Time for a change? The what and how of business entity conversion

The one constant is change. Forgive the cliché, but I think it’s an appropriate introduction as I address the topic of business entity conversions.

Your clients' businesses evolve over time — and the business environment in which they operate changes as well, especially at a time like this when the COVID-19 pandemic is having such a far-reaching impact on businesses of all kinds. As a result, the business structure they chose as a startup may no longer be the most advantageous one for their current situation. What happens at that crossroads?It might be time to consider a business entity conversion (also called “statutory conversion”) to change from their existing entity type to another.

By definition, a statutory conversion involves switching from a state-registered business entity (corporation, LLC, or limited partnership) to another type of statutory entity. For example:

• Changing from a limited partnership to a C corporation
• Changing from an LLC to a C corporation
• Changing from a C corporation to an LLC

Many states allow conversion, which enables businesses to switch from one entity type to another without going through the entire process of closing the original entity and forming a new one. Some states, however, have less streamlined processes.

Note that sole proprietorships and general partnerships (which are not state-registered business entities) can be changed to a C corporation, LLC or some other formal business entity by filing the necessary formation paperwork (e.g., articles of organization and articles of incorporation) and fulfilling other required compliance responsibilities.

Possible reasons for a business entity conversion

A company's business structure has an impact on tax obligations, reporting requirements, owners' personal liability and other things. Below, I've listed some of the reasons (and scenarios) that may drive business owners to pursue a change in business entity type.

Personal liability protection for business owners

Sample scenario: A sole proprietor (whose personal assets have no separation from those of the business) decides to hire employees but is afraid of the increased liability it may mean. By forming an LLC or a C corporation, that business becomes its own independent legal entity, thus giving the owner personal liability protection.

Self-employment tax burden

Sample scenario: Business owners that own a disregarded entity LLC are unhappy with their lofty self-employment tax burden. By electing for S corporation tax treatment or converting to a C corp, they stand to lower their personal Social Security and Medicare tax obligations. (Owners pay self-employment taxes on their wages and salaries but not on income paid to them as distributions.)

Income tax rates

Sample scenario: An LLC's members are all in high individual income tax brackets, and all profits from the business flow through to the owners' personal income tax returns.

Because the corporate income tax rate is lower than the individual rates the owners are paying, you decide to crunch the numbers to see if converting to a C Corporation might be more beneficial.

As a C corporation, rather than all profits flowing through to the business owners' personal tax returns, only their income from wages/salaries and distributions will flow through to their individual returns. Profits left in the business will get taxed at the corporate rate but not at the individual level. Also, the company would have more tax deduction opportunities as a C corp.

Even with the double taxation element factored in (dividend income gets taxed at the corporate level and the individual shareholder level), you find that being a C corporation will result in an overall lower income tax obligation.

Growth objectives

Sample scenario: An LLC is expanding its operations and needs to raise a significant amount of money to accomplish the initiative. Converting to a C corp and selling stock would provide a path for the company to get the funds it requires to fuel its growth.

Foreign owners

Sample scenario: A C corporation’s owners would like to have pass-through taxation, but some of the shareholders are not U.S. citizens. Unfortunately, the option of S corporation election is off the table because nonresident aliens cannot be shareholders of an S corp.

The owners can, however, get pass-through taxation by converting to an LLC. An LLC’s profits flow through to its members’ personal tax returns. Moreover, LLCs may have owners who are non-U.S. citizens.

5 basic steps

Different states have different procedures for doing a statutory conversion. The following steps will give you a general idea of what your clients might need to do:

1. Write a plan of conversion.

2. Get approval from the company’s governing stakeholders (e.g., partners, LLC members, shareholders, board of directors).

3. Complete the state’s required formation documents (e.g., articles of organization or articles of incorporation) for the entity type the business will be converting to.

4. Complete a certificate of conversion for the post-conversion entity.

5. File the new entity formation document and certificate of conversion with the state. Also, pay any associated filing fees.

Again, these steps represent the typical parts of the process. Your clients may have other obligations to fulfill too, depending on the state and business structure involved. For example, businesses changing from an LLC to a C corporation will have to draft bylaws and elect corporate officers and a board of directors.

Because the requirements vary, your clients will want to make sure they understand everything they must do to convert their entity type successfully.

The state doesn’t allow conversions — now what?

Some states allow for “statutory merger” rather than statutory conversion. And some have neither statutory conversion nor statutory merger. In those states, the original business entity must be dissolved and a new one formed.

Regardless of the process, changing from one business structure to another has tax and legal implications. Your clients can feel more confident in their decision by getting your financial and tax guidance and the advice of an attorney when exploring if a statutory conversion is the right move for them.