LLCs and C Corps: Changing Legal Structures

LLCs and C Corps: Changing Legal Structures

It wouldn’t be strange if your clients thought about changing their legal arrangements at some time given how frequently businesses change.

Your clients might decide to change from an LLC to a C Corp or vice versa for a number of reasons. The ownership structures and tax implications of the two legal entities vary, but they both shield business owners from personal liability for the company’s debts and legal actions.

LLC Organizational Structure

Proprietors of a limited liability company are called members. One owner constitutes a single-member LLC, while two or more owners constitute a multi-member LLC. The LLC can be controlled by members or by managers in terms of its organizational structure. The state automatically assumes that an LLC is member-managed if the LLC does not identify the management structure.

The Articles of Organization, also known as the “certificate of organization,” which the LLC files with the Secretary of State, contains information about the management structure and other things. The following information is usually contained in articles of organization, although the specifics are state-specific.

  1. Name of LLC
  2. Mission Statement
  3. The physical location of the LLC’s main office.
  4. Postal address
  5. The management structure of LLC
  6. Address and name of the registered agent
  7. Names of LLC’s organizers
  8. Requested effective date

The member of the LLC who handles all official correspondence for the LLC is known as the registered agent. LLCs must appoint a registered agent (a person or corporation) to accept legal documents on their behalf while conducting business in a state other than their home state.

Additionally, the majority of LLCs draught a formal Operating Agreement outlining the operational specifics of the business, including who is accountable for what, how taxes are to be filed, what happens to the company if a member decides to leave, etc. Even in a single-member LLC, it is strongly advised to have a contingency plan in place even though it is not mandated by the state. Operating Agreements further add to the evidence that the company is a separate legal entity, which is crucial for liability consideration.

Last but not least, an LLC might be required to submit an annual report to the state in order to inform the government of any changes to the company’s staff or address.

Management Structure for C Corps

Business owners that operate as C Corporations are regarded as the corporation’s shareholders and employees. Owners/shareholders earn a wage from the company and receive W2s. A board of directors must be established by the owners of a C Corp to manage the business. Important business decisions need to be approved by a director and officers, who must be chosen by the board. Even if there is only one shareholder and one board member, this structure is still necessary.

Additionally, the Board of Directors is in charge of keeping the company in compliance and in good standing with the law. Regular meetings of the C Corps are required, along with at least one yearly shareholder meeting when official minutes are taken.

A C Corp, like an LLC, must draught and submit Articles of Incorporation, often known as a “certificate of incorporation.” Once the company’s Articles of Incorporation are accepted by the state, the company is regarded as a distinct legal and tax-paying entity from its owners. Again, the details needed for the articles of incorporation vary but generally speaking

  1. Name of the corporation
  2. Name and address of the registered agent for the company 
  3. Name and address of the registered agent for the company 
  4. business objective
  5. Whether the company is set up as a stock or non-stock entity
  6. If stock basis: the original classes of stock, the total number of shares authorized, and share par values
  7. Each incorporator’s name and address
  8. Names and addresses of the inaugural board of directors members
  9. Requested date of effect

In order to inform the state of any substantial corporate changes, the C Corp may additionally be obliged to file corporate bylaws (which are identical to the Operating Agreement) and an annual report.

Taxation Distinctions

Despite being legally separate, the IRS treats LLC members and the corporation as one tax-paying entity. The LLC’s earnings and losses are transferred to the owners’ individual tax returns. Additionally, self-employment taxes are applicable to all profits (Medicare and Social Security).

The corporation is a separate tax-paying entity in a C Corp, where the business owners are also company employees. The C Corp gets taxed on its income when it makes a profit. In a C Corp, the corporation is responsible for remitting half of the payroll taxes and deducting the other half from employees’ paychecks. The business owners are then taxed on the portion of business income that is paid to them as salaries—often referred to as “double taxation.” In the event that shareholders receive dividend payments from the firm, they must report the funds as income and pay the necessary taxes.

The Tax Cuts and Jobs Act of 2017 (TCJA) provided C Corporations with a flat 21% tax rate, which may benefit some business owners. A conversion from an LLC to a C Corp may be necessary since certain corporate tax deductions are only available to C Corps.

The profits of an LLC, however, do not transfer to the owners’ personal tax returns if the LLC files taxes as a C Corp. By choosing to be classed as a C Corp, LLCs that retain a significant portion of their revenues (retained earnings) can pay smaller salaries and less in taxes.

LLCs and C Corporations can also decide to be taxed as S Corporations. S Corps are businesses that choose, for federal tax purposes, to pass on corporate profits, losses, deductions, and credits to their shareholders. By separating income into wages and dividends, the S Corp election enables shareholders/owners to prevent double taxation and perhaps pay less in payroll taxes. Not all LLCs, meanwhile, can choose S Corp taxes. Businesses must:

  1. Be an American business
  2. Have only permitted shareholders
  3. individual people, specific trusts, estate
  4. U.S. citizens are required to be all stockholders.
  5. a maximum of 100 shareholders
  6. Have just one type of stock.

The corporation must submit Form 2553 Election by a Small Business Corporation, which must be signed by every shareholder, in order to become an S Corp.

Management structure and a few tax advantages have thus far been cited as grounds for changing from an LLC to a C Corp or vice versa. The primary reason your customer may desire to shift business formats is the difference in investment options.

Differences in Investing

Increasing investor interest is important for the growth of many business owners’ enterprises. The key distinctions between LLCs and C Corps are how and what role the investors play.

In conclusion, LLCs are not allowed to sell any form of stock. The investors must be added as LLC members before an LLC can receive investment funds, and the business must then resubmit its Articles of Organization with the details of the new members. According to state legislation, LLC members can be other LLCs, companies, partnerships, or other LLCs. Members of an LLC are not required to take an active part in running the business.

Every member’s capital contribution to the LLC must be listed in the Operating Agreement. The Internal Revenue Service assumes the investment % proportions of profits and ownership unless otherwise stated. However, LLCs have the freedom to allocate income and ownership as they see proper; for example, more may be allocated to active members. The profits attributable to passive members are not subject to self-employment taxes.

In contrast, C Corps can sell a limitless amount of stock or shares, including stock options to workers. The business must be set up as a C Corp if your client intends to go public with it or give employees stock in the enterprise. The potential for growth, the lack of taxation on business revenue, and the protection from personal liability are the main reasons why investors prefer to invest in C Corps.

Steps for Converting the Structure

The procedure for converting an LLC to a C Corp or vice versa differs by state. However, the majority of states allow businesses to submit a “Statuary Conversion.” In those states that permit statutory conversions, the process is as follows:

  1. Make a conversion plan that must be authorized by each shareholder and member of the LLC.
  2. A certificate of conversion and articles of incorporation or organization must be submitted.
  3. Make payment for the filing fee.

The state may compel the corporation to obtain a new Federal Tax ID Number or EIN (Employer Identification Number) in specific situations. The LLC or C Corp must terminate the business and reorganize the corporation if the state does not permit statutory conversions. Assets and liabilities must be “dissolved” and “reformed” to be subject to dissolution. A “Statutory Merger,” if permitted by the state, can prevent the LLC from being created from scratch.

In a statutory merger, members adopt a merger proposal and exchange their allotted membership interests for shares in the corporation. The process must then be completed by filing a certificate of merger (or whatever the state stipulates) with the Secretary of State’s office.

Your client may be able to form a new C Corp and then make the original LLC a subsidiary of the newly formed C Corp to convert from an LLC to a C Corp. Given that a C Corp is taxed on the sale of its assets, conversion of a C Corp to an LLC is less frequent. The stockholders are then taxed on those gains, resulting in a second instance of double taxation.

Your clients have a lot to think about before altering their business structure. However, with your help, a change can present new opportunities to support the expansion of their businesses.

The tax laws are very complex. Our short blog articles cannot cover in full all the nuances of the rules. Your specific facts may hold various opportunities and possible risks that only trained, experienced, and highly qualified tax specialists can spot. We encourage you to find such help, rather than trying to figure it all out on your own. Consider giving this marketplace a try by posting your project and signing up here.

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