First the bad news:
- While the conversion from LLC to corporation is simple from a legal perspective and can be simple from a tax perspective, it is not simple from an operational perspective. You get a new taxpayer identification number, you lose credit history, need to redo all identifying documents and web pages that show you as an LLC, new bank accounts and insurance policies, etc. Every time I've converted a client and every time I've spoken to CEOs and CFOs who've done it takes about eighteen months before you figure out all the parts and pieces you need to fix.
- There is also potential serious pain if you convert from an LLC to corporation while you have debt or payables on the balance sheet. If these obligations are assumed by the corporation the owners of the LLC get attributed income from the LLC's debt forgiveness and have to pay income tax at ordinary rates. This can be very expensive and painful.
- If you are an LLC your start-up losses pass out of the entity and are not available to shelter future earnings from income tax. In the future you will have to sell more equity to have the same amount of working capital because you will have lower after tax earnings available for business needs.
- In almost every case where I have seen an LLC used for a start-up, the owners have little or no outside income so they do not benefit from the potential tax reduction which can be created by offsetting the start-up losses against other income. If you convert to a corporation, you will not be able to use these losses until you have non-salary income. This is tax inefficient for the individual and the company.
- Finally, most institutional investors and virtually all VCs will not invest in LLCs. Many angels do not understand them and will not invest. But, before you despair, keep reading for the good news.
And now, the good news:
- If you really do not expect to seek VC investment LLCs can provide a number of advantages to both founders and investors.
- I have found a number of strategic corporate investors who prefer investing in LLCs, both public and privately held.
- If you believe your business is truly capital efficient and will not need multiple rounds of investment, LLCs are a flexible structure.
- If your investors can use the tax losses you can direct those losses toward the investors, providing financial benefit for them.
- If you expect your business will generate lots of free cash relatively quickly LLCs offer a very tax efficient way to distribute cash because you do eliminate tax at the entity level. You need to be careful to protect your owners from attributed income without cash distributions but with some care in financial planning and attention to detail when you draft your LLC agreement this can be accomplished.
- You can create multiple classes of LLC units with different rights, preferences, etc. Be careful of how the classes interact for tax, distributions, etc.
- Until a few years ago you could not have options, convertible debt, warrants or other contingent forms of ownership in an LLC but the IRS changed its rules and those tools are now available.
Bottom line: LLCs can be very useful but should be used only after careful consideration of many factors. Do not use one if you think you are likely to convert to a corporation in the foreseeable future.