When you first started your business, it was just you, and you formed it as an LLC. Now, the Foundry group, or a finicky Angel has come calling, and they want you, an LLC, to convert to a corporation.
How big of a deal is it to change from one to the other? Today, this isn’t as hard as it used to be. Statutory conversion is a relatively new and relatively streamlined process, having sprung up in most states only within the last ten years. Once upon a time, the way to convert from one entity to the next was by forming a new entity and merging into it or forming a new entity and transferring all the old entity’s assets into it. Today, in most states, you can develop a plan of conversion, file a certificate of conversion, and change entities in a few days.
First, may it be noted that I’ve had dozens of companies approach me about converting from an LLC to a corporation. Never once has anyone asked me to do the opposite. There’s a lesson to be learned there.
Second, just because it is now easier to convert from one entity to the next, does not mean that there are no issues with conversion. Each state has its own laws with respect to conversion, and some states have no laws allowing conversion at all. Careful consideration must be paid to the underlying laws governing the conversion of the prior entity and the ensuing entity in each state the conversion takes place.
One important consideration is, what kind of approval is required by law to amend the formation documents of the underlying entity. If the original entity is an LLC in Colorado, for example, the LLC Act requires unanimous approval for an amendment to the primary constituent documents. However, under CRS 7-80-180, if an operating agreement allows for lesser approval, the operating agreement trumps any contrary provision of the LLC act.
Furthermore, there are tax issues to consider when converting an entity. If you are converting from an LLC to a corporation, the conversion is generally considered a tax-free contribution of assets to the new entity. Pursuant to IRC Section 357(c), an LLC may be potentially exposed to taxation during a conversion when aggregate liabilities assumed by the new corporation exceed the aggregate tax basis of the assets contributed. But we won’t get into that here.
When a corporation elects to convert to an LLC, the tax consequences are far more severe. Usually, the corporation is considered to have sold all its assets to shareholders. Big problem.
Finally, anyone looking to convert one entity to the next should review all contracts belonging to the underlying entity to make sure that there are no “change in control” or “change of business structure” provisions that might invalidate or impact existing contracts. This applies to bank documents, leases, joint ventures, licenses, and any number of other documents.