Alaska Entity Transactions Act
Not much has been written about the Alaska Entity Transaction Act, passed by the Legislature in July 2013 and signed by the Governor in September. It will be: the Act does not take effect until July 1, 2014 in order to give the State time to draft any necessary implementing regulations, and to reconcile existing regulation with the new environment. I suspect there will be a raft of articles and blog entries as advisors (including me) see the regulations and get a better idea of the Act's effect, including its effect on standardizing mergers and acquisitions and interest exchanges. But it is worth knowing just a bit about what is to come with regard to entity conversions, particularly if you are thinking about making any kind of organic change. For many companies, it may well be worth waiting until next summer to make a change from one entity form to another.
The primary thing the Act changes is how you can transition from what company form to another. For instance, say as a startup you adopted a limited liability company form in order to take advantage of perceived tax benefits from that entity choice. Now you have grown and are looking at taking on a number of new owners. You want to become a corporation, in order to transition to a more formal structure and to prepare for future funding rounds (including possibly listing on an exchange). Or maybe you need to go the other way (I see this one more often): you originally started as a corporation, perhaps because it allowed your company to pay you a salary without awkward tax reporting and related issues. Now you intend to become a passive owner, and want to enjoy the asset protection benefits of Alaskan LLC ownership. Either way, today the process of changing from one entity form to another is cumbersome, potentially expensive, and may have unintended tax consequences. The Entity Transactions Act is intended to streamline the process and remove some of these barriers.
Entity Conversions Today
For entity transactions today, you basically have three choices: conversion under the rules for your entity type, assets up, or assets over. There are dozens of variations on these basic methods, but they form a useful starting point to frame any discussion. For the sake of illustration, let's assume that you are presently the (unhappy) sole shareholder of an Alaskan corporation, and you desire to be the (happy) sole member of an Alaskan LLC. Don't think for a moment that the number of owners does not make a difference: it does, but I am going to ignore that difference for the time being.
What you have is this:
What you want is this:
How to get there?
Conversion Under Existing Rules
Some entity forms already have conversion rules. For instance, a partnership, trust, or unincorporated association may convert into an LLC. A corporation that is a subsidiary of another corporation may also convert into an LLC. Any entity may convert into a limited partnership, if it qualifies. If your company and plan qualify under one of the existing sets of rules, the Entity Transactions Act will change little or nothing except provide a concrete roadmap to your attorney for accomplishing the conversion.
Assets Up
In an assets up transaction, you form the target entity (in this case, an Alaskan LLC,) and transfer ownership of the corporation to it. Then the corporation can be dissolved, leaving the target entity owning all of the assets of the original entity. So, first you form a new LLC, which has no owner or assets. Then you transfer all of your shares in the corporation to the LLC in exchange for all of the membership interest in the LLC. After this step, you own all of the LLC, which in turn owns all of the corporation:
Finally, you dissolve the corporation so the LLC owns all of the formerly corporate assets.
There are problems with this approach. Leaving aside tax issues for a moment, one of the reasons you formed an entity in the first place was probably to avoid personal liability for the debts of the entity. That is, if the corporation got sued you did not want your personal assets at risk. One of the things that makes an LLC attractive is that it, too, has the liability protection feature. In a transition like this, sometimes one of the goals is to escape from some of those liabilities. If so, this approach will not do the trick (if any will): when the LLC obtains ownership of the corporation, it gets it subject to all of its debts and liabilities. Those do not become the personal debts of the LLC: the corporate veil of liability protection still applies. But they still appear on the corporate balance sheet. When the corporation is dissolved, those debts and liabilities must either be assumed by the LLC or satisfied by it. And because the persons to whom the debts are owed may not agree to assumption by the LLC, the assets up transaction may actually trigger an obligation to satisfy some debts that you were planning to put off.
On the plus side, assets up is easy when it is not complicated, and is unlikely to be unwound by a court.
Variations on the theme abound. In one, you never dissolve the corporation, or do it long after the initial transaction is completed: it persists as a subsidiary of the LLC, giving you an extra layer of liability protection or winding up its debts and liabilities before the assets transfer. In another, all or part of the transaction is done in another state and then the foreign LLC repatriated to Alaska. This is done to take advantage of some favorable transaction features in the other state. In others, the ownership structure or cap table is simplified as part of the process. In others, the transaction is characterized as a merger (which it is) which saves a step and has a number of other consequences.
Assets Over
The other way that is often employed is assets over, in which the target entity (in this case, the LLC) is formed and capitalized, the assets are transferred from the original entity (the corporation), and then the corporation winds up its affairs and closes its doors. In general, in order to immunize this from getting backed out by a later coming court (whichever court is considering the inevitable litigation by the corporation's lenders who are seeking to be made whole from the now asset-less corporation,) something must happen before the corporation is dissolved. Either the corporation must be left with sufficient assets to satisfy all of its creditors, and/or (preferred) the LLC must pay a fair value for the assets, and/or the liabilities of the corporation must be transferred to the LLC.
If fair value is paid for the assets, this can be a good way to leave the original corporation with its liabilities (even if they exceed the consideration paid for the assets) and not have to assume them by the LLC. The corporation declares bankruptcy, but the sale of assets to the LLC is effectively protected against unwinding because there was no total change in value.
As you might imagine, there are a wealth of issues with this one, as well. And there are also tons of variations, mostly dealing with how the asset purchase is characterized.
Entity Transactions After July 2014
So the Alaska Entity Transactions Act is designed to add a new, much simpler alternative to these two methods. Instead of engaging in a transaction (effectively a sale of assets or of the company to the new target company,) companies will be able to convert from any type of entity to any other type of entity. Moreover, any type of entity may merge with any other type, or exchange less than 100% of the ownership interest in any type of entity with any other type of entity.
Even better, the Act standardizes the procedures. In the past, each different type of entity had its own merger rules. Now every type of merger will have a mechanism available that is identical to every other type of entity. This should improve things both from the State's perspective, and from the perspective of affected entities.
What is the method for the modern conversion? First, you must draft a plan of conversion. This will contain several parts:
- The name and type of the original entity;
- The name, type, and jurisdiction of the new entity (yes, you can even convert your Alaska corporation to a Washington LLC, if Washington will permit it);
- How the interests will be converted (stock-for-membership? stock-for-cash-and-membership?);
- The organic documents for the target entity (ie - LLC Articles of Organization, etc);
- Any other terms of the conversion; and
- Some other stuff.
It is not yet clear how complete the Plan of Conversion will have to be - that will be set out by regulation, as will the form for filing them and the fee for doing so. But at a minimum, anything that the target entity is required to file in order to be considered formed will have to be filed as part of the Plan.
Then the Plan must be approved. (I write "then," but the order is probably reversed for most transactions - the Plan will have to be approved before the company management will be authorized to present it to the State.) But the approval requires nothing more than dissolution or merger of the converted entity would have required. Indeed, the approval required by the company is whatever approval would have been required for a merger (or a conversion, if conversion rules already existed for that entity). If there will be residual "interest-holder" liability (for instance, if you are converting into a partnership), you must also have a record of the approval of every person who will share any such liability.
Once the Plan is approved, a Statement of Conversion gets filed with the State (basically swearing under oath that the Plan was approved). The Plan of Conversion can be filed instead, and to the same effect.
Once it is done, the entity (now converted) will not be a new entity. Instead, according to the law of the State of Alaska, it will be the exact same entity, without interruption. As the law makes very clear, the intent of this is that third-parties are to consider that there has been no change (except a name change). As far as such entities are concerned, the new entity is the same entity and there has been no sale or transfer of assets or securities, nor has there been a winding up of affairs, etc.
Although this is untested, I take this to mean that, for instance, bank approval will not be required in order to convert. But this promises to create some hassles, which hopefully will be dealt with by regulation. In particular, there is no provision in law for notice to the bank. Security interests in personal property generally must get the name of the securing party exactly correct. What happens if that name changes due to conversion? Are banks likely to require some kind of notification and contractual consent to pre-filing financing statements and other perfecting documents? Similar issues arise in other quarters: will conversion require changing names on title to real and personal property? None of these issues are new: they all existed under the existing conversion laws (for those entity types that had them) or under de facto conversions through merger or acquisition (assets over or assets up). But under the new law, they will not be handled as a byproduct of an asset transfer, because there is (by law) no asset transfer.
Furthermore, it is not clear how federal regulators will treat Alaska conversions. I have some suspicions based on existing practice that they will honor the Alaska characterization: after conversion, nothing will have changed. But there are some places where it could be sticky. For instance, if an LLC that did not file taxes as an association converts into a corporation, the IRS will regard that as the creation of a new entity. The LLC was disregarded for tax purposes. The corporation will not be, unless it elects treatment under subchapter S (and qualifies to do so). What if the conversion goes the other way? From the IRS\'s perspective, the old entity (the corporation) has ceased to exist, and there is no longer any entity at all (because the LLC is disregarded). Does that trigger recognition of capital gain?
Remaining Issues
Note that the Entity Transactions Act cannot, and will not, completely simplify these sorts of transactions. Aside from the corporate issue (which the Act appears to simplify,) there are also tax and securities issues surrounding any change in entity form. I cannot list all of them, because there are some esoteric ones that only apply in a few circumstances. Worse, the issues are as yet unsettled: we do not know all of the answers, or even most of them. Your company's legal and financial advisors should work together to figure out these kinds of issues before you jump into an entity transition. Just to whet the appetite, a few issues include: does a transition preserve the S-corporate election? Does it subject you to capital gain (or loss) recognition? How does it effect the tax treatment of owner's compensation? Is the transition an exempt securities transaction? Is it subject to federal exemptions? Does it require an exemption filing, or is it self-executing? How will it effect future funding rounds? And there are business legal considerations, as well: will it require renegotiating your debt? Does it require approvals from contracting and lending partners? How does it impact the quality of security interests in corporate property? Can it be unwound in bankruptcy? In what circumstances?
Conclusion
The Entity Transaction Act will vastly simplify some types of conversions, and is a welcome process improvement. But it is not a panacea - these sorts of transitions will continue to be complex, because they touch on so many other areas of law and process. If your company is considering a transition from one form to another, you should analyze whether you can afford to wait until summer 2014. If so, converting under the Act may substantially simplify and cut the costs of conversion.