Has anyone formed an S Corp and then converted to a C Corp later | Hacker News Reader

Has anyone formed an S Corp and then converted to a C Corp later

13 pointsiamyoohoo13 comments

It might just be easier that way if in the short term external financing is not necessary. Has anyone done this before. Are there any problems ? -- does it take time to revoke the S election or cost a lot in legal fees ? -- does it have problems with founders stock vesting or with taxation on founders stock if 83b has already been filed in time ? -- any stock pricing issues if the conversion from S to C happens at the time of external financing? -- Any other problems ?

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I plan to write about this in a future post on my blog.

My experience is that LLC (Limited Liability Company) is a much better vehicle for starting a company than a S-Corp. LLC is an interesting hybrid between a corporation (S or C) and a partnership.

Legally LLC is not a corporation but more like a partnership. But it is an effective shield for limiting your personal liability the same way that a corporation would, yet at the same time, doesn't require the declaration of a liability-bearing general partner which is what you have to do with a Limited Liability Partnership (LLP).

Also, from the customer perspective, an LLC sounds a lot like a corporation so it doesn't have the stigma that comes with an LLP (people think of dentist, doctor and lawyer when you present them a business card that says LLP). Just like LLP or a S-Corp, an LLC is not a taxable entity so losses and profits can flow directly to the partners.

On the other hand, unlike an S-Corp, the profit and loss can be distributed anyway that is agreeable to the partners and not necessary according to the percentage ownership, which is very convenient.

Also, LLC has no limitation on foreign ownership or ownership by another corporation (Until it became AT&T again, Cingular was a LLC owned by SBC and BellSouth).

All it takes to form a LLC is an operating agreement, which is not even a legal document and does not need to be filed. So you don't need a lawyer to do what is basically common sense. So be sure you spell out the ownership structure of the LLC (there is no reason why it has to be equal but there is no reason why it cannot be, so whatever is agreeable to all partners is fine).

But be sure to spell out the circumstances when a particular partner is deemed non-contributing and therefore can be invited out by the rest of the partnership. Also, spell out what happens to his/her shares if any partner was to resign, to be terminated with and without clause, incapacitated and death (either work-related or not).

So a typical solution is to give everyone three or four years to vest and everyone agree that any shares that are unvested can be repurchased by the remaining partners at the original price. Also, make sure that everyone agrees to a right-of-first-refusal and a co-sale arrangement so that if one partner decides to sell his/her vested shares, everyone else has the right to either buy the shares or to sell part of their own vested shares to the same outside buyer at the same time.

Furthermore, make sure you put a price on the shares so that everyone writes a check and buy the shares outright (which can be very low so that the total is on the order of a few hundred dollars). This is very important because once the stock is purchased, you have started the clock for capital gain and keep in mind that these are 1244 stock which means that if you keep them for five years (which you probably will since that's how long it will take to build a company if not more), then only half of your capital gain is taxable.

There are other benefits as well but the most important one is that if you ever leave your own startup, you can walk away with property that you already owned and you don't have to worry about exercising your options and get hit with Alternate Minimum Tax (AMT).

On the other hand, for working capital, ask everyone to put in the cash as an interest-bearing loan so that when the company starts making profits, you can get the money back without any tax consequence.

Also, even as a LLC, you can elect to file your tax return as a S-Corp. This is important because as you continue to bootstrap your company, instead of paying the partners salaries, you can pay everyone a nominal stipend (which is subject to payroll tax) and declare the rest dividend, which is not subject to self-employment tax (it would be if you file tax return as a LLC).

Finally, when you are ready to take VC money, they will want to bring in a high-power lawyer and chances are that they will want you to form a C-Corp. By then, you can do a tax-free transfer between assets of the LLC and shares of the new company. The VC's are going to put a vesting schedule on your new shares, which you will need to negotiate. But hopefully by then you have some leverage (like customers and profitability) and you can negotiate from a position of strength.

But the most important issue here is that with a C-Corp you can start from a clean slate and any amateurish decision that you might have made in the past (which served the purpose at the time) is now completely in the past.

Hope this helps.

--Denny--

Denny K Miu

Startup For Less X Survival Guide for Bootstrapping Entrepreneurs

http://www.lovemytool.com/blog/startup-for-less.html

I recently met with a lawyer to discuss LLC versus S-Corp and CA versus DE. The biggest determinant for us to go with S-Corp was our aim to pick up VC funding at some point in near future. From what I have read and what the lawyer said, I understand the following:

1) VCs will want a C-Corp so some transition will have to occur. (YC member Shooter described his experience that LLCs can pick up VC funding. I don't doubt that, but we would rather remove any corporate structure issue for VCs.)

2) Tranferring from LLCs to C-Corp can be done, but it's messy. It sounds similar to a merger where the vestigal LLC is dropped down as a subsidiary. There will be more due diligence necessary to show that nothing is wrong. I did not get the impression that "any amateurish decision that you might have made in the past is now completely in the past," but would like to hear more about the LLC to C-Corp transition. In the case of S-Corps, both S and C-Corps are corporations that just differ in tax treatment, hence the ease at moving between the two. If you take on foreign or corporate shareholders, you can no longer be an S-Corp and I believe your tax treatment will change at that point of time.

VCs also prefer DE over CA. Our lawyer thought one reason they preferred DE over CA because CA laws tend to stick up for the minority shareholders, which founders eventually become after dilution. In his experience, only one VC required redomestication of the C-Corp from CA to DE.

One thing to consider is possible legal action against you. If you are a DE corporation and some big company wants to make your life miserable, you'll be appearing in a DE court. Our biggest competitors will probably be NY-based, so we believe there's some advantage to a CA incorporation. (Let the Gubernator protect us little CA guys from the non-CA competitors.)

If you are a CA-based company that incorporates in DE, you'll have a little more paperwork and you'll still have to pay all the CA fees.

I didn't know LLCs could file tax returns as S-Corps. By "nominal stipend," I presume Denny means at least the low range of salary standards. I've read the IRS will reject attempts to low-ball salary to inflate dividends and escape self-employment.

very helpful. Are you certain of the tax free transfer of assets of the LLC and the founder shares to the new C Corp company ?

The benefit of doing S Corp as opposed to LLC would be that LLC's in california have I think a franchise tax of $1000 or so. For a bootstrapped startup that may not make any revenue in the first year or so, this is additional expense that may not be necessary. Also as you mentioned, it is beneficial to file taxes as an S corp, why not just do an S corp anyways ?

You can always do a tax free transfer between two entities as long as you own the property. Keep in mind that it is important that the transfer take place between the outside investment and not after.

The franchise fee for LLC, LLP and S-Corp are the same. They are $800 in the State of California. If you don't think you need the protection, you don't need to file. You can operate as a sole proprietorship or a simple partnership.

S-Corp turns out to be very restrictive and also cost a lot more to file. You could do it on your own but most likely you will need to pay a lawyer. And it doesn't give you more protection than a LLC (in the State of California). Also, converting from a LLC into a C-Corp is simpler.

--Denny--

Corporations are exempt from the $800 for their first year of business.

"Also, converting from a LLC into a C-Corp is simpler."

Everything we have heard and read suggests otherwise. S-Corp can become C-Corp by mistake if you violate any of the restrictions. It can't get simpler than that :)

Regarding the tax event during any M&A, I quote the following from Levin's book "Structuring Venture Capital, Private Equity, and Entrepreneurial Transactions" (page 301.2.2):

"An S corporation is a corporation and hence can acquire another corporation or be acquired by another corporation in a tax-free Code S368 reorganization. In contrast, a partnership or LLC can not be a party to a tax-free reorganization."

DocSavage, thank you for your comment.

I am not familar with Levin's book and the context of his statement. But my experience with rolling assets into a C-Corp is very straightforward. Forget for a minute whether the original entity is LLC or S-Corp. Let say a lone entrepreneur has been laboring over some intellectual property and he is ready to get funding. Before he takes the VC money, his lawyer will create a C-Corp which initially has no value, it will acquire the asset from the entrepreneur in exchange for 100% of the C-Corp (which also has no value). That is a tax-free transfer. Then the C-Corp will issue preferred stock in exchange for the VC money (say 25% of the company in exchange for $5M), all the time encapsulating the asset of the entrepreneur and not subjecting him/her to any tax consequences even though on paper his/her asset is now worth $15M (since he owns 75% of the company). And it makes no difference whether the asset was originally owned by a S-Corp, LLC or just a sole propriatership. The key here is that when the tranfer was taking place, the C-Corp was just a shell and had no value. I hope this helps.

--Denny--

I think there is a problem here gigamon. In your scenario when the C Corp acquires the assets of an LLC at 0 value or extremely low value - say 0.0001 c per unit, then the founders common stock basically is assigned that value. If then right away, a VC pays say 3M pre money for a third of the company which may have 10 M shares - i.e. $1 per preferred share stock, the IRS will have a problem because the stock value cannot enhance by 10000 times so soon even if it is preferred stock. This is why lawyers ask entrepreneurs to form companies asap so that there is some time between founder share allocation and investment where you can show the company gained value from the time founders were allotted stock.

Will all due respect, iamyoohoo, it is done all the time, especially in Silicon Valley. Keep in mind that we are talking about a company that has no product, no revenues and is losing money (Founder's money). Then on one day, it has $5M in the bank and a Board of Directors of big name VC's. In fact, let's look at the problem in reverse. If the company is truly worth $15M (with the Founder's IP) and then then the VC's put in $5M to get 25% of the company, then why are we giving them preferred stock. The reason is simple. Until the company has the $5M, it was worth zero. In fact, even after the investment, we would price the common stock at 1/20 if not less of the preferred stock (so that future employees can get options at a discount price).

--Denny--

I believe the comment by byteCoder (regarding taxable gain) has to do with options and not stock. I believe in his case, the employees actually own options which they decided to exercise, causing taxable gain which normally is not taxable because it is paper gain, but under AMT is considered taxable. This hurts since as byteCoder said, you can't pay real tax with imaginary gain but IRS is insensitive to that. Tax free transfer applies if you actually own the stock which is why it is important to actually write a check in the beginning of the company when the stock cost nothing. As a practice, always own stock. Options mean nothing. But of course, this is only possible if you were one of the Founders.

--Denny--

I was in a software startup in Texas almost 15 years ago, which underwent a conversion from S to C, for the purpose of seeking external financing. Fortunately, I was not a shareholder at the time.

As I remember (and this is second hand knowledge, so take it as a cautionary tale):

The company's assets (software products and training materials) were assigned a market value by an independent accountant. The market value increased each shareholder's basis in the company, for which they were ultimately liable tax-wise by their percentage ownership in the corporation in the year of conversion to C corporation.

It was very ugly, as the current shareholders' basis went from almost nothing to a significant number, on which they had to pay taxes, but with little options to liquidate their shares to pay the gain in value.

It caused much consternation, gnashing of teeth, and bad feelings among the owners of the corporation--to the point of causing some founders to leave.

I don't know all of the details, or whether the approach they took for the conversion was a good one, but I did learn that you have to be very careful about how this is done. You absolutely must seek competent professional accounting/legal advice. And, you must communicate to the shareholders every detailed step of the process.

I thought everybody are trying to make S Corp because it's more "advanced" (if I can say so). Why should you reverse it?

I'm not sure what you mean by "advanced".

An S corporation pays no taxes on its net income. That net income flows through to the shareholders according to their percentage of ownership. Consequently, each shareholder pays taxes on the income via their own tax returns at their own rate.

A C corporation pays taxes on its net income. The money distributed to shareholders (dividends) are then taxed again on their own tax returns. Thus, you can get a double taxation effect on monies distributed to the shareholders--once at the corporate level and once at the personal level.

However, I believe that companies choose to become C corporations because S corporations are limited in the number of shareholders (35, I seem to recall) and all shareholders must be US citizens. Additionally, since the taxation occurs at the corporate level, individual shareholder's taxes are much more isolated from the effects of undistributed net income.

only if the company needs external financing. VC's can't invest in an S corp ...

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