Entity Conversions: Three Methods to Change the Entity Form of a Business
The form of an entity – corporation, limited liability company (LLC), or other entity type – can impact the development and growth of a business, with its needs evolving through time. Initial considerations that helped shape the entity formation decision at the commencement of a business may give way to other needs, requiring the entity form to be changed. Fortunately for business owners, they are not stuck with their initial decision. This article seeks to discuss the three common methods used when changing the entity form of a business, and when or why an owner may consider the entity conversion of its business.
What is an Entity Conversion and Why Convert
An entity conversion is the change from one entity type to another. As many owners already know from making their initial entity selection, there are many entity types to choose from (corporations, limited liability companies, sole proprietorships, or general partnerships) and not one entity type is right for all. For many owners, the decision process is primarily driven by tax considerations and risk of liability exposure. Initial considerations may change over time and with the operations of the business, which often times lead owners to consider the conversion of entity form to better suit current needs. Owners should consult with a legal professional and tax advisor to understand the various entity types and whether their current entity type is ideal for their current business operations, future plans, and expected growth. An entity conversion may be ideal for some business owners seeking to maximize the benefits another entity type can offer over their current entity type.
Three Entity Conversion Methods
There are three methods business owners typically use to change from one entity form to another: (i) dissolution and formation; (ii) inter-entity merger; and (iii) statutory conversion.
- Dissolution and Formation. Perhaps the most expensive and least commonly used, business owners can choose to wind up and dissolve their current entity form and commence a new business using the desired entity form. This method is complex given the many requirements to properly wind up and properly dissolve an existing business. Additionally, owners must ensure all current contracts, assets, and liabilities are properly transferred into the newly formed entity. Some assets may not be easily transferrable and may require consent of third parties (e.g., licenses, intellectual property rights, and customer or supplier agreements). There will also be administrative costs to restart the business in the new entity form, including proper documentation of ownership, which can become complex with the increasing number of owners.
- Inter-Entity Merger. Under this method, owners first form the desired entity type and then merge the original entity into the newly formed entity. By operation of law, the assets and liabilities of the original entity vest in the new entity and the original entity ceases to exist (see MN. Stat. 302A.641, Subd. 2, which is only applicable to mergers of certain entity types). Also, the owners of the original entity may automatically become owners of the new entity (see MN. Stat. 302A.641, Subd. 3, which is only applicable to mergers of certain entity types). The merger of two entities can be a complex process depending on the complexity of the business and whether the current entity has a number of different equity interests held by its owners (e.g., different share or limited liability membership unit types). Proper documentation must be prepared and maintained to ensure the merger’s validity.
- Statutory Conversion. The most commonly used entity conversion method is a statutory conversion. Under this conversion method, a filing is made with the applicable state filing office (typically with the applicable secretary of state office) to change from one entity type to another pursuant to the state’s applicable conversion statutes. Consequently, as a matter of statute, the post-conversion entity is considered the same as and a continuation of the pre-conversion entity (see MN. Stat. 302A.691, Subd. 1, which is only applicable to conversions of certain entity types). By operation of law, the assets and liabilities of the pre-conversion entity continue with the post-conversion entity and owners continue their ownership of the business through the post-conversion entity (see MN. Stat. 302A.691, Subd. 2, which is only applicable to conversions of certain entity types). This method is the least expensive entity conversion method and is the easiest to implement by experienced legal professionals.
Statutory Conversion Steps
The steps required for a statutory conversion will vary from state to state because of each state’s applicable conversion statutes governing the pre-conversion entity type and the post-conversion entity type. Generally, the following steps are required to complete a statutory conversion to a different entity type, when staying within the same state:
1. Research, analyze, and confirm applicable statutory laws allow for the contemplated entity conversion. Certain states may prohibit the conversion from one entity type to another or require additional steps not otherwise specified herein.
2. Draft a plan of conversion setting forth the terms and conditions of the contemplated entity conversion.
3. Obtain proper company and owner consent approving the statutory conversion of the business.
4. Draft proper formation or incorporation documents for the post-conversion entity type.
5. Obtain and complete the proper statutory conversion documentation within the applicable state (e.g., Certificate of Conversion, Statement of Conversion, or Articles of Conversion).
6. File the proper conversion documentation, formation/incorporation documentation, and pay the applicable filing fee with the applicable state filing office (typically the secretary of state office).
Please note, entity conversion from one state entity type to another state entity type (e.g., a Minnesota entity to a Delaware entity) may be permissible, but additional steps may be required depending on both states’ conversion statutes. Consult with a legal professional if conversion from one state to another may be beneficial to your business.
There are a number of methods owners can use to change the entity type for their business to another entity type that may better fit its current needs and future growth expectations. Navigating statutory laws to either form a business or complete a statutory conversion can be overwhelming, but a legal professional can assist you with every step. Consult with a legal professional to discuss the potential benefits an entity conversion can offer you and your business.