From a Caterpillar to a Butterfly – Converting Corporations to LLCs
Limited Liability Companies (LLCs) are almost always a better choice of entity than Corporations, yet not all business had the good fortune of being born as LLCs. There is hope for these corporate dinosaurs, however, as recent changes in the law have made it easier to convert a corporation into an LLC.
Background:
For a long time, the S-Corporation (S-Corp.) was the optimal legal structure for a private company. An S-Corp. is simply a corporation formed under state law that elects to be taxed under Subchapter S of the Internal Revenue Code by filing IRS Form 2553. Subchapter S was passed specifically to promote small business by providing qualifying small businesses (e.g. no more than 100 shareholders) with “flow through” tax benefits like those of a partnership, while at the same time shielding their owners from liability just as much as any other corporation. Although the Florida LLC Act was originally passed in 1982, S-Corps. continued to be the optimum entity choice until certain “bugs” in the Act were finally worked out in 1999. Then of course it took a few years for business lawyers to break their old habits and begin feeling comfortable recommending LLCs. Accordingly, most businesses that are more than a few years old were formed as corporations. In light of the new statutory mechanism for conversion and the compelling superiority of the LLC, there is no good reason why these corporations should remain in their current form.
Asset Protection Benefits:
Over the years, the S-Corp. law and Florida corporate statutes adapted to accommodate various aspects of small business, however, they never evolved to provide asset protection for stock held by shareholders with personal judgments against them unrelated to the business. These judgment creditors can seek to satisfy their judgment by taking the shareholder’s stock, regardless of whether the stock is part of an investment portfolio or constitutes the family business. Such a judgment could result from, for example, individual tort liability that is not sufficiently insured against. Once the judgment creditor takes the stock, it can vote the stock and exercise whatever powers the “former” owner had as a shareholder. In many cases, this power is used to force a liquidation of the company and a sale of its assets to satisfy the judgment. In this sense, corporations do not provide their owners’ stock with any asset protection at all.
Limited Liability Companies, on the other hand, can provide their owners with both asset protection and flow through taxation. In fact, the flow through aspect of the LLC can work to put asset protection on the offensive by penalizing the judgment creditor of an LLC owner. Specifically, the LLC statute prohibits the levy or “taking” of a LLC owner’s interest by limiting the judgment creditor to a charging order remedy, unless otherwise provided in the LLCs governing documents. In a properly structured and maintained LLC, this means that the judgment creditor can never acquire the right to exercise the owner’s vote; it only has the right to receive any distribution the owner would have been entitled to, if any. Of course, waiting for a distribution is not a good position for most creditors, because the IRS attributes the income that flows through the LLC to the persons who have the right to receive distributions, regardless of whether the distribution is actually made. Since the judgment is not against the LLC, it remains free in the meantime to continue paying its normal operating expenses, including salaries.
Some Other Benefits of Converting to an LLC:
· The LLC operating agreement is a hybrid document that contains governance provisions you would normally find in corporate bylaws, as well as the major elements of a good shareholders’ or partnership agreement. If the shareholders don’t already have shareholders’ agreement, they should consider just going directly to an operating agreement as part of the conversion process.
· Corporations must spell out the provisions for any preemptive rights of shareholders in their Articles of Incorporation, a public document. LLCs need not publicly disclose any relative rights of their owners.
· Under the right circumstances and with careful tax planning, the business can secure more flexible partnership tax treatment to better allocate specific items of income and loss disproportionately among the owners
· The LLC statute specifically applies to LLCs all the corporate case law regarding “piercing the corporate veil”.
Conversion Procedure:
Thanks to some recent changes to the Florida Business Corporation Act in the last legislative session, Florida Corporations can be metamorphosized relatively painlessly by a trained professional. Section 607.1112 of the Act sets forth the basic legal requirements and the filings that must be made to complete a conversion, such as a Certificate of Conversion and Articles of Organization. I always recommend the additional execution of an Agreement to Convert and an Operating Agreement, as well as Board Resolutions and Shareholder Consents of the converting Corporation.
If done correctly, the LLC that results from the conversion is for all purposes and by operation of law the same entity that existed before the conversion – it even keeps the same tax identification number. Of course, that’s not all there is to it and numerous conversion pitfalls abound for the unwary. For example, in the past the IRS considered these transactions to be tantamount to a liquidation of the corporation with a subsequent contribution of the corporation’s assets and liabilities into a new entity. Liquidation is seen as a “realization” event under the tax law meaning that any appreciation in the corporation’s assets is taxed essentially as if they were sold for a profit. Recent IRS guidance provides a roadmap that when carefully followed affords “tax free” treatment for conversions that are mere changes in form and not substance under IRC 368(a)(1)(F).
Since LLCs are hybrid entities, under the right circumstances the LLC can choose between being taxed as a partnership, sole proprietorship, C Corporation or S Corporation. Thus, a partnership can convert to a LLC taxed as a partnership, and an S-Corp. can convert into an LLC that continues to be treated by the IRS as an S-Corp. In the case of an S-Corp to LLC conversion, among other things, care must be taken when drafting the LLC operating agreement so as not to inadvertently give any owners rights that the IRS would consider a “second class of stock” which would terminate the corporation’s “S” status. Additionally, the LLC must file IRS Form 8832 (Entity Classification Election) and “check the box” to elect to be treated as a Corporation. No further election is necessary to maintain S-Status.
What Are You Waiting For?
If your insurance company offered to convert your existing policy to a new program that provides substantially better coverage with added flexibility for a relatively small, one-time fee, would you even think twice? Recommending that a Corporation’s owner(s) consider converting their business to an LLC is a compelling value proposition. Despite the myriad of potential tax and legal issues involved in converting a corporation to an LLC, as far the business owner is concerned, it’s a small amount of paperwork to obtain a large amount of piece of mind.
See also our articles on “S-Corporation v. LLC” Part 1 and Part 2.
By: Eduardo R. Arista, CPA, Esq.
Ph: (305) 444-7662
Email: Ed@AristaLaw.com
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