Is 409a Valuation Required When Converting LLC to C Corp?

The 409a valuation can be based on the criteria of how the LLC and C corp are working and what is their net income and EBITDA.

When a new business owner lacks the financial resources to form a corporation, he or she may choose to form a limited liability company instead. Due to the separation of company and personal assets, as well as the normal option for less taxation on company revenue, this may be the best approach to take at first. However, it may be more advantageous to change the business from an LLC to a C corporation at some point.

Converting LLC to C corp

Among other advantages, converting an LLC to a C corporation allows business owners to create stock in their new corporation. This draws investors and provides equity to employees without requiring them to become partners. However, converting from an LLC has some disadvantages. Learn more about how the process works, as well as the benefits and drawbacks, to determine if a corporate structure is ideal for your company.

Overview of LLC and C corp

A limited liability company (LLC) is a type of corporation that protects its owners from personal liability for the company’s debts and liabilities. The regulations governing limited liability companies (LLCs) change from state to state. An LLC can be formed by any corporation or individual, with the exception of banks and insurance companies. Profits earned by LLCs are not subject to direct taxation. Members split profits and losses, which they report on their own tax returns. A C corporation is a legal entity that serves as an intermediary between the business’s operators and its owners, who may or may not be operationally involved. Shares are used to monitor ownership, with each share equivalent to a defined part of control over the business and a claim to its economic upside. Shareholders are the people who own a company.

The major difference between LLC and C corp

An LLC is a legal company distinct from its owners, who are referred to as “members”. The members of a limited liability company (LLC) can be one or several. A C Corporation is a business entity that is taxed separately from its shareholders. C Corporations, unlike S Corporations, are taxed twice: once on earnings and again on the owners’ wages. S Corporation ownership is restricted by the IRS, but LLC ownership is not. Internally, S Corporations have extra formality. For LLCs, it is suggested but not needed. LLC owners have the option of having the LLC managed by the owners or the management. The management of an LLC by its owners is similar to that of a partnership. It strongly resembles a corporation if it is managed by management. The owners will not be involved in the day-to-day operations.

Why do LLCs convert to C Corp?

Most VCs want to place their money into businesses to protect their investments and take advantage of more clear tax reporting. In an LLC, your options for providing shares to your employees are restricted.

  • To raise venture capital – The allure of cash causes entrepreneurs to severely underestimate the amount of time, effort, and creative energy required to get the money in the bank. This is possibly the most undervalued component of fund-raising. During the fund-raising cycle, managers of new companies sometimes devote up to half of their time and the majority of their creative energy to raising outside financing.
  • To offer employee equity – Employee equity is a component of the employee’s compensation package. It is non-cash compensation in the form of equity that gives employees ownership in the company to the level of shareholding.
  • To make Tax treatment and structure easy – Individuals or organizations utilize a tax shelter to reduce or eliminate their taxable income and, as a result, their tax liability. Tax shelters are lawful, and they can range from favorable tax treatment for assets or investment accounts to activities or transactions that reduce taxable income through deductions or credits.

When should you consider converting LLC to C Corp?

Despite the fact that there are numerous reasons why a company should start as a C corporation, it is not uncommon for entrepreneurs to do so. Founders typically assume that it is easier to start a firm as an LLC and that they can always change the company to a corporation when the time comes, and this is frequently the case. However, there may come a time when different causes force an LLC to convert to a corporation or prompt the founders to consider whether changing is in the best interests of the company and its owners. For federal tax purposes, this post assumes that the LLC being converted is taxed as a partnership or a disregarded company.

409a valuation when converting LLC to C corp

A statutory conversion or reincorporation of an LLC into a C corporation is considered a continuation of the original business entity and is not a taxable corporate event. As a result, there is no reason to specify the company’s valuation at the time of conversion, and the part value chosen has no income tax implications. There is no requirement in Delaware for the par value to represent the company’s current market or book value. As with a new organization, the par value might be set low. The 409a valuation can be based on the criteria of how the LLC and C corp are working and what is their net income and EBITDA.

Important considerations when converting LLC to C Corp

Converting your small business from an LLC to a corporation is a complicated procedure that depends on a number of criteria. Here’s a quick rundown of some of the more fundamental concerns with this type of conversion.

  • Goals – One needs to understand the goals of the conversion. It’s important to understand that converting an LLC taxed as a partnership to a C corporation through a statutory merger is fundamentally different from converting an LLC taxed as a corporation to an S corporation through a statutory conversion, both in terms of tax consequences and required paperwork.
  • Management – Prepare a conversion plan and get LLC members’ approval; file a certificate of conversion, as well as an LLC certificate of formation and other legally required documents, with the secretary of state. While the technical differences between a statutory conversion and other types of conversion are significant, the practical results are the same: People who were LLC members are now stockholders in your new corporation, and your LLC’s assets and obligations are now the assets and liabilities of your new corporation.
  • Tax – Converting a C corporation to a pass-through business may be an option for C corporation owners who want to keep the limited liability and transferability of ownership that the corporate entity affords while avoiding double taxation on corporate earnings. As a prosperous firm matures, it gets more difficult to “zero out” corporate taxable income using shifting mechanisms such as salaries, fringe perks, and interest payments.
  • Valuation – Because the need for limited liability may rule out a partnership, and constraints on the number and type of shareholders, as well as the potential of entity-level taxes, a C corporation’s conversion to a single-taxation organization, is likely confined to the LLC form.
  • Pre and post company capitalization – PPS and completely diluted capitalization are indirectly proportional (i.e., when one increases, the other decreases). Hence the larger the fully diluted capitalization, the lower the price an investor will pay per share. The timing of appraisal differs between pre-money and post-money. The value of a company before external finance or the most recent round of funding is referred to as pre-money valuation. Outside funding or the most recent capital injection are included in the post-money valuation.

The right way to convert your LLC to C Corp

Converting from an LLC to a C-corp can make it easier to raise funds, among other things, but it can be a time-consuming procedure for some businesses. Here’s what you need to know if you’re deciding between a C-corp and an LLC:

  • Statutory conversion – A statutory conversion is a relatively recent, streamlined technique that allows you to convert your LLC to a corporation by completing a few forms with the secretary of state’s office. It is currently accessible in many states. Each state that allows statutory conversions has its own forms and regulations. In general, however, the stages for a statutory conversion are as follows:
    • Prepare a conversion strategy and have the LLC members accept it
    • With the secretary of state, file a certificate of conversion, as well as an LLC certificate of formation and other legally required documents, if necessary.
  • Statutory merger – The process of statutory merging is more difficult than the process of statutory conversion. If your state does not permit statutory conversions, you will almost certainly employ this procedure. While particular details vary by state, the following are the most common processes in a statutory merger:
    • Create a new company (which means your LLC members will now also be corporation stockholders)
    • Both as LLC members and as corporation investors, have the LLC members vote to approve the merger.
    • Having LLC members formally exchange their membership privileges for corporation shares; and
    • With the secretary of state, file a certificate of merger and/or other legally required paperwork.
  • Nonstatutory conversion – Nonstatutory conversion is the most difficult and costly method of converting an LLC to a corporation. The main steps are, in a nutshell:
    • Create a new company
    • Transfer the assets and liabilities of your LLC to the corporation in writing.
    • arrange for the legal swap of LLC membership interests for corporate stock.
    • Otherwise, the corporation should be properly liquidated and subsequently dissolved.

Why do valuation and capitalization matter when converting LLC to C Corp?

Choosing amongst the several possibilities can be difficult. There is no single best entity type. For one organization, the best option may be a bad one for another. Each entity type has its own set of legal and tax ramifications that may make even the most seasoned professional’s head spin.

To make problems worse, few CPAs or attorneys are ready to take a risk and make broad assertions or provide high-level counsel. They are hesitant to do so because every scenario is unique, and every rule has an exception.

IRC guidelines and approaches for LLC to C Corp

Creating an LLC is far easier than forming a corporation, and it typically requires less paperwork. Because LLCs are governed by state law, the procedure for forming one varies depending on the state in which it is filed. Most states require you to file articles of incorporation with the Secretary of State, and some even allow you to do so online.

  • “Assets-up” conversion – The LLC distributes all of its assets and liabilities to its members in order to dissolve the LLC, and the members then transfer all of the LLC’s assets to the corporation in exchange for all of the corporation’s outstanding stock and the corporation’s assumption of all of the LLC’s liabilities.
  • “Assets-over” conversion – The LLC transfers all of its assets and liabilities to the newly constituted corporation in exchange for all of the company’s existing stock, and the LLC is terminated by distributing all of the corporation’s shares to the LLC members (“assets-over” since assets are transferred.
  • “Interests-over” conversion – LLC members transfer their LLC interests to the newly-formed corporation in exchange for all of the corporation’s outstanding shares, thus terminating the LLC and transferring all of the LLC’s assets and liabilities to the corporation.

How to perform 409a valuation when converting LLC to C Corp?

If the stock was valued within 12 months of the pertinent option grant date and no material change occurred between the valuation date and the grant date, the 409A valuation is assumed reasonable. If these conditions are met, the IRS has the burden of proving that the valuation is “grossly unjustified”. Limited liability companies (LLCs) are distinct from corporations. When an LLC’s charter document is filed, there is no limit on the number of membership interests that can be declared. The number of units that can be created if membership interests are stated as units is potentially endless (subject to any limits imposed in the Operating Agreement). If membership interests are specified as percentages, the total is limited to 100%, but there is no limit on the number of members or how many they can have.

How do options work when converting LLC to C Corp?

Create a separate corporation with members of the LLC as stockholders. Make a merger plan and have each participant sign off on it. Your membership interests will be exchanged for shares in the new corporation. Submit a merger certificate to your state.

  • Liquidation options – A limited liability company is frequently formed and then continues to exist indefinitely. However, life does not always go according to plan, and the firm may need to be dissolved. There are a variety of causes for this, and economic failure isn’t usually one of them. The company owner may choose to dissolve the company willingly, or the Secretary of State may have taken the decision if the company failed to pay taxes. There are a few processes that must be followed in order to dissolve a limited liability corporation; you cannot simply stop conducting business. An LLC must formally terminate, which can be a difficult procedure.
  • Merger options – Occasionally, businesses must relocate from one state to another in order to reduce operating costs or improve the quality of life for owners and employees. Finding suitable space, applying for tax and other advantages (e.g., municipal property tax abatements), coordinating workers, contacting customers, acquiring business permits, and physically making a move are all duties that must be completed during business relocation. Another key factor to consider is how to move your formal business entity.

Get experts’ help in 409a valuation when converting LLC to C Corp

Remember that a correct 409A valuation can help insulate you from negative tax repercussions, and if an investor rejects your valuation, it’s a sign that the IRS might as well. It’s good to get a 409A valuation from a reputable independent supplier to get the most available protection. Eqvista can help you in doing the conversion of LLC to C Corp with the 409a valuation. All you need to do is to fill up the sign up form, and one of our consultants will reach out to you.

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