If you’re thinking of converting the legal form of your small business from an Arizona corporation to an Arizona LLC, you should be aware of some basic facts regarding the state’s business-entity conversion process. In general, the tax consequences associated with merging your corporation into an LLC will be complicated. Therefore, for any kind of corporation-into-LLC merger, you should consult with an experienced tax adviser.
Statutory Conversions vs. Statutory Mergers
As an initial point, be aware that there is a distinction between a “conversion” and a “merger,” and more specifically between a “statutory conversion” and a “statutory merger.” A statutory conversion is a cheaper, quicker way to convert a corporation to an LLC—largely because you do not have to form a separate LLC before the conversion can occur. However, Arizona is one of only about ten states that do not allow statutory conversions of corporations to LLCs; instead, Arizona only allows statutory mergers. Unlike statutory conversions, statutory mergers do require you to form a separate LLC before you can convert—or, perhaps more accurately, merge—your business.
Notwithstanding the distinction between statutory conversions and statutory mergers, “conversion” is a more general term that can include mergers. In this article, we’ll use “conversion” and “merger” somewhat interchangeably, sometimes speaking broadly about “conversions” and “converting” your business, even though, more narrowly and technically, we’ll be talking about a merger.
Variable Elements of Conversions
Before looking at the specific steps for converting your business, let’s be clear that there is not just one kind of corporation or one tax status for an LLC. On the contrary, there are:
- C corporations and S corporations
- for-profit corporations and non-profit corporations
- corporations formed under Arizona law and corporations formed under other states’ laws
- multi-member LLCs and single-member LLCs; and
- LLCs taxed as partnerships, LLCs taxed as corporations, and LLCs taxed as “disregarded entities.”
We won’t be looking at every possible combination of these variables. Instead, we’ll try to keep matters as simple as possible, focusing mainly on the general rules of Arizona’s merger statutes as they apply to closely-held, for-profit Arizona corporations merging into multi-member LLCs.
Arizona’s Merger Statutes
Bearing in mind that mergers can be among the most complicated of business transactions, this section provides a very brief summary of the process of conversion-via-merger under Arizona’s merger statutes. As in most states, Arizona has one merger statute under its Business Corporation Act and another merger statute under its Limited Liability Company Act; portions of each of these statutes apply to a corporation-into-LLC merger. For the most important parts of each of the two statutes, check Sections 10-1101, 10-1103, 10-1105, 10-1108, and 29-752 through 29-757 of the Arizona Revised Statutes (A.R.S.).
To convert your Arizona corporation to an Arizona LLC via a statutory merger, you need to:
- create a new LLC
- prepare a plan of merger
- have your corporation’s board of directors adopt the plan of merger
- obtain shareholder approval of the plan of merger
- obtain LLC member approval of the plan of merger; and
- file articles of merger with the Arizona Corporation Commission.
Step 1: Create an LLC
Creating an LLC is a multi-step process. However, for immediate purposes, the key elements are preparing articles of organization and an operating agreement; the articles of organization will be filed with the Arizona Corporation Commission. Through these LLC organizational documents, the shareholders of your preexisting corporation will also become the members of your new LLC. For more detailed information on forming an LLC in Arizona, check How to Form an LLC in Arizona. Note: Initially, the name of your corporation cannot also be used as the name of your new LLC. However, you can specify in the plan of merger that the name of the LLC will be changed to the name of your corporation when the corporation merges into the LLC (at which point the corporation ceases to exist).
Step 2: Prepare a Plan of Merger
As its name suggests, the plan of merger will contain details about the merger. It must include:
- the name of your corporation and the jurisdiction where it was formed (Arizona)
- the name of your new limited liability company prior to the merger and the jurisdiction where it was formed (Arizona)
- the “terms and conditions” of the proposed merger
- the name of the limited liability company after the merger
- the manner and basis for converting corporate shares into LLC membership interests; and
- any amendments that will be made to the new LLC’s articles of organization as a result of the merger (such as a change in name).
Steps 3 and 4: Board Adoption and Shareholder Approval of Plan
On the corporation side of this transaction, the plan of merger must be adopted by a majority vote of the board of directors, and then approved by the shareholders. (For a small business, the directors may well be the same people as the shareholders.) By default, shareholder approval requires a simple majority vote in each voting group entitled to vote separately on the plan. However, the relevant statute allows for the possibility that the board of directors or the articles of incorporation require a greater shareholder vote. For more details, check A.R.S. § 10-1103.
Step 5: LLC Approval of Plan
On the LLC side of this transaction, the plan must be approved by all LLC members unless the LLC’s operating agreement provides otherwise. Generally speaking, where the LLC is formed for the primary purpose of the merger, and the shareholders of the corporation are also the members of the LLC, it should be the case that all LLC members will approve the merger. For more details, check A.R.S. § 29-752.
Step 6: File Articles of Merger
The articles of merger will include:
- a copy of your plan of merger
- the name of your corporation
- the name of your new LLC prior to the merger
- a statement that a plan of merger was approved by your corporation and by your new LLC in the manner provided by law
- for your corporation, the designation, number of outstanding shares and number of votes entitled to be cast by each voting group entitled to vote separately on the plan as to each corporation
- for your corporation, the total number of votes cast for and against the plan by each voting group entitled to vote separately on the plan
- the name and business address of your new LLC after the merger
- the effective date for the articles of merger, if other than the filing date
- any amendments to the articles of organization for your new LLC; and
- authorized signatures.
The Arizona Corporation Commission does not publish a blank form or template for the articles of merger; you will have to draft your own. (The Arizona Corporation Commission does publish a cover sheet that must accompany the filing.)
Other Important Advice
Some people may consider the formation of the new LLC, the plan of merger, the plan approval process, and the articles of merger all to be straightforward. However, as mentioned above, mergers are generally complex transactions, and often involve unexpected complications. Therefore, you should strongly consider working with a business attorney to draft the required documents and otherwise complete the merger process.
Total filing fees will be at least $150, which includes $50 for filing articles of organization for the new LLC and $100 for filing the articles of merger.
The merger statute under Arizona’s Limited Liability Company Act states not only that all of your corporation’s property, as well as all of its debts and obligations, are transferred to the new LLC, but also that the rights of creditors against your business’s property remain unimpaired, and any legal actions against your business “may be prosecuted to judgment as if the merger . . . had not taken place”—or your new LLC may be substituted for your old corporation as a party in such actions. For more information, check A.R.S. § 29-757.
Apart from the items mentioned in How to Form an LLC in Arizona, one other important step when undertaking this type of merger is to make sure that no business contracts or agreements, such as bank documents, leases, licenses, and insurance, will be nullified by your corporation’s conversion to an LLC.
Merging a C corporation into an LLC taxed as a partnership often results in a large tax bill. This is largely because the IRS considers this kind of merger to be a liquidation of the corporation for which the corporation will owe tax, on top of which the corporation’s stockholders will also be taxed personally on the corporate assets assumed to be distributed to them; in other words, there is double taxation.
Merging a corporation into an LLC that will continue to be taxed as a corporation generally does not have the same degree of adverse tax consequences as when merging into an LLC taxed as a partnership, and may even be largely tax-free. However, as this type of merger will not change the basic elements of how your business will be taxed going forward, you should investigate closely how it would benefit the business, other than by providing a more flexible management structure. Also, in order for your LLC to continue to be taxed as a corporation, you must file a special election form with the IRS.
Merging an S corporation into an LLC is fundamentally different from a merger involving a C corporation, because an S corporation has only one level of taxation; as a rule, an S corporation itself does not pay tax, only its shareholders do. Therefore, the tax consequences for this type of merger are often more limited than mergers involving a C corporation.
In general, the tax consequences associated with merging your corporation into an LLC will be complicated. Therefore, for any kind of corporation-into-LLC merger, you should consult with an experienced tax adviser.
Additional Reading and Guidance
For further guidance on converting from a corporation to an LLC, check Corporations and S Corporations vs. LLCs. Also, while they are not a substitute for expert tax advice, you should also consider looking at Tax Savvy for Small Business, by Frederick Daily (Nolo), and Legal Guide for Starting & Running a Small Business, by Fred Steingold (Nolo). For a more complete discussion of the steps involved in forming and running an LLC, consult Your Limited Liability Company: An Operating Manual, by Anthony Mancuso (Nolo). And, finally, for information on conversion rules in other states, check Nolo’s 50-State Guide to Converting a Corporation to an LLC.