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Question about starting out as LLC and converting to C Corp - is this issue a real problem?

Someone just raised an issue with one of my partners and I've never heard anyone else mention it before. Considering the possible implications I'm surprised that it isn't something that comes up all the time, so maybe this other person is mistaken. (I'm not a financial guy at all so bear with me as I try to explain this in my own words.)

There are four founders - one will hold the majority of the equity while the others are 10% each, for simplicity. So far we've each contributed what we could (or had to) in developing the new business idea (research, coding, travel, etc). We feel good about the market and how we can address it, and our financial projections are strong, but conservative.

We have been planning on creating an LLC first because that's quick and cheap, and leaves us more flexible if the business doesn't grow as quickly, or the way we expect. After forming the LLC we will be looking for $1.5 million as convertible notes. If all goes according to plan, in 12 to 24 months we expect to raise more money in a series A round, and at that point we would convert to a Delaware C Corp.

So far that sounds like the path many startups would take, right?

However, while looking at our financial projections someone mentioned that the LLC was accumulating losses, right up to the time of our series A round. Those losses in the LLC would be passed through to the four members of the LLC so we would each have a large negative capital account. On converting our LLC to a C Corp the founders would be hit with a big tax bill because the IRS will treat the previous losses (from the LLC) as a forgiveness of debt since we wouldn't be passing them to the new C Corp.

I understand that the LLC is treated as a partnership for tax purposes, so the profits and losses flow to the members. After all, one of the benefits of LLCs is that they avoid double taxation.

So is the tax hit a real issue? Is this other person just confused/wrong? If it is a potential problem, is there an obvious workaround that everyone else already knows about? Since we expect to raise more money in the future should we really spend more money on legal fees now to set up the C Corp from the beginning. (Cash is very tight and we would prefer to invest what we have in the new products and recruiting a few key people.)

I hope this question makes sense.

5 Replies

Roger Royse
2
0
Roger Royse Advisor
Royse Law Firm
Yes your partner is correct at a high level. This is an issue and one that most parties don't realize until after it's too late. Technically, a partnership debt shift is treated as a distribution. Additionally, Code sec 351 (which exempts the incorporation from tax) carves out debt in excess of basis (sec 357). There is also a requirement that net value be transferred. All of this is generally beyond the areas of many corporate lawyers and you should get tax advice whenever you deal in Subchapter K (LLCs as partnerships). There are strategies to deal with the problem. See my slides at
http://www.slideshare.net/rroyse/incorporating-the-venture-backed-llc-00033040x-c0cb4
Another way of looking at this is that the founder is only recapturing the tax benefit that he took by deductions early on, although there may be some inefficiencies depending on his relative tax position in those years.
This is one of the reasons I like Subchapter S. But that is another story
Scott McGregor
2
0
Scott McGregor Entrepreneur • Advisor
Advisor, co-founder, consultant and part time executive to Tech Start-ups. Based in Silicon Valley.
I think your forgiveness of debt model is mistaken. You, collectively, put in founding capital. Your company has been spending it faster than accumulating more income. So the company has a net loss. As a result while every one's share percentage is unchanged, the dollar value of that percentage has declined.

There is no implied debt that the company owes you because your share is now worth less.

That net loss flows to your K1 partnership distribution and to your schedule C. There it offsets other income you have or accumulates as a carry forward to offset future gains when you are profitable.

But once the losses are distributed, they are gone from the LLC and your capital account is just smaller.

It maybe easier for you to understand this if you think about the case where the LLC makes a profit. When profits are distributed you get your 10%. Again it is reported on your K1 and now shows up as extra income on your schedule C. That money won't flow to the C corp because the cash has already been distributed to you and is no longer in the assets transferred to the new corp.

When your LLC converts to a C Corp your existing capital account (probably lower than what you initially put in if there have been losses) will transfer over at that lower value. When you raise your new round, the company valuation will probably be higher than what the LLC was at conversion. Your (now diluted post series A) shares will probably have a dollar value higher than your value at time of conversion. This will be a capital gain when you sell.

To see this in perspective, imagine you personally buy a publicly traded stock. Let's say the stock drops in value $500. If you sell at that point you will receive a loss of $500 that you can use to offset your other gains. Then let's say you decide that you think it will recover so you buy it back at the depressed price, let's say it recovers the full $500. You now have a $500 gain. Net across the TWO transactions you are even. the annual distributions effectively reset the value in the same way.

Elise Krentzel
0
0
Elise Krentzel Entrepreneur • Advisor
CEO & Chief Creative Officer at ek Consulting, Author
A while back I was in the exact predicament as you. My advice today as given to me quite recently by an attorney was, go the C route and if you have to change it do it quickly because your investors will need that structure as will you and your partners in the long run. Good luck. Do it in DE.
Spencer Wolff
1
0
Spencer Wolff Entrepreneur
Startup Lawyer at General Standards
I would second Roger Royse and set up the C-Corporation and then file for subchapter S treatment if you really want to take the losses against your personal income. Before you raise the round with the convertible notes, just switch back to C-Corp status (it's a simple letter you have to send to the IRS to make the change). Also, given only four founders, setting up a Delaware C-Corp should be no more expensive, or barely more expensive, than setting up an LLC. If anyone wants to charge you significantly more for that work, then don't do your legals with them.
Robert Stoeber
0
0
Robert Stoeber Entrepreneur
Co-founder at Workglue
So, Roger and Spencer seem to agree that my description is essentially correct and that the original LLC founders would face a taxable event when the LLC (which has significant operating losses) converts to a C Corp. So we should just skip the LLC and form a C Corp from the beginning (changing the company's tax status as necessary).

On the other hand, Scott says my "model is mistaken" which sounds clear enough, but then I get lost in his description. However, after reading it a few times, I get the impression that Scott isn't describing a way to avoid the problem so much as saying it really doesn't exist.

If either of you have a few more minutes to clarify this difference of opinion (if that's what this is) I would appreciate it.


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