What If My Business Has Changed and My Entity Type Needs To Change?

Changing your line of business does not necessarily call for a change in your entity. This report will cover some aspects of a business that might require you to revise and/or restructure your entity. The change from one entity type to another is typically called a conversion as opposed to a merger, but with some foreign entities, a merger may be required first.

The need to convert from one entity type to another is typically driven by the need for a particular ownership structure or to meet regulatory guidelines. This discussion would benefit from first covering some examples to give you a feel for who these rules apply to and when a change is actually needed.

If none of the management and regulatory issues apply to your business, then focus on the costs, maintenance and liability protections afforded by each type of entity to pick what is right for you. The conversion from one type to another is actually the easy part; the hard part is figuring out what you need to do in the first place. Let’s begin with some of the issues you might face.

Ownership/Management Structure for Service Businesses:

Virtually any time that licensed services are performed through an entity, the management structure of that entity must allow for essential control by the licensed individual. This makes sense to us because that license is supposed to be granted upon the achievement of sufficient education and training that the general public can trust in the care, advice or service they receive.

The risk here is that a shareholder of a corporation or a partner in a partnership who is not licensed could exercise control over the licensed provider and affect her decision making. The bylaws of a corporation, the operating agreement of an LLC or the partnership agreement of a partnership are used to define the roles and controls of the ownership group. Those controls must be sufficient to preserve the independent judgment and management of the company.

Because they are very illustrative of this point, let’s review California’s rules regarding the corporate practice of medicine and who can make certain management decisions. In California only a physician can perform the following tasks:

• Determining what diagnostic tests are appropriate for a particular condition.
• Determining the need for referrals to, or consultation with, another physician/specialist.
• Responsibility for the ultimate overall care of the patient, including treatment options available to the patient.
• Determining how many patients a physician must see in a given period of time or how many hours a physician must work.

All of those items seem pretty straight forward, as they all relate directly to patient care the licensed physician being in control without restraint by another unlicensed owner who could complain about the costs or profits associated with the particular care decisions. But, this theory of control goes even further, reaching to the basic business operation: According to the state of California, the following management decisions should also be made solely by the licensed physician:

• Ownership is an indicator of control of a patient’s medical records, including determining the contents thereof, and should be retained by a California-licensed physician.
• Selection, hiring/firing (as it relates to clinical competency or proficiency) of physicians, allied health staff and medical assistants.
• Setting the parameters under which the physician will enter into contractual relationships with third-party payers.
• Decisions regarding coding and billing procedures for patient care services.
• Approving of the selection of medical equipment and medical supplies for the medical practice.

Thus we see that according to the State, any business or management decision that can impact client care should be made by the licensed professional. Bringing this back to our main topic, you should be selecting a business form that allows for the division of responsibilities according to what the law requires. Keep in mind that having structure that does not impose proper divisions would be in violation of such a law, it is not required that actual control be exercised by an unlicensed person to find a violation.

Many of these control issues can also be obscured by the levels of management imposed under corporate ownership although they still exist and pose the same risks. If a shareholder can vote for the members of the board of directors, and the board of directors choose the officers, then the shareholders have indirect control of the officers and the decisions they make because those officers are beholden to the board and the shareholders.

Regulatory Demands by Business Class:

For certain professions or services a particular type of entity may be required by the relevant licensing authority or statute. For example, Arizona professional regulatory bodies require that licensed real estate agents and cosmetologists perform their services through either a Professional Corporations or Professional Limited Liability Company.

Even further, for certain professions the licensing body may restrict the ownership of the business to only licensed individuals. This is true of realty companies and law firms in Arizona. You may have also guessed that California restricts the ownership of medical facilities to licensed physicians (specials exemptions had to be made for hospitals and public health organizations). California also requires that medical practices be operated as corporations and not as LLC’s. Most states and licensing bodies are not so restrictive.

Costs and Maintenance:

We have covered the costs and maintenance of the entities in other emails, so we will handle this in a brief review. In Arizona, corporations require an annual report to be filed and a $45 filing fee to be paid. LLC’s require no annual fees or filings in Arizona. California requires any entity, corporation or LLC, to pay a minimum $800 franchise tax for the privilege of doing business in the state. This annual fee applies if your company is licensed to do business in California but does not actually do any business there. If we view Arizona as the lowest cost for maintenance and California as the highest (just for this hypothetical) then the other states will fall somewhere in between.

In Arizona at least, if you do not need to provide for different classes of ownership, an LLC will be preferred because it will not lapse or be dissolved due to forgotten annual reports or delinquent filing fees.

The Conversion:

The conversion of the entity with the state really is the easiest part of all of this. Most states, including Arizona, promulgate the forms necessary to convert from one entity to another. The cost to convert a corporation to an LLC in Arizona is a one-time $50, plus the standard LLC filing fees. The filed articles for the converted entity will also need to be published in a newspaper of record to complete the process.

That type of simple conversion from one entity to another may be sufficient to meet the regulatory requirements. If management and ownership issues are mandating the change, then it is the operating agreement or bylaws that will be the key documents in effecting the necessary structural changes. These documents will have to be customized to adapt to your exact needs and situation to properly divide controls and ownership according to the law.

A Word about S-Corporations:

We discussed the structural and regulatory reasons to convert from one entity type to another but we should touch on one point that is very relevant to this audience. Pursuant to federal law, S-Corporations (or LLC’s taxed as S-Corporations) must have only one class of ownership and must all be natural persons. This restriction means we cannot implement a structure that has both voting and non-voting ownership, or ownership through other entities. Therefore, if you have an S-corporation it is unlikely that you will face any of the issues listed above. If you do have these issues, then we need to discuss not only your ownership structure, but also your tax election

Conclusion:

Converting an entity from one type to another is not difficult, knowing when to do it is. If there is a need for conversion or reformation, most of the substantive changes will be made in your bylaws or operating agreement and not in the articles filed with the state.

If you have questions about your business structure, tax elections or regulations, please contact our office to schedule complimentary consultation with one of the attorneys at Nielsen Law Group. Click here to get started.