Considerations for Converting a Corporation to an LLC

Corporations and LLCs both offer their shareholders and members limited liability to operate a business for profit, and while these two forms of business entities are similar in many ways, they also have important differences. . For example, there are key distinctions between corporations and LLCs in their ability to modify or eliminate fiduciary duties that directors, officers, or managers owe to the corporation or LLC.

Once formed, companies can also be converted into LLCs (and vice versa). These conversions, however, have a number of consequences and should therefore only take place after careful analysis. This article reviews some of the corporate governance, tax, and disclosure considerations that shareholders of a corporation may wish to evaluate before converting their corporation to an LLC.

Converting a Corporation to an LLC under Texas Law

The shareholders of a company can take the decision to transform the form of the company into a limited liability company by adopting a transformation plan under Section 10.101 of the Texas Business Organizations Code and by filing a certificate of conversion with the Texas Secretary of State pursuant to Items 10.154 and 10.155. The conversion can take place immediately or it can take effect up to 90 days after deposit.

Intended consequences: flexibility of corporate governance

One important reason shareholders may wish to convert their company to an LLC is that it provides a company with greater flexibility in corporate governance.

By law, the powers of a for-profit corporation are exercised or authorized by its board of directors, which directs both the management and affairs of the corporation. Texas Bus. Org. Code § 21.401(a). A for-profit corporation must have at least one director, president, and secretary, although the same person can fulfill all of these roles. Identifier. §§ 21.403(a), 21.417. Officers and directors of a for-profit corporation have fiduciary duties to the corporation of obedience, loyalty, and diligence. To see Ritchie vs Rupe443 SW3d 856, 869 (Texas 2014). These fiduciary duties can be mitigated (but not eliminated) by limits adopted in the articles of association, to see Texas Bus. Org. Code § 7.001(b), (c), or by optional compensation. This allows a company to indemnify a director or officer who breaches their fiduciary duties of obedience and care (but not their duty of loyalty), if the director or officer acted in good faith and reasonably believed that his conduct was in the best interests of the company, identifier. §§ 8.101(a), 8.102(b). Indemnifying directors and officers encourages them to make decisions for the company without fear of personal liability if their decisions go wrong, as long as they made those decisions fairly and in good faith. To see Hibbert v Hollywood Park, Inc.457 A.2d 339, 344 (Del. 1983) (explaining that “the broader purpose of compensation is to encourage capable men to serve as corporate directors” (internal quotes omitted)).

LLCs allow their members greater flexibility in these governance matters. Specifically, LLCs are run under the terms of a corporate agreement, which defines the relationships between members, managers, and officers of the LLC. Texas Bus. Org. Code § 101.052(a). Unlike a corporation, which must be managed by a board of directors, an LLC can be managed directly by its members (owners) or by managers (who are appointed by the members). To see identifier. §101.101. Additionally, unlike corporations, LLCs provide substantial flexibility to expand or restrict the fiduciary duties that principals owe to the LLC and its members. To see identifier. §§ 7.001(d)(3), 101.401. There are risks associated with investing in an LLC managed by persons who have limited fiduciary duties to the LLC or its members, and investors should carefully consider these risks before investing.

Expected consequences: tax consequences of the conversion

The conversion of a C corporation to an LLC is a significant taxable event, as the conversion is treated as a distribution of all of the corporation’s assets and liabilities to its shareholders in exchange for or delivery of their shares. Thus, a corporate to LLC conversion has the potential to generate a substantial tax bill, and shareholders will want to carefully consider the tax consequences before moving forward with converting a C corporation to an LLC.

Unintended consequences: disclosure of ownership

Shareholders choosing to convert from a corporation to an LLC have likely weighed the corporate governance and tax implications of the conversion. But there may also be other unintended consequences. An example was revealed in a recent case challenging the jurisdiction of a federal court.

Generally, a lawsuit can be brought in federal court if it involves a federal issue—interpretation of federal law or the United States Constitution—or if it involves diversity jurisdiction. Diversity jurisdiction comes into play when all of the parties suing are citizens of different states from all of the parties being sued. Individuals are citizens of the state in which they are domiciled – at most one state. Corporations are citizens of the state where they are organized and the state where their head office is located – a maximum of two states. LLCs, on the other hand, are citizens of all State where one of their members has nationality. If one of the members of an LLC is also an LLC, the citizenship of the members of this second LLC is also citizenship of the first LLC. Depending on the number of members in an LLC and whether any of those members is an LLC, it can lead to citizenship in many jurisdictions.

In Ben E. Keith Co. v. Dining Alliance Inc., the plaintiff sued, relying on the diversity jurisdiction of the federal court to assert rights under state law. Plaintiff, however, was unaware that Defendant had converted from a corporation to an LLC prior to the filing of the complaint. As the discovery progressed, the parties realized that the diversity jurisdiction may not have existed when the case was first filed. By then, the parties had added federal claims, the defendant had filed counterclaims, and the defendant had filed third party claims against new parties. The court ordered the parties to establish their citizenship to confirm that diversity existed to support the jurisdiction of the Federal Court, which required the LLC defendant to identify each of its members and their citizenship. Defendant LLC turned out to have members who were also LLCs or partnerships, and he claimed that some of those members had a complex ownership structure that included multiple levels of partnerships and funds including he was unable to determine citizenship. The court ultimately sanctioned defendant LLC by dismissing all of its counterclaims and mis en cause with prejudice.

Conclusion

There are a number of factors that corporate shareholders should consider before converting their corporation to an LLC. These include the flexibility of corporate governance and management after the conversion and the potential tax consequences of undertaking the conversion. But there are other potential consequences, including disclosure of the identities of an LLC’s members if the LLC is (or becomes) involved in litigation in federal court. Shareholders should only undertake the process of converting a corporation to an LLC after carefully considering these and other possible consequences.