiary of the new corporation. You can then either continue to operate the business through the subsidiary LLC or you can liquidate the LLC into the parent corporation. Continuing to operate the business through the subsidiary LLC can work well if the LLC has a bunch of contracts that you don’t want to re-title in the name of the new corporation, or if you don’t want to re-do bank accounts, business licenses, etc. If you follow this route, the transaction looks like this:

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Another method to convert an LLC to a corporation for federal income tax purposes is to “check the box” and file form 8832 to treat the LLC as a corporation, but this is not an ideal alternative. While this will change the tax treatment of the LLC, its legal structure is unchanged, causing any number of complications due to the dual status of the entity.

Tax Issues

The biggest issue on the incorporation of an LLC is typically tax. You don’t want to trigger a tax on the incorporation of an LLC. The most common way you can do this is if the LLC has debt in excess of the basis of its assets.

One not uncommon reason to incorporate an LLC is to be eligible for a tax-free stock-for-stock exchange. If this is your motivation, you will need to avoid incorporating immediately before the exchange, as the IRS has ruled that such a series of transactions can be collapsed, resulting in a taxable LLC interest for stock transaction.

There may also be different state tax consequences among these methods. A number of states (like California) treat LLCs as separate taxpaying entities. Leaving the LLC intact may add another layer of tax filings and/or additional state tax, while merging it may require additional steps to eliminate the need for future filings.

Conclusion

You should always work closely with your counsel and tax advisors on LLC incorporation. It doesn’t have to be a painful process, but you will want to make sure it is done right.

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