Converting a Corporation into an LLC Can Lead to Unintended Consequences: Don’t Convert to an LLC Without Careful Advance Planning
Corporations and LLCs both provide their shareholders and members with limited liability to operate a for-profit business, and while these two forms of business entities are similar in many ways, they also have some important differences. For example, there are key distinctions between corporations and LLCs in their ability to modify or eliminate the fiduciary duties that the directors, officers, or managers owe to the corporation or to the LLC.
Once they have been formed, corporations may also be converted to LLCs (and vice versa). These conversions come with a number of consequences, however, and should therefore take place only after careful analysis. This post reviews some of the corporate governance, tax, and disclosure considerations that shareholders of a corporation may wish to evaluate before converting their corporation into an LLC.
Converting a Corporation to an LLC Under Texas Law
The shareholders of a corporation may make the decision to convert the form of the business into a limited liability company by adopting a plan of conversion under Section 10.101 of the Texas Business Organizations Code and by filing a certificate of conversion with the Texas Secretary of State under Sections 10.154 and 10.155. The conversion may take place immediately or it may become effective as late as 90 days after filing.
Intended Consequences: Corporate Governance Flexibility
One important reason that shareholders may wish to convert their corporation into an LLC is that it provides a business with greater flexibility in matters relating to corporate governance.
By law, the powers of a for-profit corporation are exercised or authorized by its board of directors, which directs both the management and affairs of the corporation. Tex. Bus. Orgs. Code § 21.401(a). A for-profit corporation must have at least one director, a president, and a secretary, although the same person may serve in all of those roles. Id. §§ 21.403(a), 21.417. The officers and directors of a for-profit corporation owe fiduciary duties to the company of obedience, loyalty, and due care. See Ritchie v. Rupe, 443 S.W.3d 856, 869 (Tex. 2014). These fiduciary duties may be mitigated (but not eliminated) through limits adopted in the bylaws, see Tex. Bus. Orgs. Code § 7.001(b), (c), or through permissive indemnification. This allows a corporation to indemnify a director or officer who breaches his or her fiduciary duties of obedience and care (but not the duty of loyalty), if the director or officer acted in good faith and reasonably believed that his or her conduct was in the corporation’s best interests, id. §§ 8.101(a), 8.102(b). Providing indemnification to directors and officers encourages them to make decisions for the corporation without fear of incurring personal liability if their decisions turn out poorly, so long as they made those decisions loyally and in good faith. See Hibbert v. Hollywood Park, Inc., 457 A.2d 339, 344 (Del. 1983) (explaining the indemnification’s “larger purpose is to encourage capable men to serve as corporate directors” (internal quotation marks omitted)).
LLCs permit their members more flexibility in these governance matters. More specifically, LLCs are run according to the terms of a company agreement, which sets out the relations among the members, managers, and officers of the LLC. Tex. Bus. Orgs. Code § 101.052(a). Unlike a corporation, which must be managed by a board of directors, an LLC may be run directly by its members (owners), or by managers (who are appointed by the members). See id. § 101.101. Further, unlike corporations, LLCs afford substantial flexibility to expand or restrict the fiduciary duties that governing persons owe to the LLC and its members. See id. §§ 7.001(d)(3), 101.401. There are risks associated with investing in an LLC that is run by persons who owe restricted fiduciary duties to the LLC or its members, and investors should carefully consider those risks before investing.
Intended Consequences: Tax Consequences of Conversion
The conversion of a C corporation to an LLC is a significant taxable event, because the conversion is treated as a distribution of all of the corporation’s assets and liabilities to its shareholders in exchange or a surrender of their stock. Thus, a corporate conversion to an LLC has the potential to generate a substantial tax bill, and shareholders will want to carefully consider the tax consequences before moving forward to convert a C corporation into an LLC.
Unintended Consequences: Disclosure of Ownership
Shareholders who choose to convert a corporation into an LLC have likely evaluated the corporate governance and tax consequences of the conversion. But there may also be other, unintended consequences. One example came to light in a recent case involving federal court jurisdiction.
As a general rule, a lawsuit can be filed in federal court if it involves a federal question – interpretation of a federal law or of the U.S. Constitution – or if it involves diversity jurisdiction. Diversity jurisdiction comes into play when all of the parties bringing suit are citizens of different states than all of the parties being sued. Individuals are citizens of the state in which they are domiciled – a maximum of one state. Corporations are citizens of the state where they are organized and of the state where their principal office is located – a maximum of two states. LLCs, on the other hand, are citizens of every state where one of their members has citizenship. If one of an LLC’s members is also an LLC, then the citizenship of that second LLC’s members is also the citizenship of the first LLC. Depending on how many members an LLC has, and whether any of those members are LLCs, this can lead to citizenship in many jurisdictions.
In Ben E. Keith Co. v. Dining Alliance Inc., the plaintiff brought suit, invoking the federal court’s diversity jurisdiction to assert claims under state law. The plaintiff had not been aware, however, that the defendant had converted from a corporation to an LLC before the lawsuit was filed. As discovery progressed, the parties realized that diversity jurisdiction may not have existed when the case was first filed. By that point, the parties had added federal claims, the defendant had filed counterclaims, and the defendant had filed third-party claims against new parties. The court ordered the parties to establish their citizenship to confirm that diversity existed to support federal court jurisdiction, which required the LLC defendant to identify each of their members and their citizenship. As it turned out, the LLC defendant had members who were also LLCs or partnerships, and it claimed that some of those members had a complex ownership structure that included multiple tiers of partnerships and funds whose citizenship it was not able to determine. The court ultimately sanctioned the LLC defendant by dismissing all of its counterclaims and third-party claims with prejudice.
There are a number of factors that corporate shareholders should take into account before converting their corporation into an LLC. These include the flexibility of corporate governance and management after conversion and the potential tax consequences of undertaking the conversion. But there are other potential consequences, including disclosing the identities of an LLC’s members if the LLC is (or becomes) involved in litigation in federal court. Shareholders should undertake the process of converting a corporation to an LLC only after carefully considering these and other possible consequences.