As clients’ businesses grow and evolve, the business entity type they begin with may not serve them well for the long term from taxation and legal standpoints. Depending on their circumstances, they might benefit from doing a “statutory conversion” (changing from one business structure to another).
Many states allow businesses to switch from one entity type to another without closing the original entity and forming a new one. There are some states, however, that have a more involved process.
By definition, a statutory conversion involves changing one statutory entity (corporation, LLC, or Limited Partnership) to another type of statutory entity. For example:
- LLC to C Corporation
- C Corporation to LLC
- Limited Partnership to C Corporation
Sole proprietorships and partnerships, which are non-statutory entities (meaning they’re not state-registered business entities), can be changed to an LLC, a C Corp, or some other formal business entity. statutory entity by filing the necessary paperwork (e.g., Articles of Organization, Articles of Incorporation) and following through with any other required business formation responsibilities.
Signs That It Might Be Time to Convert to a Different Business Entity Type
Considerations that often drive changes in business structure include:
- Income tax rates, allowed deductions, and self-employment tax obligations
- The degree of personal liability their owners are comfortable with
- Plans to add or remove owners (or shareholders)
- Management flexibility
- The desire to raise capital for expanding or growing the business
- Ongoing business compliance requirements
Based on these drivers, here are some examples of when clients might benefit from a change in business entity:
- The business owners have an LLC and want to reduce their self-employment tax burden. To do that they pursue electing to be taxed as an S Corporation or converting to a C Corp.
- A sole proprietor wants to add employees and is now losing sleep over having personal assets tied to the business. By forming an LLC or incorporating, that company becomes an entity independent of its owner for tax and legal purposes.
- An LLC is finding that it will need to raise a significant amount of money to fuel its plans for growth. Converting to a C Corp and selling stock would provide a path for doing that.
- A corporation has non-U.S. citizens as shareholders. The company wishes to avoid corporate double taxation and instead have pass-through taxation. Electing S Corp status isn’t an option because non-resident aliens cannot be shareholders of an S Corp. However, if changed to an LLC, the company can have pass-through taxation and move forward with the same owners because LLCs allow non-U.S. citizens to be members.
- An LLC’s members are all in high-cost individual income tax brackets. After you’ve done the math for them, it appears they could save money by converting to a C Corp because paying the corporate income tax rates will reduce their tax burden.
These are just a sampling of scenarios; your clients might find themselves in other circumstances when a statutory conversion will help them and their companies.
Basic Steps in a Statutory Conversion
The process of doing a statutory conversion varies by state. Here are some general steps to give you an idea of what your clients would need to do.
- Write a Plan of Conversion.
- Get approvals from the governing stakeholders (e.g., partners, LLC members, shareholders, board of directors).
- Complete the formation documents (e.g., Articles of Organization, Articles of Incorporation) for the entity type the business will be changing to.
- Complete a Certificate of Conversion for the post-conversion entity.
- File the new entity formation document and certificate of conversion, along with any required filing fees, with the state.
Depending on the state and the entity type, there might be other requirements, too.
What If the State Doesn’t Allow Statutory Conversions?
Some states that don’t allow statutory conversions offer “statutory mergers.” In states that have neither option available, the original business entity must be dissolved and a new one formed.
Because not all states allow statutory conversions and those that do may have a process that's different from those in other states, it's critical for clients to not only tap your financial and tax expertise but also to get professional legal guidance when changing their business entity type.
Author Bio: Nellie Akalp is a passionate entrepreneur, small business expert and mother of four. She is the CEO of CorpNet.com, a trusted resource for Business Incorporation, LLC Filings, and Corporate Compliance Services in all 50 states. Nellie and her team recently launched a partner program for accountants, bookkeepers, CPAs, and other professionals to help them streamline the business incorporation and compliance process for their clients. More info at: CorpNet.com/partners.