If you're thinking of converting the legal form of your small business from a New Jersey corporation to a New Jersey LLC, you should be aware of some basic facts regarding the state's business-entity conversion process. Because the tax consequences can be significant, you should consult with a tax adviser before undertaking any conversion.
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, New Jersey is one of only about ten states that do not allow statutory conversions of corporations to LLCs. Instead, New Jersey only allows statutory mergers. Unlike statutory conversions, statutory mergers do require you to form a separate LLC before you can convert—or, 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:
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 New Jersey's merger statutes as they apply to closely-held, for-profit New Jersey corporations merging into multi-member LLCs.
New Jersey'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 New Jersey's merger statutes. As in most states, New Jersey has one merger statute under its corporations laws and another merger statute under its LLC laws; 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 14A:10-1 through 14A:10-14 and Section 42:2B-20 of the New Jersey Statutes (N.J. Stat.).
To convert your New Jersey corporation to a New Jersey LLC via a statutory merger, you need to:
Step 1: Create an LLC
Creating an LLC is a multi-step process. However, for immediate purposes, the key elements are preparing a certificate of formation and an operating agreement; the certificate of formation will be filed with the Department of the Treasury. 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 New Jersey, check How to Form an LLC in New Jersey.
Step 2: Prepare an Agreement of Merger
The agreement of merger likely will contain items such as:
However, because New Jersey's merger statute for LLCs does not specify what an agreement of merger must contain, you are very strongly advised to consult with a business attorney regarding this document. (The items listed here are based on New Jersey's merger statute for corporations.)
Steps 3 and 4: Corporation Board and Shareholder Approval of Agreement
On the corporation side of this transaction, the merger agreement must be approved by the board of directors and then by the shareholders. (For a small business, the directors may well be the same people as the shareholders.) The rules for shareholder approval of the agreement of merger may vary depending on, among other things, when your corporation was formed and whether there are any merger approval provisions in your certificate of incorporation. In most cases, approval will require a simple majority of the votes of all outstanding shares entitled to vote on the plan, including a simple majority of votes in each separate share class entitled to vote on the plan, unless your certificate of incorporation requires a greater majority vote. For more details, check N.J. Stat. § 14A:10-3. Because the variety of potential voting rules contained in the statute can be confusing, you should consider consulting with a business attorney for guidance.
Step 5: LLC Approval of Agreement
On the LLC side of this transaction, the agreement of merger generally must be approved by more than fifty percent of the LLC membership interests. For more details, check N.J. Stat. § 42:2B-20(b). (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.)
Step 6: File a Certificate of Merger
The certificate of merger likely will include items such as:
However, because New Jersey's merger statutes do not provide clear guidance specifically regarding mergers of corporations into LLCs, you are very strongly advised to consult with a business attorney before attempting to file a certificate of merger. (The Department of Treasury provides a blank certificate of merger form relating to mergers of LLCs. However, this form may not be appropriate for use in mergers involving both LLCs and corporations.)
Other Important Advice
In short, not only are mergers generally complex transactions, often involving unexpected complications, but New Jersey's merger laws are not as clear as you might expect. Therefore, as already stated, you should work with a business attorney to draft the required documents and otherwise complete the merger process.
Your total filing fees for this process probably will be at least $225, which includes $125 for filing a certificate of formation for the new LLC and $100 for filing the certificate of merger.
New Jersey's LLC merger statute states not only that all of your corporation's property, as well as all of its debts, liabilities, and duties, are transferred to the new LLC, but also that all rights of creditors against your business are preserved, and any legal actions against your corporation become "vested in" your new LLC. For more information, check N.J. Stat. § 42:2B-20(g)—or consult with a business attorney .
Apart from the items mentioned in How to Form an LLC in New Jersey, 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.
Tax Consequences
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.