Choosing the type of entity to form for your business and the state in which to form it is an important decision. If you try to process everything out there on the internet about how to make this decision, it will drive you batty. It’s actually, IMO, a fairly simple decision. There’s a lot of noise out there, although there aren’t many factors to consider when making this choice (considering forming your company in Delaware? Read Incorporating in Delaware? Consider This.
Nevertheless, sometimes entrepreneurs make the wrong one. Or, sometimes circumstances change. In that case, business owners need to convert their corporation, LLC or other entity into a different type of entity or move it to a new state.
What then? What do you do if you are running a Texas limited liability company and you realize it ought to be a Delaware corporation (this typically happens because venture capitalists require it)? Or, what do you do if you need to change a Texas corporation to a Texas LLC? Or an Idaho LLC to a Delaware public benefit corporation? Or, whatever state and entity type to whatever state and entity type?
The most obvious thing to do is close your existing entity and open a new one. While obvious, that approach is rarely preferred. There are legal, administrative and often tax implications. Assets of the entity must be distributed to owners (an issue if the entity is a corporation or LLC taxed as a corporation) and then contributed back to the new entity. If contracts are among those assets, they generally require consent from the other party (counter party) to the contract – oftentimes there is sensitivity to asking for consents to assigning contracts.
Years ago, closing one entity and opening another was the primary approach to changing a type of entity or moving it from one state to another. To overcome some of the issues I mentioned above regarding transfer of contracts and other assets, you could also merge an existing entity into a newly-formed one. I ran into this recently where, due to unique nuances of Massachusetts law, to change my client’s Massachusetts LLC into a Texas LLC, we first had to form a new Texas LLC. Then, we merged the Massachusetts one into the new Texas entity. Mergers are interesting creatures. What happens is that all the assets of one entity are transferred “by operation of law” to the other entity and, in the process, one entity ceases to exist. Mergers can actually involve many companies and the surviving entity doesn’t need to be the newly-created one. In our case, it was. Sound complex? It’s not overly difficult, although it’s not simple either.
Enter the statutory conversion.
What is a Statutory Conversion of an Entity?
In the early 2000s, states began to revise their business statutes to allow for a simpler, more elegant approach to changing a type of entity or moving it from one state to another – the statutory conversion.
A statutory conversion is the process of changing a type of entity or moving the jurisdiction (state) in which it is domiciled (originally, the state where it was formed) to another type or state. Most states allow statutory conversions now (2017). The process generally requires preparing the following documents:
- Plan of Conversion
- Appropriate approvals (resolutions, minutes of meetings) from the governing body or bodies of the entity (shareholders and directors in a corporation; members and managers (if manager-managed) in an LLC)
- Certificate of Conversion
- Certificate of Formation (this may be called different things, depending on what type of entity you are ending up with and in what state, e.g., Certificate of Incorporation, Articles of Organization, etc. – it’s the same document you’d file to create an entity from scratch)
The last two documents – Certificate of Conversion and Certificate of Formation – are filed with the Secretary of State in the state where the entity will end up (or where it already is if you are not changing the state of domicile). If you are transferring from one state to another, there may be a document that needs to be filed with the Secretary of State of the state you are leaving.
A conversion of an entity simply to move it from one state to another without changing the entity type or tax classification is called a re-domestication or may be referred to as re-domiciling the entity. Example: Converting a Georgia LLC into a Delaware LLC, or a Georgia corporation into a Delaware corporation.
Considerations When Converting Your Business Entity
The first thing to determine when considering a statutory conversion is whether the states involved (one or two states, depending on whether you are moving the entity out of one state into a new one) allow statutory conversion. As I mentioned, most do. But, not all.
In 2016, a client came to me wanting to move their existing Massachusetts limited liability company to Texas. They wanted to remain an LLC, but had moved from Boston, Massachusetts to Austin, Texas and we agreed it didn’t make sense to keep the entity as a Massachusetts LLC. Unfortunately, at the time (perhaps it has changed – it will at some point), Massachusetts didn’t recognize conversions out. We briefly thought about just doing the conversion anyway and sending Massachusetts a letter telling them what happened, although we couldn’t get comfortable with that approach because Texas requires a representation that the Plan of Conversion complies with the state laws of both the existing state and Texas. So, we created a Texas limited liability company and merged the Massachusetts company into the Texas one, with the Texas LLC surviving the merger. It accomplished the same goal, although with slightly more work, but it complied with all required laws and avoided messy things like assigning all the customer contracts to a brand new entity.
You also need to determine the requirements of your existing entity to convert to a new one or new state. For example, to convert your Texas corporation to a Texas LLC, you need to get both the corporation’s board of directors and the corporation’s stockholders to approve converting the corporation. By default, the Texas conversion statute requires approval of the plan by at least two-thirds of each class of shares for a corporation.
Benefits of Converting an Entity rather than Forming a New One
As previously discussed, you need consider the impact to your business’ already existing contracts. If you open a new entity, you’ll need to assign all your existing contracts from the old entity to the new one. Most commercial contracts have some type of anti-assignment provision, which prohibits an assignment without the approval of the counterparty to the contract. Getting these approvals can be challenging. If the contract is favorable for you (sub-market pricing, etc.), the counter party may use the opportunity to renegotiate the terms of the contract. Even if the terms are standard/market, with larger companies, their legal departments often move slowly and obtaining a consent to assignment isn’t high priority, so the process can drag along. If you perform a statutory conversion or a merger, most anti-assignment provisions in business contracts are not tripped up.
Transferring assets and liabilities may be complex if you need to dissolve the old business entity. As an illustration for a new corporation from an LLC, the transfer of assets and liabilities is usually done through one of the following three methods: by directly transferring assets and liabilities from the old entity into the new corporation, distributing assets and liabilities to the owners who then transfer them to the new corporation, or contributing partnership or LLC shares to the corporation. All three exchanges trade capital interest in the old business for corporate stock in the current one. The old partnership or LLC is considered terminated upon the liquidation of its assets. Note that while the conversion is technically tax free, you’ll have to report gains made through the process, such as reduced liability.
Beyond legal liability and taxes, changing your business entity may have additional consequences. For example, if you are running a business that requires licensing, you will have to apply for a new license for the new business entity.
Tax Consequences (and, Do I need a new EIN?)
While specific tax advice is outside the scope of this general article, most conversions of limited liability companies to corporations are nontaxable. On the other hand, converting a corporation (even an S-corporation) into an LLC is almost always taxable. This can cause challenges if there isn’t any cash for the corporation to dividend out to shareholders to pay taxes owed.
One commonly contemplated conversion is from a corporation to an LLC, but it’s one of the potentially most expensive conversions. This business move creates an immediate taxable transaction at the entity and shareholder levels because the LLC is generally a pass-through tax entity. The IRS considers this kind of conversion to be a liquidation of the corporation for which the corporation will owe tax and the stockholders will be taxed personally on the corporate assets assumed to be distributed to them. However, converting a corporation to an LLC that will continue to be taxed as a corporation may be largely tax-free. For your LLC to continue to be taxed as a corporation, you must file a special election form with the IRS.
You mostly will contemplate this this form of conversion when a new purchaser of the business prefers to buy assets. Rarely will an existing owner of a business prefer to accelerate a taxable gain in order to gain the benefits of an LLC.
Re-domestication conversions generally have state law implications but no income tax consequences provided the form of the entity remains the same between the two states.
You may also need a new EIN (federal employer identification number) for your business, although that depends on the particular type of statutory conversion you are undertaking. Generally, businesses need a new EIN when their ownership or structure has changed. This is primarily an issue of tax classification. The IRS has information about whether you need a new EIN here – https://www.irs.gov/businesses/small-businesses-self-employed/do-you-need-a-new-ein. As to be expected, those guidelines are not crystal clear. However, my determination is that a change of an existing corporation (or LLC taxed in one way) in one state to an existing corporation in another state (or LLC taxed in the same way) won’t trigger a need to order a new EIN. Earlier last year, I worked on the conversion of a New Jersey LLC to a North Carolina LLC. That was simple. Both states were easy to work with and we didn’t order a new EIN. On the other hand, a conversion of an LLC taxed as pass-through entity (i.e., sole proprietorship or partnership) to a corporation will trigger the need to obtain a new EIN.
Texas Conversion Process
Texas allows conversions from out-of-state (foreign) and domestic entities. This procedure, technically known as “statutory conversion,” will automatically convert your current business and the business’s assets and liability to the new entity. The state allows businesses to convert to the following Texas entity types: corporation, LLC, limited partnership, professional association, and cooperative association.
To transfer a “foreign”, or out-of-state, entity or domestic entity to any of the above listed Texas entity types, the converting entity must:
- Adopt a Plan of Conversion,
- File a Certificate of Conversion ($300 filling fee) with the Texas Secretary of State, and
- File a Certificate of Formation (generally a $300 filling fee) with the Texas Secretary of State for the converted Texas entity.
The Plan of Conversion is a relatively simple statement of key elements of the conversion. At a minimum, it must provide the name of your current business and new entity, a statement that your company is continuing its existence, and a statement that your company is to now be a Texas entity.
The Certificate of Conversion includes statements that the Plan of Conversion has been approved as required by the laws of the jurisdiction of formation (where your business is transferring from) and approved by the converting entity’s governing documents.
Evidence that the franchise taxes have been paid or that the converted Texas entity is liable for the payment of required franchise taxes must also be included with the certificate of conversion. This requirement may be satisfied by either: (1) a certificate of account status from the Texas Comptroller of Public Accounts indicating that the converting entity is in good standing having no franchise tax reports or payments due; or (2) a statement in the certificate of conversion that the converted entity is liable for payment of the required franchise taxes.
If your company is already registered to do business in Texas as a “foreign” entity, the foreign entity registration is automatically withdrawn upon conversion. If you are not doing business in the state of Texas, you will need to reserve your company’s name with the Secretary of State. The converted entity’s name can’t be the same as or substantially similar to an already existing Texas entity (Texas has a two word rule and looks at the first two words of legal entity names).
For more information about conversions of other state entities to Texas, read https://www.sos.state.tx.us/corp/forms/647_boc.pdf. This process is similar in states that allow conversions. When I recently converted a New Jersey LLC to a North Carolina, the process was nearly identical.
Summary
Converting your business entity is a significant decision that may affect your legal liability and taxes. Converting or moving your business from one type of entity to another or from one state to another can have varying tax consequences depending on the beginning entity and the ending entity. Some conversions may be tax-free to the owners and the entity, but others may trigger income tax consequences
The process of converting or transferring your company may be very simple. In some states, a conversion can be done through a formal filing with the Secretary of State. But, not all states recognize or permit conversions. For moving a business from one state to another, the law of both states must permit the transaction. In some cases, it’s necessary to dissolve the existing business entity and then form a new one; or, merge an existing entity into a newly-created one.
If you need assistance with a statutory conversion, please get in touch.
Author: Brett Cenkus
Brett Cenkus is a business attorney with 18+ years experience based in Austin, Texas. He has worked with a variety of businesses and has clients throughout Texas as well as many technology clients throughout the United States. Brett is a Harvard Law graduate with a sharply seasoned mind and an entrepreneurial heart. As a founder of 6 companies himself, he is especially passionate about helping startups succeed. In 2016 Brett was named the winner in the Individual category for RecognizeGood’s Ethics in Business & Community Award. He offers businesses solutions that are in sync with their culture, goals and values. You can learn more about Brett by visiting the About page on this website.