Domestication and conversion are two ways of changing the form of a business entity. Both can be useful for tax purposes, but they work differently and have different implications for the business. It’s important to know how these processes work so you can make an informed decision about how to change your company structure.
Business domestication is the process of registering a foreign registered entity in a state where it is not registered. Business domestications are not the same as statutory conversion, merger, or reorganization.
The most common reason for business domestication is that an M&A transaction requires one party to convert its legal entity type for tax purposes. This can be beneficial when performing due diligence on an acquisition target and deciding whether or not to purchase their assets (i.e., structure your deal with an OLIT structure). In addition, some foreign entities may have strict requirements regarding their jurisdiction of incorporation that require them to change jurisdiction once they have acquired certain amounts of U.S.-based assets (i.e., structure your deal with an OLIT structure).
A statutory conversion is a process in which a company establishes its legal citizenship in another state. This can be done for several reasons, but it must meet the following criteria:
Which US States Allow Business Domestication
The United States offers the best potential for domestication, with all 50 states allowing business domestication. Additionally, Puerto Rico allows business domestication and is an attractive jurisdiction for foreign investors because of its tax benefits and efficient government programs that make it easy to start a new business. The U.S. Virgin Islands, American Samoa, and the Northern Mariana Islands do not allow for the formation of a domestic corporation under their laws; however, some U.S.-based corporations choose these locales as their headquarters due to favorable tax incentives which are available there only to certain types of companies (e.g., banks).
When Should I Consider a Statutory Conversion
There are four main reasons to consider a statutory conversion:
Tax Implications of Statutory Conversions
A statutory conversion is a taxable event. If the transaction is not intended to be a reorganization of the business entity, or if it fails to qualify as such, then you may be liable for capital gains tax on the value of your shares in the corporation.
In some cases, however, you can avoid paying this tax by demonstrating that your intent was genuinely to reorganize and not simply exchange your shares in one company for those in another company (i.e., exchanging one stock certificate for another).
Tax Implications of Business Domestication
Conversions of a partnership or corporation to S status are subject to tax in the same manner as other terminations of any entity that is not an S corporation. In some cases, this may result in a special termination distribution that may be taxable at ordinary income rates or qualifying dividends rates. The amount of the distribution will depend on whether it is treated as a liquidating dividend or as a reduction in your basis in stock and debt of the entity. However, there are exceptions where no termination tax applies even if your business was deemed liquidated (for example, if less than two years have passed since formation).
By now, you should have a good idea of what conversions and domestications are. Statutory conversions are a great option for businesses that are ready to grow but can’t afford the high costs associated with starting a new corporation. Business domestications, on the other hand, offer more flexibility than statutory conversions but require more planning and paperwork. With these two options available, there’s no reason not to consider converting your business! Contact us if you need help with domestication or conversion!
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