I had a client press me recently about converting from an LLC (taxed as a partnership) to a corporation. The client had been considering raising money from angels and wanted to grant traditional corporate-style stock option to employees.
I suggested that if he wanted to raise money from third parties (whether angels or venture funds) and grant traditional stock options to employees and service providers, that it would probably make sense for him to convert to a C corporation.
“Most investors don’t want to invest in a pass through company. Either an LLC or an S corporation,” I told him. “They don’t want to receive a Form K-1. Plus, stock option style equity grants in an LLC are not easy; they require book ups and complex capital account maintenance accounting.”
He and his co-founder changed their minds about raising angel money. The client didn’t think they needed or wanted to raise money from third parties, but still wanted to give employees traditional equity incentives. Their concern was, if they converted to a C corporation and decided to sell down the road, the future buyer might only want to buy the company’s assets and not the stock – thereby giving rise to the dreaded double tax.
“It is possible that if you convert your LLC to a C corporation that you could spend several years growing the business, and then have a buyer demand to buy the assets and not the stock,” I said. “If that happened and you went ahead and had the C corporation sell the assets, there would be a corporate level of tax owed that you would have avoided had you remained an LLC.”
“However,” I added, “there are still a number of good reasons to be a C corporation, and the likelihood of what you described happening is, in my experience, not common. You see, most ‘up’ deals are stock deals, or structured one layer of tax transactions, such as reverse triangular mergers.”
The client remained uncertain. I couldn’t tell the him that what they were afraid of was out of the realm of possibility, because frankly, it was a possibility. I have seen it happen on a few occasions in my career (granted, it’s been a long time). On at least one occasion in the past, a C corporation received an acquisition offer on its assets. The buyer wouldn’t budge on its demand to buy assets and not stock. In that case, due to the adverse tax consequences, the C corporation had to pass on the deal.
“Well, we want to remain an LLC then,” the client said.
“OK,” I said “but keep in mind that if in several years an acquiror company wants to acquire your company in an all stock transaction, you won’t be able to defer your gain on a stock deal until you sell the stock.”
“What do you mean?”
“Well, it is not uncommon for some acquirors, especially public company acquirors, to purchase other companies in all stock or mostly stock transactions. Meaning, your stockholders will receive a portion of the deal (at least 40%) in stock, which might not be liquid. In that case, they won’t be able to sell it for some time. But if you are an LLC, such an acquisition could not qualify as a ‘reorg’ under the tax law, thus you would be taxed on the stock as if you received cash and turned around and bought the stock.”
“That sucks,” he said.
“I know,” I replied.
“What do I do?”
He wanted me to make the decision for him; to end his agonizing over the decision. I couldn’t do it. It was his business; his decision.
“If I just stick as an LLC,” he said, “just how bad will it be again?”
“Well,” I said, “you will have to worry about book ups, and capital account maintenance, and a complex LLC agreement. But there are worse things that could happen to you than spending quality time with your tax lawyers and tax accountants. Just enjoy.”
“Plus,” I added, “if you remain an LLC you will not have to worry about a double level tax on sale of the LLC and you can always convert to a C corporation later.”
Conclusion
Choice of entity is not always easy. Sometimes it is agonizing.
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