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Converting Your Corporation to an LLC - Still a Good Idea?

Written by: John M. Cunningham

(Published in New Hampshire Business Review, September 2010)

The emergence of New Hampshire LLCs in recent years has made New Hampshire corporations essentially obsolete.  For example, in 2009, almost seven New Hampshire LLCs were formed for every New Hampshire corporation.  In the future, this trend is likely to accelerate.

In fact, until July 2009, when the New Hampshire Legislature enacted the “LLC tax,” which effectively imposed the New Hampshire Interest and Dividends Tax (the I&D Tax) on members of LLCs who reside in New Hampshire, it often made sense for the shareholders of New Hampshire corporations to convert their corporations to LLCs to protect their shareholders from that tax.

However, as every New Hampshire business person is aware, in June of this year, the “LLC tax” was effectively repealed.  If you own a New Hampshire corporation, does it once again make sense to consider converting your corporation to an LLC?
Unfortunately, the answer is complicated.  Here are the factors you should consider:
The first thing to consider is that, for many New Hampshire businesses, LLC law is much better than New Hampshire corporate law.  First, although the law permits exceptions, both single-shareholder and multi-shareholder corporations generally have to have the classic management structure of shareholders, directors and officers; they have to hold annual shareholder and director meetings in person or by written consent; and they have to record these meetings and consents in up-to-date corporate minute books.
 
Thus, the classic corporate management structure is complex and cumbersome.  All by itself, this can be a bad thing.  But in addition, if a corporation doesn’t implement the classic corporate management structure, it runs the risk of “veil-piercing.”  Veil-piercing is a legal doctrine under which a judge can disregard the liability shield of entity owners and can hold the owners personally liable for entity debts.  One of the classic grounds for piercing the veil of corporations is their failure to comply with corporate statutory formalities.  And very large numbers of New Hampshire corporations don’t comply with them. 
However, corporate statutory formalities don’t apply to LLCs.  Thus, LLCs probably face a lesser risk of veil-piercing than corporations.

In addition, under the New Hampshire LLC Act, LLCs and their members have a special set of business asset protections called “charging order protections.”  Because of these protections, if a member of a multi-member LLC incurs a judgment unrelated to the LLC’s business, the creditor can obtain a “charging order” that requires the LLC to distribute to the creditor any profits it would otherwise have distributed to the member.  However, the creditor can’t obtain a court order transferring to the creditor the debtor-member’s voting rights and other non-economic rights.  Thus, charging order protections may well remove the risk that creditors of members of multi-member LLCs will force the sale of LLC assets to satisfy member debts.  Charging order protections also go far to protect non-debtor members of LLCs from the risk that creditors will become unwanted new members.  Especially for New Hampshire family-owned businesses, this is a major LLC legal advantage. 

However, New Hampshire corporations don’t qualify for charging order protections.  The fact that they don’t is, for many NH business people, the biggest single reason for forming their businesses as LLC or for converting their corporations to LLCs.

Unfortunately, however, a tax cloud has recently descended on a good many New Hampshire LLCs and on all New Hampshire corporations considering conversion to LLCs. 

Before the enactment of the “LLC tax,” it was reasonably clear that members of LLCs who resided in New Hampshire did not owe the I&D Tax on distributions of LLC profits as long as these LLCs had “non-transferable shares.”   This was true whether or not the LLCs happened to be taxable as C or S corporations for federal income tax purposes.  The New Hampshire Department of Revenue Administration (the DRA) treated the New Hampshire members of all multi-member LLCs, regardless of their federal tax regimen, as immune from the I&D Tax as long as each member was required to obtain the consent of at least one other member in order to transfer the member’s management rights—normally an easy requirement to meet.  And, by careful drafting of their LLC agreements, it was even possible to protect the members of single-member LLCs from the I&D Tax.

However, in February 2010, the DRA adopted a new regulation that significantly  complicated NH LLC tax.  The new regulation provided, in essence, that if a New Hampshire LLC was a C or S corporation for federal income tax purposes—a federal tax regimen which, for many New Hampshire LLCs, made a lot of sense—its New Hampshire members would be subject to the I&D Tax even if the LLC had “non-transferable shares.”

It’s not clear that the new regulation was legally valid when enacted; and now that the “LLC tax” has been repealed, it’s not clear that the regulation is even effective.  And if the DRA reissues it, one can argue that it will conflict with the repeal of the “LLC tax.” 

However, if there’s one thing you don’t want as a New Hampshire taxpayer, it’s tax uncertainty.  The new regulation creates very significant tax uncertainty for New Hampshire LLCs that are C or S corporations for federal income tax purposes.
In short, if you’re thinking about converting your New Hampshire corporation to an LLC, you can be pretty sure you’ll get better much law.  But whether the conversion will shield your shareholders from liability for the I&D Tax is a big question.

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