Should You Convert Your Land Partnership to an LLC?

Thursday, April 5, 2012

Since 1997, the Michigan Limited Liability Company Act has provided for an "automatic conversion" of Michigan Partnerships (both regular and Limited Partnerships) into a Limited Liability Company. Over the years, a lot of land-owners formed partnerships for various reasons, including succession planning, rent and tax considerations, and joint-ownership buy and sell provisions. In many (if not most) cases, there is little reason not to consider the conversion from a Partnership to a Limited Liability Company (LLC). There is a one-time filing fee for filing the Articles of Organization for the LLC, and an nominal annual fee and relative simple Michigan Annual Report. These are the only real changes to reporting and bookkeeping requirements. The organization will continue (in most cases) to file the Federal Income Tax Form 1065 (and MI 1065) with no substantial changes.

In return, the partners (now called "members") gain something pretty valuable—limited liability. Note that this limited liability only applies to incidents and occurrences after the conversion. You cannot use the conversion to "cure" a problem that arose prior to the conversion. In a traditional co-partnership, a partner is personally liable for all of the activities and liabilities of the partnership, even if it is one of the other partners who created the problem. Worse, a creditor can pick and choose which partner they want to pursue and can hold that one partner liable for 100% of the liability. The law takes the position that it is between the partners to allocate losses due to liability among themselves and not the problem of the creditor. Moving forward, the LLC form of business offers many opportunities to arrange the affairs and agreements among the members in some very flexible ways.

One concern about making the change is the so-called "domino-effect" it might have with all of the different facets of land-ownership. In most cases, there are mortgages, lease agreements, and often P.A. 116 Farmland Development Rights Agreements. The tax status of the property is also a potential problem.

Section 707 (5) of the Michigan Limited Liability Company Act provides that when an automatic conversion is done, the resulting limited liability company is "considered the same entity that existed before the conversion." The provision goes on to say that all the property rights of the prior partnership remain vested in the limited liability company. This means that on the record, nothing really changes. There is no requirement in the Act, other than the filing of the Certificate of Conversion (built into the Articles of Organization, if the proper form is filed), for filings, notices, or recording of new deeds. This should mean, as a legal matter, that no change in ownership, or transfer has occurred.

While it should be noted that specific situations are not directly addressed by the statute, the following concerns should be covered:

  • Mortgage "Due on Sale Clauses" should not be triggered
  • There should not be an "uncapping" for purposes of Michigan ad valorem real property taxes (while the Michigan Tax Tribunal has indicated that a transfer to or from a limited liability company is a "transfer" – and therefore an "uncapping" event – as a practical matter, the filing of an "Affidavit of Agricultural Use" generally cures that problem and unless there is a good reason not to, should probably be filed simply to take a conservative approach).
  • A recent conversation with the Michigan Department of Agriculture informally confirmed that neither they nor the Michigan Department of Treasury require a transfer of existing P.A. 116 agreements upon an automatic conversion.
  • Leases are rights in property and in accordance with the Act language, neither Lessor nor Lessee's rights and obligations should change or be effected by the conversion.
  • Nor should Land Contracts, Purchase Agreements, Joint-ownership agreements, easements, licenses or any other property rights be effected by the conversion.
  • The rights and liabilities of the Partners to each other should be essentially unchanged, and any Partnership Agreement should continue to be effective unless and until an new "Operating Agreement" is executed. Since banks and other third parties commonly request or require copies of the Operating Agreement, it may be advisable to either create a new agreement, or create one which "adopts" the existing partnership agreement.

As always, when dealing with legal matters, it is very dangerous to take a "one-size-fits-all" approach. Before making a conversion, it is critical that you consult with both tax and legal advisors to be certain there are no unintended negative consequences. For example, in some limited cases, if the Partnership/LLC is also the operating entity, certain third parties (notably the Farm Services Administration) may treat a LLC differently than a Partnership. That could have significant economic consequences. LLC's, by their statutory nature, can be very difficult to exit as an individual member, unless there are clear terms in the operating agreement. It is important to discuss all of these issues prior to making the conversion. As a practical matter, many of the Partnerships I work with have been in existence for many years, and it is often a good time to "dust off" the Partnership Agreement and revisit its terms anyway.


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