How to Change Your Business Entity

It’s not unusual for an entrepreneur to change their business from one entity type to another. Most often, someone who’s been running a Sole Proprietorship or General Partnership sees a need to register their business with the state and become either a Limited Liability Company (LLC) or a Corporation.

This could occur because owners wish to lower their risk for personal liability if the business is sued or can’t pay its debts. Tax considerations are another reason for changing a business structure, as is an increased ability to attract investors and raise capital for the business. Or maybe a Sole Proprietor or member of a General Partnership is no longer capable of handling all the work in a one or two-person business.

Let’s take a closer look at why someone might want to change the type of business entity they have, and how to go about doing so.

Why Would You Switch Entity Types?

The need to change a business from one entity type to another often becomes apparent as the business grows and the initial structure no longer makes sense. Consider this example.

Robert and Miguel started a business marketing firm as a General Partnership eight years ago and their business has increased by 400%. They’re finding it very difficult to keep up with their workload and demands of their clients, and they’ve had to turn down a number of opportunities for new business.

Also, as their business has grown and profits have increased, each of their net worths has increased, as well. That’s great news, unless a customer wages a major lawsuit and wins, putting Robert and Miguel’s personal bank accounts and other property at risk because they have no legal or financial separation between themselves and their business and are personally liable.

Robert and Miguel hope to continue growing their business significantly, and they’re going to have to raise some capital to be able to do so. Having a business that’s not registered with the state puts them at a disadvantage for attracting investors who are willing to loan money. Also, they’re tired of paying the combined employee and employer amounts of Social Security and Medicare taxes, which claims a sizable chunk of their earnings, in addition to the income taxes they pay.

It’s clear that converting their General Partnership to a Limited Liability Company or a C Corporation would provide numerous advantages for Robert and Miguel. Adding other owners would enable them to increase their workload and attract more clients. Their personal liability would be greatly reduced, they’d be better positioned to attract investors, have options for how their business is taxed, and gain the potential for decreasing their tax burden.

The same reasons for changing their business entity could apply to someone operating a Sole Proprietorship and facing issues similar to those of Robert and Miguel. Additional incentives to change your business entity from a Sole Proprietorship or a General Partnership include acquiring the ability to sell the business if you wish, gaining the perception that your business is official and professionally operated, and enabling you to expand into other states.

Members of an LLC might consider transitioning to a Corporation if they feel they need a more formal management structure or want to be able to support an employee stock ownership program. Much less frequently, a Corporation or LLC might choose for whatever reasons to convert to a Sole Proprietorship or General Partnership.

Regardless of why you’re interested in changing the type of business entity you have, you’ll need to take some steps to do so.

Legally Changing Your Business Entity

The process for changing your business entity will depend on the type of business you have, what entity you want to change to, and where the business is located. In many states, the Secretary of State or equivalent agency can provide information about how to change a business entity.

Generally, converting a Sole Proprietorship or General Partnership to an LLC or Corporation follows many of the same steps as forming a business from scratch. Because your business isn’t recognized by the state as a separate entity from its owner, there’s no need to dissolve it before registering as an LLC or Corporation.

If you want to change the type of business entity for a business that is already registered with the state, however, you’ll need to take additional steps. If permitted by your state, you can employ a statutory conversion, which enables you to change from one entity form to another without the need to start a new business. This is the simplest method of changing your business entity type. You simply prepare and file a plan of conversion along with the Articles of Organization for an LLC or Articles of Incorporation for a Corporation.  A problem, however, is that not every state allows it.

If you want to convert an LLC or Corporation or another type of business that’s registered with the state and you cannot employ a statutory conversion, you may be able to use a statutory merger. In a statutory merger, the new entity type is formed and the old type merged into it. If you have an LLC and want to change to a Corporation, for instance, you would first form the Corporation and then merge the LLC, including all its assets and liabilities, into the Corporation. Members of the LLC would automatically become the owners of the Corporation.

If you cannot use either statutory conversion or statutory merger, you’d need to dissolve the current business and start a new one from scratch. The other two methods are preferable, as the dissolution and formation method is more complicated and expensive and can result in tax liabilities. I strongly suggest that you consult an attorney before taking steps to change a registered business entity type to a different one.

If you want to change a Sole Proprietorship or General Partnership to an LLC or a Corporation, you’ll need to create and file Articles of Organization or Articles of Incorporation, the same as you would do if you were starting a business from scratch.

Before you file those documents, confirm that the name you’ve been using for your Sole Proprietorship or General Partnership is available for your new entity type. If a business that’s already registered with the state as an LLC or Corporation is using the same name, it belongs to the registered business, and you’ll need to choose a new one. You can check to see if the name is available by using CorpNet’s Corporate Name Search.

You’ll also need to appoint a Registered Agent before filing Articles of Organization or Articles of Corporation, as all businesses registered with the state must have one. A Registered Agent is an individual or company designated to receive legal correspondence on behalf of a company and assure that the documents are relayed to the proper recipients within the company. Sole Proprietorships and General Partnerships, which are not registered with the state, are not required to appoint a Registered Agent.

Check any contracts you entered into as a Sole Proprietorship or General Partnership to determine if you’re permitted to assign the contracts to your new entity without the consent of the other parties. Most contracts contain a clause called “assignments,” which state whether one party is permitted to transfer the terms of the contract to another party. If you are, you can simply assign the terms of the contract to your new business entity without having to get permission from the other party.

Another task will be to obtain an Employer Identification Number (EIN), which is a nine-digit number assigned by the IRS for tax filing and reporting purposes. If you had an EIN as a Sole Proprietor or General Partnership instead of using your Social Security Number, check to see if your state requires you to apply for a new one for your new entity type.

You’ll also want to assure that your personal and business accounts remain separate by opening new bank accounts in the name of your new business entity, and, depending on your industry and state, you might have to apply for business licenses and permits.

While changing the type of business entity you have is fairly straightforward in some instances, it can be complicated and potentially expensive in other situations. Be sure you fully understand what you’re required to do to act in compliance with your state.

Once the Conversion is Complete

Once your business is registered with the state and operating as a new entity, you’ll need to take some follow-up action to make sure it’s operating correctly and in compliance with state laws.

All permits, licenses, registrations, and other documents should be changed to reflect your new business entity and name. Even if you kept the name you’d used previously, the documents will need to be changed to reflect your designation as an LLC or Corporation. If your business’s name was Good Grounds Coffee Shop and Bakery, for instance, you’d need to change it on the documents to something like Good Grounds Coffee Shop and Bakery, LLC or Good Grounds Coffee Shop and Bakery, Inc.

If your new business entity is a Corporation, you’ll need to appoint a Board of Directors to oversee business activities and represent its shareholders. During its initial meeting, the Board of Directors should approve the business’s Corporate Bylaws, which outline how the business will operate and function. Corporate Bylaws are essential to a business, regardless of whether they are required by your state.

A Corporation will also issue stock to each initial shareholder, serving as evidence of the individual’s ownership in the Corporation. The names and addresses of all shareholders must be recorded, and the corporation must comply with all securities laws of the state.

Every LLC should establish a complete Operating Agreement, which, similar to Corporate Bylaws, establishes how the business will be structured, owned, managed, and operated. LLCs generally are not required to have an Operating Agreement, but again, it’s an essential document for running the business.

Also, if your business is planning on hiring employees, you’ll need to register for payroll taxes, which are a legal requirement for hiring and paying employees in the United States. It’s important that your business track and report all payroll taxes to remain in compliance with government regulations.

We’re Here to Help

As I’ve said, changing a business from one entity type to another is not unusual. If you wish to do so, you can tackle the process on your own, relying on instructions and direction from the state in which you’re registering the business.

If you’re unsure about the process or want a guarantee that the process will be handled quickly and smoothly,  however, reach out for help from a business lawyer or a business formation and compliance firm, such as CorpNet. If you want to convert an LLC or incorporation to another business entity CorpNet can help by saving you both time and money with a service that is fast, reliable, and affordable in processing the required documents for a minimal service fee.