Contrary to popular belief, the legal structure of your business is not permanent and can change to meet the needs of your evolving family business. Your family business's legal structure plays a role in determining your tax rates, governance and paperwork requirements, liability protection, and more. Thus, as your family business grows and its unique needs change over time, it is worthwhile to take the time to consider whether a change in corporate entity type might better align your business with your priorities.
This article is the first in our "Converting Your Family Business Entity" series, which will provide an overview of the factors you might wish to consider and provide an example based on one of the most commonly used conversions. The series will focus on the factors to evaluate when considering entity conversion in Washington, as well as the implications of certain entity types. Although this series is specific to the conversion of entities in Washington, similar processes exist in most states.
Here we begin by focusing on explaining entity conversion and the key reasons a family business may want to change its form. In subsequent articles, we will describe other possible conversion options including through dissolution and formation, inter-entity merger, and statutory conversion.
What Do I Have Now?
If you have started a business but have not taken any formal steps to choose an entity type for your business, you will likely be deemed to have one of two types of entity: a sole proprietorship or a partnership. A sole proprietorship, as the name suggests, is only possible where there is a single owner of the business. A partnership, on the other hand, is only possible where there are two or more owners of the business.
What Is Entity Conversion?
A business entity conversion, or change in business form, is the legal process of converting an existing business entity from one legal form into another. Most of the time, a business will change from a less complex structure like a partnership to a more complex structure like a limited liability company. The "converting entity" refers to your family business prior to a conversion, and the "converted entity" refers to the business after a conversion is complete.
Why Would You Change Your Business Form?
Change is often required as the business grows. The three key reasons to change the form of your business are tax burdens, corporate governance requirements, and liability protection.
- Tax Burden. Tax requirements differ depending on how your family business is legally structured. Your business entity form determines, at least in part, your tax rates and paperwork obligations. The business entity you choose can help separate your personal and business income. For example, sole proprietors classify their business income as personal income. Alternatively, C corporation income is taxed first as business income and then, if distributed up to its owners, as personal income. The tax implications of a change in business entity form can be very fact-specific and have a significant economic impact. This article is not tax advice, and as part of your consideration of a potential change in business form, you should consult your tax advisor.
- Corporate Governance Requirements. The applicable laws and regulations, along with rights of equity holders and, in certain cases, the default rules that apply automatically if you do not opt out differ between entity types and are all very important to the determination of which entity form is appropriate for your family business. For example, depending on the drafting of its organizational documents, the members or managers of a limited liability company (depending on who is responsible for management of the business) may owe fiduciary duties of loyalty and care to the limited liability company and its members. For entities such as limited liability companies and corporations, there are important governance documents that govern the management of the company and, depending on the language they include, may restrict or alter your ability to take actions on behalf of the company. Optimizing your business type as it grows to accommodate changes in management structures, changes in ownership, and other evolving priorities is crucial for the steady development of your business.
- Protection From Liability. Lowering the risk of personal liability while running a business becomes even more important as it grows because the risks associated with running the business increase in both number and magnitude. Some legal entity structures offer significantly more liability protection than others. For example, while the owner of a sole proprietorship is personally liable for the obligations of the business, limited liability companies, as the name suggests, offer greater protection from personal liability for any wrongdoing committed by the co-owners or employees of the company during the course of business. Although there are important exceptions, usually only the limited liability company itself is liable for the debts and obligations incurred by the business—not the owners or managers. In such cases, although the assets of the business may be at risk, the personal assets of the owners or managers will be protected.
As your small business expands, it may make sense to change its structure. Many small family businesses start as sole proprietorships or partnerships, but a more complex legal entity might become beneficial over time and help facilitate the long-term success of your business. We offer this DWT article to learn more about selecting the legal entity type of your business.