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Editorial 9 MIN READ

Converting an LLC to a C-corp in a pandemic market

Thirty months after our first pass at this conversion, the statute is the same, the revenue ruling is the same, and the 21 percent rate has only made the math more decisive

The Editors
Staff, Incorporator.org
9 min read Updated
Contents 6 sections
  1. What 2017 missed and 2020 makes obvious
  2. The three paths, unchanged
  3. The § 1202 clock is the reason to care
  4. What the 2019 § 351 regs cleaned up
  5. Who should actually do this in 2020
  6. Sources

he term sheet still lands, even in April 2020. The wire still requires a Delaware C-corp with a clean cap table, and the conversion from an LLC still runs through 6 Del. C. § 266 and Rev. Rul. 84-111. What has changed in the thirty months since we first wrote this up is not the mechanics. It is the math on the other side of them.

Pandemic diligence is slower by a week or two and harder to schedule, but Y Combinator is running its S20 batch virtually, Sequoia circulated a "black swan" memo in early March that did not stop them writing checks, and term sheets dated after March 15 have been closing. If yours is one of them, the paragraph below is the only thing that changes.

What 2017 missed and 2020 makes obvious

The Tax Cuts and Jobs Act took the federal corporate rate from 35 percent to a flat 21 percent effective for taxable years beginning after December 31, 2017 (Pub. L. 115-97, § 13001). That single line is the reason the LLC-versus-C-corp argument reads differently now. In 2017 the pass-through structure was defensible on rate alone for a profitable company that intended to distribute its earnings; today the combined federal corporate plus qualified-dividend rate on distributed earnings lands meaningfully below the top individual rate on ordinary pass-through income, and the 199A deduction that was supposed to close the gap has enough carve-outs (specified service trades, wage-and-basis limits, the $163,300 / $326,600 2020 thresholds under Rev. Proc. 2019-44) to leave most venture-track founders outside it anyway.

The argument for staying an LLC used to be: you will pay ordinary rates once instead of corporate plus dividend. In 2020, for a company that will not distribute for years and will eventually sell stock under IRC § 1202, the argument flips. The C-corp gets a 21 percent entity rate, retains earnings at that rate, and lets the founder exit into the § 1202 exclusion. The LLC gets a 37 percent top ordinary rate on allocated income whether it distributes cash or not.

The investor does not care about any of this. The investor cares that the entity taking the wire is a Delaware C-corp with common stock and a preferred series authorized in the charter. The founder who reads only the investor's checklist converts without understanding what the conversion is buying them. The founder who reads this piece converts with the § 1202 clock in mind and structures accordingly.

The three paths, unchanged

Rev. Rul. 84-111 (1984-2 C.B. 88) still governs, and the three situations it lays out still describe the only three ways to get from LLC to C-corp without triggering tax beyond what IRC § 351 allows on the contribution of assets for stock. A Delaware LLC taxed as a partnership converts to a Delaware C-corp by one of these routes.

Situation 1, the assets-up path. The LLC contributes its assets and liabilities to a newly formed corporation in exchange for stock, then distributes the stock to its members in liquidation. Two steps. The members end up holding stock; the LLC ceases to exist. Used when you want the cleanest possible historical basis story and are willing to accept the paperwork of forming a new corporate entity and winding up the LLC.

Situation 2, the assets-over path. The members distribute their LLC interests to themselves in liquidation of the LLC (treated as a distribution of the underlying assets under IRC § 731), then contribute those assets to a newly formed corporation in exchange for stock. The members are the middlemen. This path is tax-identical to Situation 1 on paper but structurally awkward, and most practitioners avoid it unless state-law constraints forbid the other two.

Situation 3, the interests-over path. The members contribute their LLC interests directly to the corporation in exchange for stock. The corporation becomes the sole member of the LLC, which then terminates as a partnership for tax purposes (a single-member LLC defaults to disregarded entity status under Treas. Reg. § 301.7701-3). This is the most common path in practice because it maps neatly onto the statutory conversion mechanism the Delaware legislature provides.

That statutory mechanism is 6 Del. C. § 266, "Conversion of a limited liability company to a corporation of this State." The LLC files a Certificate of Conversion and a Certificate of Incorporation with the Division of Corporations, the conversion takes effect on the date filed (or a later effective date up to 90 days out, per § 266(d)), and the entity "shall be deemed to be the same entity" as the converting LLC, with its existence continuing unbroken. One filing, one effective date, no transfer of assets in the formal sense. Delaware treats the LLC and the resulting corporation as the same person for state-law purposes; Rev. Rul. 84-111 still governs how the IRS characterizes the transaction, and the statutory conversion is treated as the Situation 3 interests-over path for federal tax purposes.

The filing itself costs $214 for the Certificate of Conversion plus $89 for the Certificate of Incorporation at current Division of Corporations fees, with the usual expedite menu on top. The legal bill runs higher: somewhere in the $3,000 to $15,000 range for a clean conversion with a sophisticated corporate counsel, depending on the cap-table complexity and the number of equity holders who need substituted grants.

The § 1202 clock is the reason to care

IRC § 1202, qualified small business stock, excludes from gross income gain on the sale of QSBS held more than five years, up to the greater of $10 million or 10 times the taxpayer's basis. For stock acquired after September 27, 2010, the exclusion is 100 percent (IRC § 1202(a)(4), as amended by the PATH Act of 2015 making the 100 percent rate permanent). For a founder who sells a venture-backed company five-plus years into the life of the C-corp, this is the single largest tax-preferred item in the individual code.

The rule that founders miss, every time, is when the five-year clock starts. It starts on the date the C-corp issues the stock. It does not start on the date the LLC was formed. It does not tack on to the founder's LLC holding period. IRC § 1202(c)(1) defines QSBS as stock "acquired by the taxpayer at its original issue... from the corporation," and § 1202(b)(2) runs the five-year period from the acquisition date. The day you sign the conversion documents is day one.

A company that formed as an LLC in January 2019, converts to a C-corp in April 2020 to close its seed, and sells in 2024 gets no § 1202 exclusion on the founders' stock even though the underlying business is more than five years old at exit. The partnership history does not count.

This is why the timing conversation matters more than the mechanics conversation. If you are pre-revenue and your next round is a year or more out, the question to ask is not "can we convert before the wire" but "should we have been a C-corp eighteen months ago." For founders who can credibly see a venture outcome within five years of the projected exit, the answer in 2020 is almost always yes.

Two further § 1202 gates matter at conversion. The corporation's aggregate gross assets must not exceed $50 million immediately after the issuance (IRC § 1202(d)(1)); for a converting LLC this is almost never a problem, but the test is measured at issuance, so if the conversion is happening simultaneously with a priced round the investor dollars count. And the corporation must be a C-corp engaged in a qualified trade or business for substantially all the holding period (§ 1202(c)(2), (e)); the common exclusions are health, law, accounting, consulting, financial services, and any business "where the principal asset... is the reputation or skill of 1 or more of its employees."

What the 2019 § 351 regs cleaned up

T.D. 9847 (84 Fed. Reg. 1835, Feb. 5, 2019) finalized the regulations under IRC § 351 and related sections, resolving a handful of questions that had been open since the 2006 proposed regs. The substantive bite for LLC-to-C-corp conversions is narrow but real: the final regs confirm that the contribution of property in exchange for stock in a transaction structured under Rev. Rul. 84-111 Situation 1 is respected as a § 351 contribution even where the contributing entity is itself a partnership, so long as the control requirement (80 percent ownership of the corporation immediately after the transfer, under § 368(c)) is met by the transferor group. For conversions where the LLC has a dozen members and the resulting C-corp has the same dozen shareholders in the same proportions, the control requirement is satisfied by construction. Where a simultaneous priced round dilutes the former members below 80 percent at the moment of conversion, the transaction structure matters: the conversion should close, the stock should be issued to the members, and only then should the investor subscription close against a newly authorized preferred series. The order matters for § 351 even though Delaware treats all of it as one instant.

For most 2020 seed-stage conversions this sequencing is the only piece of the 2019 regs a founder needs to know about. The law firm running the closing has a checklist that handles it. The failure mode is compressing the timeline: if the investor insists on same-day conversion-and-wire and counsel does not push back on ordering, the § 351 analysis gets harder and the conversion takes on entity-level gain that could have been avoided.

Who should actually do this in 2020

Convert if the term sheet is signed and the investor will not wire into an LLC. That is almost every institutional investor; the exceptions are rare and specific (a handful of real-estate and royalty-focused funds). The conversion is cheaper and faster than the alternative of arguing with counsel on the other side.

Convert pre-emptively if you are twelve months out from a priced round and you are confident the § 1202 math will matter at exit. The conversion costs roughly the same in April 2020 as it did in October 2017, but the § 1202 clock you start is thirty months further down the track toward the five-year finish line. Starting it earlier is the single most valuable timing decision a venture-track founder can make.

Do not convert if you are a services business that does not clear the § 1202 qualified-trade-or-business bar and is not raising institutional money. The LLC structure is fine. The 21 percent rate is attractive in isolation but becomes a 39.8 percent combined rate the moment you distribute, and a pass-through entity avoids the second layer. If you are profitable, distributing, and local, stay an LLC.

Do not convert to chase § 199A deductions and then undo it later; the flip back to an LLC is a taxable liquidation of the C-corp under IRC § 336 and eats most of whatever 199A saved you. The entity choice decision is a multi-year one, not a filing-season one.

The first LLC-to-C-corp piece we published in 2017 treated the conversion as a late-stage emergency. The 2018 piece on timing a Delaware flip reframed it as a window inside the seed-to-Series-A interval. The 2020 version of the same argument is shorter. The 21 percent rate and the § 1202 exclusion have moved the question from "should we convert before the wire" to "why are we still an LLC." For most venture-track founders reading this in the April 2020 market, the honest answer is that their counsel from 2018 was right and they have been lucky the investors have been patient.

The rule of thumb: if the next priced round is within twelve months and a venture exit is plausible within five years of that round, convert now. The § 1202 clock is the only clock you cannot buy back.

Sources

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