If you’re thinking of converting the legal form of your small business from a corporation to a California LLC, you should be aware of some basic facts about the state’s conversion process.
Variable Elements of Conversions
First, let’s be clear that there is not just one kind of corporation, one tax status for an LLC, or one kind of conversion. On the contrary, there are:
- C corporations and S corporations
- corporations formed under California law and corporations formed under other states’ laws
- multi-member LLCs and single-member LLCs
- LLCs taxed as partnerships, LLCs taxed as corporations, and LLCs taxed as “disregarded entities;” and
- multiple methods for converting your business—including statutory conversions, statutory mergers, and nonstatutory conversions
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 California’s business-entity conversion statute as it applies to closely-held California corporations converting to multi-member LLCs.
California’s Conversion Statute
In California, you can use a relatively new, simplified procedure that allows you to convert your business from a corporation to an LLC largely by filing a single document with the Secretary of State. This procedure, technically known as a “statutory conversion,” will automatically convert your corporation to an LLC and automatically transfer your corporation’s assets and liabilities to that new LLC. Unlike other methods of conversion, only one business entity is involved, and you do not need to separately form an LLC before the conversion can occur. As a result of the statutory conversion, your corporation becomes an LLC, and so there is no need for a separate process to dissolve the corporation. General provisions for converting corporations to other types of business entities can be found in Sections 1150 through 1160 of the California Corporations Code (CA Code); also relevant is CA Code § 17540.8, which concerns converting specifically to an LLC.
To convert your California corporation to a California LLC, you need to:
- prepare a plan of conversion
- get both the corporation’s board of directors and the corporation’s stockholders to approve the plan of conversion; and
- complete and file California Form LLC-1A (Articles of Organization – Conversion) with the Secretary of State
The plan of conversion is a relatively simple statement of key elements of the conversion; according to the statute, it must state:
- the terms and conditions of your conversion
- the jurisdiction where your corporation was formed and the jurisdiction where your LLC will be formed (here we assume both will be California)
- the name of your new LLC
- the manner of converting your corporate shares into LLC membership interests
- the provisions of your new LLC’s articles of organization to which the LLC members will be bound; and
- “any other details or provisions that are required by the laws under which the converted entity is organized, or that are desired by the converting corporation.”
Depending on your level of expertise, it may be advisable to seek the assistance of an attorney in preparing this document. By default, the statute requires approval of the plan of conversion by at least two-thirds of each class of shares for a closely-held corporation, as well as approval by any shareholder who would become a manager of the new LLC. However, the conversion statute also lays out several possible alternative voting requirements for approving a plan; check CA Code § 1152 for more details. You’ll need to keep a copy of the plan of conversion at a local office associated with your business.
Form LLC-1A, including instructions, is available online from the Secretary of State. Note that several signatures are required in order to file the form. You will also need to pay a $150 filing fee.
California’s conversion statute makes clear not only that rights and property, and debts and liabilities, are automatically transferred to the new LLC, but also that the rights of creditors and all legal actions against the corporation continue unimpaired against the new LLC. (See CA Code S 1158.)
Apart from the foregoing steps, you will also need to take care of all the tasks normally associated with creating and running a new LLC, such as:
- drafting your LLC’s operating agreement
- holding required LLC meetings (such as member or manager meetings); and
- keeping proper minutes of LLC meetings.
Following the proper LLC formalities is important for maintaining the limited liability status of your business. 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).
Finally, you also will need to make sure that no business contracts or agreements, such as bank documents, leases, licenses, and insurance, will be nullified by the entity change.
A key point to keep in mind is that converting a C corporation to an LLC taxed as a partnership often results in a large tax bill. This is largely because the IRS considers this kind of conversion 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.
Converting a corporation to an LLC that will continue to be taxed as a corporation generally does not have the same degree of adverse tax consequences as when converting to an LLC taxed as a partnership, and may even be largely tax-free. However, as this type of conversion 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.
Converting from an S corporation to an LLC is fundamentally different from converting from 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 conversion are often more limited than conversions from a C corporation.
In general, the tax consequences associated with converting from a corporation to an LLC will be complicated. Therefore, for any kind of corporation-to-LLC conversion, you should consult with an experienced tax advisor.
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). And, finally, for information on conversion rules in other states, check Nolo’s 50-State Guide to Converting a Corporation to an LLC.