The tax consequences for converting an LLC into a corporation depends on a number of factors. Since the Internal Revenue Service doesn’t have a separate tax category for LLCs, some of the consequences depend on how the company was taxed prior to conversion. How the conversion takes place also has an impact, as each of the possibilities creates a different tax scenario.
An LLC doesn’t receive special tax consideration by the IRS. It can be classified as a sole proprietorship if there’s only one owner, or a partnership or corporation if it is not. Start-ups may choose to be considered a partnership, because if the business takes losses, they are passed through onto the individual owners’ tax returns and can reduce their taxable income. Once a business starts turning a profit, converting to an S corporation and paying its owners a salary can save on self-employment taxes, and treatment as a corporation can lower the tax liability as it grows.
LLCs can covert to corporations in three ways. In many states, a statutory conversion transforms LLC members into corporate stockholders with the filing of a few forms with your secretary of state. It’s the quickest and least expensive method of converting into a corporation. In those states that don’t allow statutory conversions, a statutory merger performs much the same function, but the new corporation has to be formed as a separate entity before the transfer can occur. Finally, the transfer can take the form of a nonstatutory conversion, with three methods recognized by the IRS.
In assets-over conversion, the first of three nonstatutory conversion options, the LLC transfers the company’s assets and liabilities to a corporation. The corporation then issues stock to the LLC owners in proportion to their stake in the venture, and the LLC subsequently dissolves. When an LLC chooses an assets-up conversion, it first distributes its assets to its owners and then dissolves. Owners then transfer their shares of assets and liabilities up to the newly formed corporation. Similar to the assets-over conversion, in an interest-over conversion, LLC owners transfer their capital interests to the corporation and receive in exchange a proportionate amount of stock in the new venture. In this case, it’s the owners doing the converting individually, rather than the LLC as an entity.
Converting an LLC into a corporation can have different tax effects depending on the state of incorporation and the revenue of the business. If your business chooses to liquidate assets in the LLC and then transfer assets to a newly formed corporation via the assets-up method, for example, you'll pay taxes on the distribution that exceeds your basis in the company. Meanwhile, using the assets-over method would not require that the owners pay capital gains taxes, because that isn't deemed to be a distribution of cash. As a result, therefore, assets-up generally is used only if there's a specific tax benefit for doing so, or if a facet of your state law requires it.