If you’re thinking of converting the legal form of your small business from a Pennsylvania corporation to a Pennsylvania 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, Pennsylvania is one of only about ten states that do not allow statutory conversions of corporations to LLCs. Instead, Pennsylvania 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 Pennsylvania’s merger statutes as they apply to closely-held, for-profit Pennsylvania corporations merging into multi-member LLCs.
Pennsylvania’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 Pennsylvania’s merger statutes. As in most states, Pennsylvania 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 1921 through 1929 and 8956 through 8959 of Title 15 of the Pennsylvania Consolidated Statutes (Pa.C.S.).
To convert your Pennsylvania corporation to a Pennsylvania 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 organization and an operating agreement; the certificate of organization will be filed with the Department of State. 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 Pennsylvania, check How to Form an LLC in Pennsylvania. (If you want to use your corporation’s name as the name of your new LLC, you should also include a completed Consent to Appropriation of Name form with your certificate of organization and other filed documents.)
Step 2: Prepare a Plan of Merger
As its name suggests, the plan of merger will contain details about the merger. It must include:
Steps 3 and 4: Corporation Board and Shareholder Approval of Plan
On the corporation side of this transaction, the plan of merger must be adopted by the board of directors, and then approved by the shareholders. (For a small business, the directors may be the same people as the shareholders.) Shareholder approval of the plan of merger requires a simple majority of all votes in each voting class entitled to vote on the plan. Unlike some other states’ statutes, Pennsylvania does not clearly allow for the possibility that your corporation’s board of directors or articles of incorporation will provide for different voting requirements. For more details, check 15 Pa.C.S. § 1924.
Step 5: LLC Approval of Plan
On the LLC side of this transaction, the rules for plan approval depend in part on whether the LLC is member-managed or manager-managed. If your LLC is member-managed, the plan must be approved a majority of the votes cast by all members entitled to vote on the plan; if classes of members are entitled to vote on the plan as a class, then a majority of votes in each class must approve the plan. If your LLC is manager-managed then, as a rule, the managers must also approve the plan. However, in the case of some manager-managed LLCs, no member approval of the plan may be necessary. For more details, check 15 Pa.C.S. § 8957. (Generally speaking, where a member-managed 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 will include:
For your convenience, the Department of State makes available a blank certificate of merger form for cases where the surviving entity is an LLC. Be aware that you will need to tweak this form to work for a corporation-into-LLC merger.
Other Important Advice
Some people may consider the formation of the new LLC, the plan of merger, the plan approval process, and the certificate 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.
Your total filing fees for this process probably will be at least $275, which includes $125 for filing the certificate of organization for the new LLC and $150 for filing the certificate of merger.
Pennsylvania’s LLC merger statute states not only that all of your corporation’s property, as well as all of its debts and liabilities, are transferred to the new LLC, but also that any liens on the property remain unimpaired, and 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 15 Pa.C.S. § 8959.
Apart from the items mentioned in How to Form an LLC in Pennsylvania, 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.