Your business might need a legal entity change as it grows and evolves. Many business owners face this exact situation.
Business owners can change from one entity type to another more easily now. Statutory conversions have simplified this process substantially since the early 2000s . A “conversion” lets the converted entity take ownership of all assets, property, debts, and liabilities from the converting entity . Business owners typically use three main methods to convert their entities: statutory conversion (most common), inter-entity merger, and dissolution and formation .
The decision to change your business entity type needs careful thought. Each state has different rules, and some don’t allow certain types of conversions . On top of that, it can impact your taxes in ways that need thorough evaluation .
In this piece, we’ll guide you through the essentials of changing your business entity type. You’ll learn the right time to convert, see the step-by-step process, and understand the legal and tax factors that matter most.
Understanding Entity Conversion
A legal entity change lets your business switch from one structure to another while keeping its identity intact. Your business retains its assets, contracts, tax records and original identity, unlike starting a new company from scratch [1].
What is a legal entity change?
The law allows your business entity to transform into a different type through entity conversion. A limited partnership can become a limited liability company [2]. Your business automatically transfers all its assets, property, debts and liabilities to the new entity during this process.
Your business stays the same after conversion, just with a different legal structure [2]. This is different from launching a new business because you keep your legal continuity while changing the structure [3].
Common reasons businesses change entity type
Business owners think about changing their entity type because:
- Tax optimization – Companies switch structures to get better tax benefits [4].
- Liability protection – Sole proprietors switch to LLCs or corporations to protect their personal assets [5].
- Business growth – Growing operations might need a more complex structure [4].
- Investment opportunities – Venture capitalists and angel investors prefer C Corporations over partnerships [6].
- Professional requirements – Some licenses, certifications, or government contracts need specific entity structures [5].
When is the right time to convert?
Your business circumstances determine the best time to convert. Corporations should plan their conversion at the start of the tax year (usually January 1) [7]. This timing helps you avoid filing multiple tax returns in one year and simplifies your accounting [7].
Entity conversion becomes crucial during major business changes. This is especially true when you have rapid growth, need outside investment, or face increased liability risks [5]. Many startups that begin as LLCs convert when investors demand corporate status before funding [7].
You should ask tax and legal professionals to get the full picture and structure the deal right before making any changes [2].
Methods to Change Your Business Entity Type
Businesses that want to change their legal entity structure can choose from three distinct methods. Each option comes with its own complexity level, costs, and legal implications. The right choice depends on your specific situation.
Statutory conversion
Statutory conversion emerged in the early 2000s and has become the most accessible way to change business entity types [8]. Your company can convert directly from one entity type to another without creating a new entity or dissolving the existing one [1]. The post-conversion entity remains legally the same business as the pre-conversion entity, just in a different form [9]. The law automatically transfers all assets, liabilities, and ownership interests [10].
Inter-entity merger
The inter-entity merger process starts when you form your desired entity type. You then merge the original entity into the newly formed one [9]. The original entity stops existing once complete, and all its assets and liabilities automatically vest in the new entity [9]. The original entity’s owners become the new entity’s owners by default [9]. This method proves useful in states that don’t allow statutory conversions, even though it requires more steps [11].
Dissolution and reformation
This approach costs the most and businesses rarely use it. The process involves closing your current entity and forming a completely new business [9]. You must carefully transfer all contracts, assets, and liabilities to the newly formed entity [9]. Some assets might need third-party approval to transfer, such as licenses, intellectual property rights, and customer agreements [9].
Choosing the right method for your situation
Statutory conversion offers the quickest way forward. It costs less, requires fewer steps, and keeps your business running smoothly [9]. Notwithstanding that, some states restrict statutory conversions between certain entity types [4]. Your location and specific needs might then require a different approach.
Businesses moving to another state should check if both states allow their desired conversion [4]. You might need dissolution/reformation or merger approaches instead. Companies with complex ownership structures or multiple equity interest classes might find inter-entity mergers more suitable [9].
Step-by-Step Process to Change Entity Type
Legal entity structure changes need careful attention to specific steps. States provide a well-laid-out path that will give a smooth legal transition throughout the process.
1. Draft a plan of conversion
A written plan of conversion serves as the foundation for any entity conversion. Your plan must include both converting and converted entities’ names, a statement of continuing existence, your target entity type, and its jurisdiction of formation [12]. Texas businesses should also specify how ownership interests will convert into the new structure [13].
2. Get member or shareholder approval
Each state and entity type has different approval requirements. Texas requires a simple majority approval from LLC members or corporation shareholders for the conversion plan [12]. This step makes sure all stakeholders back the structural change before moving forward.
3. File conversion documents with the state
The next step after approval is to file a conversion certificate with your state’s Secretary of State office. Your filing must include statements that confirm proper approval of the conversion plan under applicable laws [14]. This filing starts the official conversion process.
4. Submit formation documents for the new entity
You must file formation documents for your new entity type with the conversion certificate. This includes articles of organization for an LLC or articles of incorporation for a corporation [15]. Many states let you file these documents at the same time as your conversion certificate.
5. Notify other states where you’re registered
Companies registered in multiple states must update their registrations in each location. You’ll need to file conversion papers in every state where you do business [16]. The process might require a new Employer Identification Number based on your specific conversion case [15].
Legal, Tax, and Compliance Considerations
The world of entity conversion goes beyond just following procedures. Your business transition will go smoothly if you meet all compliance requirements.
Tax implications of entity conversion
Changes in business entities can lead to major tax effects. The IRS sees corporation-to-LLC conversions as corporate liquidation, which might result in double taxation [6]. The corporation must pay taxes on appreciated assets first. The shareholders might face extra taxes when they get these assets [6]. LLC-to-corporation switches usually don’t create immediate tax bills but they can alter asset basis [6].
Impact on contracts and licenses
Entity conversion needs agreement updates even though legal continuity stays intact. Business contracts usually have clauses about business changes [5]. You might need novation agreements to swap one party for another or documentation to transfer rights and duties [5]. Professional licenses also need notification or new registration after entity type changes [17].
Updating EIN, bank accounts, and public records
Your business needs these vital updates after conversion:
- EIN changes: You’ll need a new EIN if you incorporate, start a partnership, or switch your entity structure [18]. Tax filing issues can arise without proper EIN updates.
- Public record filings: Your business must update registrations in every state where it operates [19]. Missing required documents can hold up your conversion date or lead to tax penalties [19].
- Banking updates: Let your financial institutions know about your entity change and give them conversion documentation [20].
Conclusion
Your company’s legal status change marks a vital step in its development. This piece walks you through the process, methods, and work to be done for a smooth transition. Without doubt, statutory conversions give businesses the most direct path, though inter-entity mergers and dissolution/reformation could work better based on your specific needs.
Timing is vital to this process. Many businesses find it best to schedule conversions when their tax year begins. This helps reduce administrative hassles. A chat with legal and tax professionals before starting any conversion will help spot potential risks unique to your case.
Our roadmap breaks down the key steps – from drafting a conversion plan and getting approvals to filing documents and updating records. Tax implications need special focus since they can affect your finances by a lot.
Once you complete your entity conversion, update your EIN, banking details, and public records to stay compliant with regulations. Think about entity conversion as a complete business transformation rather than just paperwork.
This guide should help you decide if changing your legal entity status fits your business goals. It gives you the knowledge to make this transition work. The right entity structure can help your business grow, protect your assets, and improve your tax situation over the next several years.
FAQs
Q1. Is it possible to change my business entity type? Yes, it is possible to change your business entity type through a process called entity conversion. This allows you to transform your business from one legal structure to another while maintaining its identity and continuity.
Q2. What are the common methods for changing a business entity type? There are three primary methods for changing a business entity type: statutory conversion (the most common), inter-entity merger, and dissolution and reformation. The best method depends on your specific situation and state laws.
Q3. What are the key steps in changing a business entity type? The key steps include drafting a plan of conversion, obtaining member or shareholder approval, filing conversion documents with the state, submitting formation documents for the new entity, and notifying other states where you’re registered to do business.
Q4. Do I need a new EIN when changing my business entity type? In many cases, you will need to obtain a new Employer Identification Number (EIN) when changing your business entity type, especially if you’re incorporating or forming a partnership. However, the specific requirements depend on your conversion scenario.
Q5. What are the potential tax implications of changing my business entity type? Changing your business entity type can have significant tax implications. For example, converting a corporation to an LLC may trigger corporate liquidation taxes, while converting an LLC to a corporation typically doesn’t create immediate tax liability but may affect asset basis. It’s crucial to consult with a tax professional before proceeding with any entity conversion.
References
[1] – https://www.activefilings.com/manage-your-business/entity-conversion/
[2] – https://www.wolterskluwer.com/en/expert-insights/converting-to-or-from-an-llc
[3] – https://durity.com/en-us/glossary/entity-conversion/
[4] – https://www.cogencyglobal.com/blog/business-conversion-changing-company-type/?srsltid=AfmBOooK-V2h4wPRmZDdIpk80O8g56vkOR4esoDWtK-w-CBkuzLRLqva
[5] – https://www.thebalancemoney.com/what-happens-to-a-contract-when-a-business-changes-3974595
[6] – https://www.gfrlaw.com/what-we-do/insights/not-so-fast-–-consider-income-tax-consequences-using-entity-conversion-statute
[7] – https://www.dwt.com/blogs/startup-law-blog/2020/12/converting-startup-llc-to-corporation
[8] – https://www.nossaman.com/practices-Entity_Formation_Conversions_Restructurings
[9] – https://pruvent.com/2023/08/01/entity-conversions-three-methods-to-change-the-entity-form-of-a-business/
[10] – https://www.wolterskluwer.com/en/expert-insights/statutory-conversions-llcs-corporations-other-business-entities
[11] – https://www.corpnet.com/blog/difference-between-business-entity-statutory-conversion-business-domestication/
[12] – https://realdealdocs.com/understanding-business-plan-of-conversion-a-complete-guide/
[13] – https://sulleelaw.com/business-conversion-in-texas/
[14] – https://www.sos.state.tx.us/corp/forms/instructions/632-instructions.shtml
[15] – https://www.corpnet.com/blog/how-to-change-your-business-entity/
[16] – https://www.oregon.gov/employ/Businesses/Documents/Tax/uipub212_0910.pdf
[17] – https://www.wolterskluwer.com/en/expert-insights/4-business-changes-that-can-impact-business-license-compliance
[18] – https://www.irs.gov/businesses/small-businesses-self-employed/when-to-get-a-new-ein
[19] – https://www.wolterskluwer.com/en/expert-insights/public-records-filings-in-merger-transactions
[20] – https://www.uschamber.com/co/start/startup/adjusting-business-ein