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Editorial 6 MIN READ

Converting an LLC to a C-corp before the round closes

Three mechanics, one IRS revenue ruling, and the QSBS clock that starts over the day you sign

The Editors
Staff, Incorporator.org
6 min read Updated
Contents 5 sections
  1. The three mechanics
  2. Rev. Rul. 84-111 and what actually happens to the tax basis
  3. The §1202 clock, which is where founders lose real money
  4. What you actually file, and what it costs
  5. Sources

he term sheet lands and the investor's counsel sends a clean-up list: Delaware C-corp, 10 million authorized shares, 83(b) elections on file. Your company is an LLC. You now have roughly two weeks and somewhere between $3,000 and $15,000 in legal fees to become the entity the wire is being sent to.

This is a guide to the October 2017 version of that conversion: the three mechanical paths, the one revenue ruling that governs the tax treatment of each, and the one timing point — the Section 1202 holding period — that founders almost always miss until after they've signed.

The three mechanics

There are exactly three ways to turn an LLC into a C-corp, and the IRS has been publicly on record about how each is taxed since 1984.

The first is a statutory conversion. If your LLC is in a state whose statute permits it — Delaware does, under 6 Del. C. § 266 — you file a Certificate of Conversion and a Certificate of Incorporation at the same time, and the entity keeps its EIN, its contracts, and its history. It does not dissolve. It changes form. Delaware charges filing fees for both certificates and processes the pair in the order filed. This is the path most Delaware LLCs use because it is the cleanest on paper: one entity, one timeline, one set of cap-table mechanics.

The second is an assets-up merger (sometimes "assets-over"). You form a new corporation, the LLC transfers its assets and liabilities to the corporation in exchange for stock, and the LLC liquidates, distributing the stock to its members. Two entities briefly exist; one survives. This is the path you use when your LLC is in a state without a conversion statute, or when the deal's structure requires a new entity for reasons of IP ownership or licensing.

The third is a membership-interest contribution. The members contribute their LLC interests to a newly formed corporation in exchange for stock. The corporation now owns 100% of the LLC, and the LLC becomes a disregarded single-member entity of the corporation (or is later merged up). Two entities survive, at least initially. This is the path you use when the LLC itself needs to keep existing — for a state-licensed operating subsidiary, or where a landlord won't consent to a change-of-control.

Rev. Rul. 84-111 and what actually happens to the tax basis

Rev. Rul. 84-111 is the single most important piece of federal guidance here. It describes three situations — an assets-up transaction (Situation 1), a liquidation-in-kind followed by a contribution (Situation 2), and a membership-interest contribution (Situation 3) — and confirms that each qualifies as a tax-free exchange under IRC § 351, provided the members end up in control of the new corporation.

The three situations produce the same answer on the income statement (no gain, no loss, no tax) and different answers on the balance sheet. In Situation 1, the corporation takes a carryover basis in the assets and the shareholders' stock basis equals their old outside basis in the LLC. In Situation 3, the corporation takes the members' outside basis in the LLC interests as its basis in those interests, and the LLC keeps its inside basis in its assets — which, if inside and outside basis have diverged (because of prior distributions, §754 elections, or debt allocation), is where the conversion quietly creates a different future depreciation schedule than you'd get from Situation 1.

A Delaware statutory conversion under § 266 is, for federal tax purposes, treated as a Situation 1 transaction under Rev. Rul. 84-111. The entity-classification regulations at Treas. Reg. § 301.7701-3 are what make this work: the LLC was a partnership (or disregarded entity) by default, a conversion changes its classification to a corporation, and the change in classification is deemed to be a contribution of assets followed by a liquidation. No election is required; the state filing does the work.

None of this produces a tax bill in the ordinary case. What it does produce is a set of basis numbers your new CFO will have to know in Year 2, which is why you want the conversion memo in writing from whoever advises you, not a verbal "it was tax-free."

The §1202 clock, which is where founders lose real money

Here is the point most founders do not learn until they've already signed: the Section 1202 holding period for qualified small business stock starts the day the corporation issues the stock. It does not tack back to when you formed the LLC.

IRC § 1202, in the version in force in October 2017, excludes up to 100% of gain on qualified small business stock held for more than five years, capped at the greater of $10 million or 10x basis per issuer. The stock has to be issued by a domestic C-corp with gross assets of $50 million or less at the time of issuance, and the holder has to acquire it at original issuance in exchange for money, property (other than stock), or services.

A statutory conversion, an assets-up merger, and a membership-interest contribution all issue new corporate stock. That stock can qualify for §1202 if the other tests are met — domestic C-corp, the $50 million gross-asset cap, a qualified trade or business — but the five-year clock on that stock starts at the conversion. Your three years as an LLC do not count.

The practical consequence is straightforward and expensive. A founder who converts in November 2017 with a plausible exit in 2021 has no §1202 benefit on the founder shares. A founder who converts in November 2017 with an exit in late 2022 or 2023 has a full exclusion on the gain up to the cap, which on a modest outcome is worth more than the entire cost of the conversion several times over. If you have an LLC that's been operating for two or three years and you're about to raise, the conversion timing is also your §1202 timing.

There's a secondary consequence. The $50 million gross-asset test is measured, for these purposes, immediately after the issuance and including the assets contributed. An LLC with significant accumulated assets — real estate, an IP portfolio with a high stepped basis, a large cash balance from prior distributions reinvested — can push the new corporation over the cap at issuance and disqualify the founder shares permanently, regardless of how long they're held. This is a real problem for later-stage LLCs and a reason some founders split the contribution or carve out assets before filing.

What you actually file, and what it costs

For a Delaware statutory conversion, the state paperwork is a Certificate of Conversion from a Limited Liability Company to a Corporation and a Certificate of Incorporation, filed together, with state filing fees on each. On the federal side, the entity keeps its EIN but should file a final Form 1065 (if it was a partnership) for the short year ending on the conversion date and a short-year Form 1120 after. The members become shareholders and need new stock certificates or book-entry records, a new cap table with a post-money share count, and 83(b) elections on any unvested stock within 30 days of issuance — the 30-day clock is hard, and missing it is the other way founders quietly lose money at conversion.

For an assets-up merger or a membership-interest contribution, the paperwork is longer: a new Certificate of Incorporation, a plan of merger or contribution agreement, assignments of contracts and IP, landlord and lender consents where required, and dissolution paperwork for the LLC if it's going away.

Legal fees in this market run roughly $3,000 to $15,000 depending on the path, the state, the complexity of the cap table, and whether there are vested options or SAFEs to roll. The statutory conversion in Delaware with a simple cap table and no options sits near the low end. An assets-up merger in a non-conversion state with existing employees on profits interests sits near the high end. Most venture deals run two weeks from engagement letter to closing-ready entity if nothing unusual surfaces.

Rule of thumb: if you're in Delaware with a clean cap table, use § 266 and get the conversion filed the week the term sheet is signed so the §1202 clock starts before, not after, the round closes.

Sources

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