Greg Corombos: Hi, I'm Greg Corombos. Our guest this week on Expert Insights is Sandra Feldman. Sandra is Publications Attorney at CT Corporation. She joins us today to remind us of the importance of choosing the right entity for your business, but also how to go about changing that entity if a mistake is realized, or you're changing business requires it. And Sandra, thanks so much for being with us.
Sandra Feldman: My pleasure.
GC: Good to have you with us. How important, first of all, is the choice of entity for a small business owner?
SF: Well, choosing the business entity or business structure is one of the most important decisions small business owners will make. It affects liability, taxation, the ability to obtain financing, how the management and financial rights will be shared by the owners, exit strategies, estate planning, and more.
GC: So what are some of the options? What are the choices that small business owners have?
SF: The first choice they have is whether they want to own the business themselves, or form a separate statutory entity on the business. If they want to own the business themselves, and there's only one owner, that's called a sole proprietorship. If there's more than one owner, that's called a general partnership.
But the other option they have is to form a statutory entity. And there are a number of those choose from. The most common are the corporation, the limited liability company or LLC, limited partnership, and a limited liability partnership, or LLP. Those four are authorized by every state.
Now, there are also several statutory entities that are available in some but not all states. And that would include the business trust, limited liability limited partnership. There is a limited cooperative association, a statutory foundation, and there are even others. And there are even some special kinds of corporations and LLCs, such as the benefit corporation or the series LLC, or the low-profit LLC.
Now I refer to these as statutory entities because they can only be formed if there's a state statute authorizing their existence. Also, they have to file formation documents with the state in order to exist. Neither is true for a sole proprietorship or general partnership. You don't need a statute or a filing to do business in those forms.
GC: What about S corporations and C corporations?
SF: I'm glad you brought that up. It’s actually kind of a pet peeve of mine when people talk about forming an S corporation or forming a C corporation, and they make it sound like these are two different kinds of corporations. They’re not. You don't form a C corporation or form an S corporation. You just form a corporation.
The “S: and the “C” actually referred to subchapters of the Internal Revenue Code. A corporation can be taxed under subchapter C—or if they meet certain requirements of the Internal Revenue Code under Subchapter S. And by the way, LLCs can also be taxed on the Subchapter C or Subchapter S as well as Subchapter K. So the choice of “C” vs. “S” is not a choice of entity. It's a choice of how an entity is taxed.
GC: Now a moment ago Sandra, you listed a lot of different potential entities depending upon the type of business, and it sounds like there's a lot to choose from. But is that a good thing or a bad thing?
SF: I think it's a good thing. Each business structure, whether it's a sole proprietorship, partnership, LLC, corporation, or one of the others, has its own characteristics, and its own advantages and disadvantages, and every business owner will prioritize some characteristics over others. For a person whose main priority is not spending too much money when they're starting out, a sole proprietorship may be a good choice. But for a person who wants liability protection, an LLC or corporation would be better. If you have a couple of people starting a business, who not only want limited liability but also want to run the business together, an LLC may be a better fit than a corporation.
GC: So as you've explained here, Sandra, every small business owner needs to decide on a business entity form when starting out, but is it possible to make a change in that entity if they want or need to?
SF: Yes, it is. No one is stuck with the choice they made them starting out. If they started with a sole proprietorship or a general partnership, they can form an LLC or a corporation or another statutory entity. And if they formed a statutory entity to own and operate the business, they can switch to another form of entity.
GC: You work in this field a lot. So why would business owners want to make a change?
SF: Because the one constant in life, Greg, is change. The business changes. It may be more or less successful than anticipated. The people who started the business, they're likely going to change. The laws that affect businesses change. And all of those factors may make the business structure chosen when starting out, less appropriate sometime down the line.
Let me give you some examples to illustrate. Let's take Susie, whose business is selling cakes and cookies she bakes in a kitchen to a few local stores. My main concern was not spending a lot of money on her business. She also wasn't very worried about liability. So she decided on a sole proprietorship. But now Susie wants to open her own bakery. That means leasing property, entering into contracts with vendors, hiring employees, having customers in her store. What if a customer slips in the bakery and sues, or a disgruntled ex-employee? So Susie decides she needs to form a statutory entity to protect her personal assets from the bakeries, debts and liabilities.
Now let's take a couple of college friends who created an app in their dorm room, and they decided to go into business together. They wanted limited liability and flexibility and how they split their economic and management rights. So they decide an LLC was the best choice. But now they want to expand, and they need financing. A couple of venture capital firms have shown interest. But none of them will invest in an LLC; they'll only invest in a corporation. So our college buddies decide they need to convert their LLC into a corporation.
GC: What other reasons, you just gave us a bunch of them, but what other reasons could business owners have for wanting to make the switch?
SF: Well, now in discussing why someone would make a change, we should probably also remember that the corporation—that's been around since the 1800s, the LLC, really only since the late 1980s, and 1990s. The LLP is even more recent than that. So some people formed a corporation before there even was such a thing as an LLC or an LLP, may decide that an LLC or an LLP meets their needs better and may wish to make a change.
Of course, taxation is another factor that's important to a lot of small business owners. They may choose between a corporation or one of the unincorporated entity types like an LLC based on which one will result in paying less income taxes if the tax laws change. You know, just a couple of years ago, we had a major change in the federal income tax laws. We had the Tax Cuts and Jobs Act, which among many other things reduced the corporate tax rate from a maximum of 35% to a flat rate of 21%. So maybe you had some small business owners who really wanted to form a corporation, but they were advised not to because of the dreaded double taxation. But now being taxed as a corporation that pays its own income taxes may not be such a disadvantage.
GC: Sandra. I can imagine some folks listening to this and saying, Yes, she's explaining exactly why I need to change my entity. But how do I go about doing it? So how do you change from one kind of business entity to another?
SF: Before I get into the details of how to make a change, I need to emphasize that any change in business form as legal and tax consequences, so it's very important to consult with legal and tax practitioners. That should always be the first step.
Now regarding how it's done, that depends on what business form you’re starting was and what business form you want to end up with. Probably the simplest change is to go from a sole proprietorship or general partnership to a statutory entity. You just form the new statutory entity and you transfer the business to it in exchange for the ownership interest.
Forming a statutory entity involves what I like to call the big five choices. First, there’s choice of entity, which in the case of most small businesses these days is an LLC, with the corporation next.
Second is choice of formation state, which will usually be where the business is located, although it does not have to be.
Third, we have choice of name. And here you have to remember that a statutory entity’s name has to meet certain statutory requirements.
Fourth, we have choice of taxation, which is basically whether you want the income tax to be paid by the statutory entity or by its owners.
And fifth, we have choice of Registered Agent. The most important decision here is whether to appoint a professional Registered Agent or not.
GC: Sandra, you mentioned a moment ago about how to shift from a sole proprietorship or a general partnership to a statutory entity. But what if you already have a statutory entity and want a different one.
SF: Changing from one form of statutory entity to another is more complicated. You have to comply with both the requirements of the state business entity law and the requirements of the governing documents. There are three main ways to change from one kind of statutory entity to another. You can form the new entity and dissolve the old one. You can form the new entity and merge the old into the new. Or you can convert the old and put the new through a statutory conversion.
To illustrate, let's return to our college friends. They've agreed to change from an LLC to a corporation, as required by a venture capital firm that's agreed to invest in their business. One way they could do that is to form a new corporation. Their LLC enters into an agreement in which it transfers its assets to the corporation in exchange for corporate stock. The corporation also agrees to assume the LLC’s liabilities. The LLC then dissolves, winds up, and terminates. It's only remaining asset, which is the corporate stock, is distributed to the members—that is our college friends, who now own the corporation.
But that's the most complicated and expensive way to make the change. A better way is through a merger. This also requires forming a new corporation.
However, they'll be no need for the LLC to enter into separate agreements to transfer its assets and liabilities, and no need to dissolve the LLC. Instead, a plan of merger is drafted, which contains the terms and conditions of the merger and certain other information that's required by the LLC incorporation laws, and our college friends to approve the plan—as members of the LLC and the shareholders of the corporation. Then articles of mergers are filed with the state. Once that merger is effective, the LLC ceases to exist, the corporation survives, and all of the LLC’s assets and liabilities automatically belong to the corporation by operation of law.
Now, the third and easiest way is through a fairly new transaction called the statutory conversion. Mergers, of course, been around for a long, long time. But the need for a transaction intended to change from one kind of entity to another really wasn't even necessary until fairly recently when the state started authorizing all these new entity types. The steps for a conversion is basically the same as that of a merger. Once it's effective, the assets and liabilities of the old entity type automatically belong to the new entity type. And the owners of the old entity type become owners of the new entity. So what our college friends are going to do is they'll dress the plan of conversion containing terms and conditions, will approve the plan on the LLC’s behalf, and then they’ll file articles of conversion along with the articles of incorporation. Now, you'll note that there was no need to first form the corporation. Unfortunately, the problem with the statutory conversion is that not every state authorizes it. However, more and more are adding it to their business entity statutes. But I still recommend you check to make sure first,
GC: Sandra, that was very thorough, but is there anything else that small business owner has to do?
SF: Unfortunately, yes. There are steps that have to be taken after the change is made. State agencies where the original business entity type is on file will have to be notified. Say an LLC was qualified to do business in foreign states, and it converts to a corporation, filings will have to be made with those foreign states to reflect the new reality. Also, a lot of business licenses require the applicant to set forth the type of entity that owns the business. Those licenses are going to have to be updated. The IRS and the state tax department should be notified, and a new employer identification number may have to be obtained. Also if business is conducted under a registered name or a DBA name, as it's also called, the registration should be updated. And those are just some of the regulatory compliance requirements.
You should also check the business contracts to see if they required the other party to be notified of any major changes. A business’s bank and insurers should also be notified. And it might be a good idea to tell the vendors and even the customers, as well.
GC: Sandra, we're just about out of time Any final advice or any other final comments related to entity and entity change?
SF: I just like to review some of the main points that I hope the listeners will take out of this. First, it's very important to choose and operate under the right type of business entity. Second, there's no one size fits all choice. The right fit depends on each unique situation. Third, if that situation changes, making another business entity a better fit, a changing entity type can be made. However, you should always get legal and tax advice first.
GC: Sandra, a lot of great advice here for our existing and aspiring business owners. Thank you so much for your time today. We greatly appreciate it.
SF: Thank you for having me.
GC: Sandra Feldman is Publications Attorney at CT Corporation. I'm Greg Corombos reporting for Expert Insights.