With increasing frequency, companies are considering a change in their form of entity. The reasons for the change vary considerably: sometimes companies are underwhelmed by the tax benefits of being a limited liability company and are overwhelmed by its complexities (international tax withholding issues, multi-state K-1’s, profits interests management, phantom income, and employee education regarding equity-based incentives), while other times companies are frustrated by the restrictions on S corporations and desire the flexibility that limited liability companies afford. In other cases still, institutional investors may require a certain form of entity (e.g., a C corporation), while other investors (e.g., active angel investors) are looking to take advantage of pass through losses.
Today, most states make it fairly easy to change the type of entity or even to change the state of organization of the entity. It is important to keep in mind though that while the mechanics of converting to a new entity from a legal perspective are not typically too complex, the related tax issues can be incredibly intricate, especially for an organization with a long operating history and a complex capitalization structure. While in many situations converting to a different type of entity will be tax-free, that will not always be the case. Your tax advisor and accountants should be consulted early in the process when considering a change in entity form. Assuming a change in structure is justified and the tax issues are manageable, this article focuses on the mechanics of converting from one type of entity to another.
While there are variations among the states, there are generally two ways to change your type of entity from a legal perspective: merging with and into another entity of a different type and effectuating a conversion. The method selected, as well as some of the finer details associated with the particular method selected, is often driven by tax considerations.
Change of Entity Form Through Merger
The more traditional way to change the form of an organization is through a merger. Sometimes people refer to this as a cross-species merger. A merger enables two or more entities to combine into a single entity. The surviving entity can be recently created just to effectuate the change in entity form or it can have an operating history. The surviving entity typically files with the applicable state a plan of merger and a statement that the plan was approved in accordance with applicable law. In most states, the plan of merger identifies the parties to the merger, the surviving entity, and the manner and basis of converting equity interests in each entity into interests in the surviving entity. The plan of merger also includes any applicable amendments to governing documents (e.g., articles) for the surviving entity.
After the merger, only the surviving entity continues to exist and it is responsible for all liabilities of each business entity that is a party to the merger. Subject to certain exceptions and filing requirements, title to assets automatically vests with the surviving business entity.
Change of Entity Form Through Conversion
Within the last decade, most states have adopted statutes that allow organizations to convert their form of entity by just filing the applicable conversion documentation. For example, in Wisconsin, a business that desires to convert to another type of legal entity must submit to the Department of Financial Institutions a certificate of conversion with a plan of conversion and a statement that the plan was approved in accordance with the laws applicable to the pre-converted entity.
Similar to a plan of merger, most states require that a plan of conversion include the name, form of business entity and jurisdiction governing the entity both before and after the conversion. In addition, the post-conversion articles of incorporation or other charter document is an attachment to the plan of conversion. Some states however require a separate filing for the charter document. Like with a plan of merger, the plan of conversion must also include the terms and conditions of the conversion and the manner and basis of converting the ownership interests in the old entity to the ownership interests in the new entity.
Upon conversion, the new entity continues to be subject to the liabilities incurred prior to the conversion. If a business owner had any personal liability by reason of the owner’s position in the entity (such as the general partner of a limited partnership), such liability will continue, but only to the extent accrued prior to the conversion. The new entity continues to be vested with title to all its properties, subject to modest exceptions and certain filing requirements. Any legal proceeding pending against the old entity will be continued against the new entity.
Conducting Due Diligence When Changing Your Form of Entity
Despite the fact that the legal filing requirements for cross-species mergers and conversions are rather straight forward and mechanical, there are a number of due diligence issues that should be considered prior to making the change in entity form. For example, in contracts, a merger is sometimes treated as an assignment of a contract from one entity to another and many contracts prohibit such assignments without prior consent. Businesses should review all their material contracts and consider seeking consent for assignment where necessary. Trademark and patent filings in the U.S. Patent and Trademark Office (USPTO) will need to be updated to reflect new company names in a conversion. Mergers are treated as an assignment that also needs to be recorded with the USPTO. Likewise, regulatory approvals, permits and licenses may need to be updated. Because a conversion, rather than a merger, involves only a single entity, many consider that general contract anti-assignment provisions do not apply to conversions unless conversions are specifically addressed and prohibited. In either case, however, there is frequently a company name change that may need to be reflected on a variety of documents.
In addition to third party contracts and government filings and licenses, there are a number of organizational documents that may need to be created as a result of the merger or conversion. For example, if an entity changes from a limited liability company to a corporation, many of the provisions from the organization’s operating agreement prior to the cross-species merger or conversion will be incorporated into a combination of the new corporation’s bylaws and perhaps a separate shareholders agreement, investor rights agreement or voting agreement. Some of these organizational-related documents can be adopted wholesale with no or modest changes. Others, however, will need considerable changes or even termination because of statutory requirements, efficiency, or custom.
While it would be convenient to have all the facts up front prior to choosing an entity’s form when creating it, even the most diligent and seasoned entrepreneurs experience change in facts or laws that necessitate changing the organization’s form of entity. With proper planning and involvement of your attorney and accountant, the process of converting your form of entity is usually manageable. In the end, like with most things, the decision often becomes a cost-benefit analysis.