Legal and Tax Conversions: Changing Your Company Structure Without Changing Your Company
Do you remember talking with your co-founders, your attorney and your accountant about what type of entity you should choose for your new company? And all of that discussion about limited liability, governance structure, flow-through tax treatment, tax deductions, and capital structure? You may have good or bad memories of that exercise, but that discussion should not be over—it should be on-going. The right entity for your company then may not be the right entity for your company now (or in the future).
Choosing an entity type is a decision based on a current set of circumstances and goals. Maybe when your business first started, the informality of an LLC's governance structure or the flow-through tax treatment afforded to members of an LLC were very attractive. But circumstances and goals change. At some point, it may be that the informality of an LLC's governance structure gets in the way of effective governance. Or new members invest in the company who do not want the flow-through tax treatment afforded to members of the LLC. The good news is that there are mechanisms for changing the entity of your business even after it has been established.
One common but often misunderstood mechanism is a conversion. A conversion is a change in an entity's legal type (e.g., a change from an LLC to a corporation) or, sometimes, an entity's tax election (e.g., a change from taxation as a sole proprietor or partnership to taxation as a corporation). In either case, the company is still the same legal person it was before the conversion, it simply is a different type of entity. Think of it as a person, say "Bobby," who has converted from one religion to another—Bobby is still the same Bobby, but now he practices another religion.
This is different than other mechanisms for changing the type of entity for your business, such as creating a new entity of a different type (say, a corporation) and merging your current entity (say, an LLC) into the new entity. In that case, the entity has not only changed “type,” it has become a completely different entity altogether. It’s not that “Bobby” has just changed religions, he’s actually changed into someone completely different—Bobby now has a new social security number, passport, name (he always wanted to be called “Thor”) and religion.
A legal conversion is a conversion in its purest sense. It affirmatively changes the type of entity for all legal purposes. In fact, a whole new set of laws applies to the converted company. If your company was organized as an LLC, its organization, capital structure and management is governed by a state's Limited Liability Company Act. If your company is then converted into a corporation, all of those matters will be instead governed by a state's Business Corporation Act.
A tax conversion is different and more limited. As it turns out, the IRS does not formally recognize LLCs (or a variety of other entity types) as such. The IRS essentially categorizes all federal income tax payers into one of only three categories: sole proprietorships, partnerships, and corporations. If your company is organized under state law as an LLC, it is legally an LLC but will be treated by the IRS for tax purposes as something else (for example, a partnership if there are multiple members and no alternative tax election is made). A tax conversion affirmatively changes the tax treatment elected with the IRS for tax purposes only. For example, if your company is am LLC under state law and is now being taxed by the IRS as a partnership and you convert its tax treatment to a corporation, your company will still be an LLC. It does not become a corporation after making this election, it simply is taxed by the IRS like the IRS taxes corporations.
So is your company’s governance structure ineffective? Do you have new investors with different wishes for tax treatment? Then it’s time to re-consider what kind of entity your business is. Talk to your accountant—you may be ready for a conversion.