The Pros and Cons of Changing Structures

Change will dictate the direction of your business. As a successful business owner at some point, you will have to deal with change and growth. When a majority of businesses start, they begin with growth as one of their main goals. Growth and expansion come with many decisions, and some can seem daunting.

Hopefully, you will come to a point in your business where you will have to make some major decisions based on growth and opportunity. If this happens, you should be prepared. One key question you will have to ask yourself is “Should the business exist in its current legal structure?”

If you’re unsure if you should even be asking yourself that, here are different reasons why businesses make the decisions to change their legal structure:

Business Expansion

Acquisition – Acquiring an additional business may require a new structure.

Public Stock Offering – The company plans on making a public stock offering, and in order to accomplish this, they must change their corporate structure.

Venture Capital Funding – Venture capital is often acquired through shares of stock. An existing LLC would not be able to seek this type of funding.

Owner may want less Compliance

Fewer requirements – The owners or managing board of the company may decide that they prefer a simpler structure for the business. Owners of a small business may decide to form an LLC to avoid annual meetings. Their decision may also include changing from either a corporation or an LLC to a sole proprietorship, which would entail dissolving the existing entity. However, changing from a corporation or LLC to a sole proprietorship is a rarity because you as the business owner would lose limited liability protection.

Tax Reasons

Pass Through Taxation – A corporation may decide to convert to an LLC because they have shareholders who want to take advantage of “pass through taxation.”

IRS Requirements – Converting from a corporation to an LLC may be a wise choice for a company that has international shareholders to bypass the S Corporation restrictions.

 

If you decide that you should change your business entity, you should be aware of the characteristics of each and the steps to change. The first step that you should take is to be aware of your options. You must make sure you are knowledgeable about the different types of business entities before you decide to change your structure. The most common business entities are

Sole Proprietorship – An unincorporated entity owned by one individual.

Limited Liability Company – The simplest form of an incorporated entity which provides the business with the protection of a corporation and the tax benefits of a sole proprietor or partnership.

Corporation – The creation of a corporation separates the business assets from the personal assets of the corporation, thus providing asset protection.

S Corporation – A tax election that is made with the Internal Revenue Service after the business has been incorporated.

The second step is to assess your choices for changing your business structure. Here are the options for changing:

Sole Proprietor–>Corporation/Limited Liability Company

Corporation–>S Corporation

LLC–>Corporation

Corporation–>LLC

Merging Entity A and Entity B–>New Business Entity

So if you come to the point where you decide to change your structure, what are the appropriate steps to take to change your existing structure? Let’s take a look at each type of change listed above and breakdown the process for each.
Changing from Sole Proprietor to a Corporation or LLC
This change is simple and not as daunting as the other steps. Because a sole proprietorship is an unincorporated entity, you must file the necessary paperwork to form it as either a corporation or an LLC.
Changing from a Corporation to an S Corporation

An S Corp is an election that is made with the IRS after the incorporation is complete at the state level. This is done by filing Form 2553 with the IRS.
Converting from an LLC to a Corporation
Most states recognize converting one entity to another. In the event that your state does not recognize a conversion, you will have to dissolve the company and re-incorporate it into the changing structure. Most likely this will not be the case. Here are the steps to take if your state recognizes converted entities:

1.     Prepare a plan of conversion, which must be approved by the members of the LLC.

2.     File a Certificate of Conversion with the Secretary of State (See sample Certificate of Conversion here).

3.     File Articles of Incorporation and any other documents required by the Secretary of State.

4.     Transfer the units of ownership over to shares of stock by issuing the stock to the previous members who are now shareholders. Make sure any changes are documented in the bylaws of the corporation and the stock transfer ledger.

Converting from a Corporation to an LLC

As stated previously, most states recognize conversions. This is also the case in converting from a corporation to an LLC. In the event that your state does not recognize a conversion, you will have to dissolve the corporation first and then create the LLC. Here are the steps to convert from a corporation to an LLC if your state recognizes conversions:

1.     Create a plan of conversion, which must be approved by the Board of Directors and the shareholders.

2.     File Certificate of Conversion with the Secretary of State.
Merging Two or More Entities 

A common occurrence in the business world happens when two companies merge together to become one entity. This is another example of changing a business structure. An example of this type of change would be if two competing healthcare companies decide to merge into one company in order to share resources and clients. In some cases, one of the entities may cease to exist. The steps outlined below can serve as a guideline for an LLC merging with a corporation, a corporation merging with an LLC, or two similar entities merging with one another.

1.     Form a new LLC by filing either a Certificate of Formation or Articles of Organization. Or create a corporation by filing Articles of Incorporation.

2.     Any outstanding shareholders must approve and exchange shares of stock for units of ownership and membership rights.

3.     File a Certificate of Merger with the Secretary of State.

4.     File a Certificate of Dissolution for the entity that ceases to exist.

Additional Steps
Generally, there are additional steps that must be taken when you change your business legal structure.
New EIN
Any new charter that exists is required to issue a new EIN. A charter consists of Articles of Incorporation, Certificate of Formation, or Articles of Organization. You can refer to the IRS EIN checklist for more information.
Business License
Some states and local government agencies may require a new business license. To ensure compliance, check with the agency that issued the initial business license to you.
Contact Foreign State if Applicable
If you have taken the steps to formally “qualify” your company to conduct business in the state of operation, you will have additional requirements. This means that if you change the business structure and have also qualified, there will be additional requirements. To make sure your businesses in compliance with the state of operation verify the requirements with the Secretary of State’s office in that particular state.

At first, the prospect of changing your business structure can be intimidating. But with a few points to guide you, nothing should be stopping you from changing your business structure now! So no matter which structure you change to, don’t forget to conduct your due diligence and verify all requirements for changing your business structure with the IRS and the Secretary of State’s office. Changing your business can be a simplified process. However, before you change your business structure, it is suggested that you seek the advice of your legal counsel before moving forward.

By: Chantal Towles, President of Creative Business Assistants, LLC, provides dynamic, customer-focused, small business incorporation services, as well as compliance and virtual business support services.  To learn more about Creative Business Assistants visit www.cbadirect.com or view Chantal’s profile on LinkedIn.

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