If you’re thinking of converting the legal form of your small business from a corporation to a Delaware LLC, you should be aware of some basic facts regarding the state’s business-entity 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 Delaware 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 Delaware’s business-entity conversion statute as it applies to closely-held, for-profit Delaware corporations converting to multi-member LLCs.
Delaware’s Conversion Statute
In Delaware, 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 few basic forms with the Secretary of State. This procedure, technically known as “statutory conversion,” automatically transfers your corporation’s assets and liabilities to the 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. By the same token, there is also no need to dissolve your corporation; on the contrary, under Delaware’s conversion statute, the one business entity involved in the conversion, which is originally a corporation, is simply considered by default to continue its existence in the form of an LLC. The conversion procedure is codified primarily in Section 18-214 of the Delaware Code (Del. C.).
To convert your Delaware corporation to a Delaware LLC, you need to:
- get the corporation’s stockholders to approve the conversion; and
- file a certificate of conversion and certificate of formation with the Secretary of State.
Delaware’s conversion statute requires that your corporation approve the conversion before you file the necessary paperwork with the Secretary of State. The statute is very general regarding what is necessary for approval, stating simply that the conversion must be approved in whatever manner is specified by the appropriate corporation documents. In many cases, this will mean a simple majority vote of your corporation’s shareholders, but you should check your articles of incorporation and bylaws to make sure. (You can find the exact language regarding statutory approval requirements at Del. C. § 18-214(h).)
The certificate of conversion is a simple document that provides basic information primarily about your corporation, such as its name, the state where it was formed, and the date it was formed, as well as the name of the new LLC. Similarly, the certificate of formation at least will contain basic information about the name and address of your new LLC, as well as the name of the LLC’s registered agent, if you have one. The Delaware Secretary of State makes available a PDF file containing blank templates of the certificate of conversion and certificate of formation, along with a form letter providing limited instructions regarding filing of the certificates. Note that while the certificate of conversion and certificate of formation may appear straightforward, some of the issues involved in converting your particular business may involve unexpected complications, particularly with regard to the certificate of formation; therefore, it may be advisable to consult with a business attorney before completing these documents.
The basic filing fees for this process should total $290, which includes $200 to file the certificate of conversion and $90 to file the certificate of formation. Additional fees apply if you request certified copies of these documents. The state asks that you include a cover letter with contact information with your filing.
Keep in mind that Delaware’s conversion statute states makes clear not only that all of the corporation’s property, as well as debts, are automatically transferred to the new LLC, but also that all rights of creditors against the corporation continue against the new LLC, all corporate debts and liabilities continue in force against the new LLC, and all legal actions involving the corporation “remain vested in” the new LLC. For more information, check Del. C. § 18-214(f).
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
- notifying customers, clients, suppliers, and others with whom your business has relationships of its new status as an LLC
- holding required LLC meetings (such as member or manager meetings)
- keeping proper minutes of LLC meetings
- keeping LLC finances separate from personal finances
- using the official LLC name on your business documents; and
- paying Delaware’s annual LLC tax.
Following the proper LLC formalities is important for maintaining the limited liability status of your business and ensuring certain potential tax benefits. 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).
One other key step in the conversion process is to make sure that no business contracts or agreements, such as bank documents, leases, licenses, and insurance, will be nullified by your business’s 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 adviser.
For additional, general guidance on converting from a corporation to an LLC, check Corporations and S Corporations vs. LLCs. For information on conversion rules in other states, check Nolo’s 50-State Guide to Converting a Corporation to an LLC. And, 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).