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Converting a corporation to an LLC.

Until a few years ago, if a company desired to have the protection of limited liability, the company either operated as a limited partnership with a corporate general partner or as a corporation. Companies that chose the corporate format basically received what they bargained for, that is limited liability. However, among the costs of the protection are numerous tax consequences, such as the potential double taxation of a C corporation or the strict (though lessening) requirements of an S corporation. The playing field expanded in recent years with the passage at limited liability company legislation in many jurisdictions. Even so, there are still many instances where the corporate format remains the preferred way to go. However, as the limited liability company does provide limited liability (as its name says) and the format is generally much more flexible than the corporate format, many companies that had previously chosen the corporation would today choose the limited liability company. The question then is what are the consequences, at least from a tax perspective, of converting the company from a corporation to a limited liability company. Clearly, a new company can easily form the type of entity it wishes to operate under and, if careful, can usually do so without any problems. However, in the case of a conversion from a corporation, life is not so easy. For along with administrative problems there are potential serious tax consequences of converting from either a C corporation or an S corporation to a limited liability company.

The most direct method of converting is simply to liquidate the corporation by transferring the corporate assets to the corporation's shareholders and then have the shareholders contribute the assets to the limited liability company. This method could, however, result in substantial tax consequences. Unfortunately, when a corporation liquidates, the corporation is treated as if it sold all of its assets, including goodwill, at fair market value to its shareholders. For a C corporation this will result in double taxation. First the corporation will pay tax on the gain (the amount the fair market value exceeds the corporation's basis in its assets) on the deemed sale and then the shareholders will pay tax on their gain (the fair market value of what they receive over their basis in their stock).

For an S corporation, the corporation will recognize the gain on the deemed sale, which it will pass through to its shareholders. The shareholders will then pay the tax on the gain. In many cases, there will not be any double tax as the gain will increase the shareholder's basis in the stock and therefore the amount received will not exceed the basis of the stock. This may not be the case, however, where, for example, the shareholder purchased the stock from a third party. In certain situations, the S corporation may, however, also be subject to a double tax, for example, where the S corporation was previously a C corporation and the built-in gains tax applies. In addition, for those S corporations having the honor and privilege of operating in New York State, which charges a tax above a certain income level, or New York City, which does not recognize S status, additional taxes may apply. To make matters worse, the S corporation shareholder may be taxed at higher than capital gain rates. For example, if the property being transferred to the shareholder is depreciable and the shareholder is a related party, the ordinary income tax rates loom. The tax consequences of a straight liquidation will usually discourage many businesses from converting. It may be attractive in certain situations though, such as where the corporation does not have highly appreciated assets, or where the tax consequences are reduced due to the corporation and/or its shareholders having carryover net operating losses or suspended losses that could be used to reduce the tax to an acceptable level. The approach might also be considered where it is expected (or at least very strongly hoped) that the business will substantially appreciate in value in the future and the company is willing to bite the bullet now in order to avoid double taxation in the future. However, if the straight liquidation approach is being considered for this last reason, the reader should definitely compare the corporate liquidation to the approach below. A potential alternative exists to the above corporate liquidation, or for that matter the do-not-do-anything approach. Some commentators have warned, however, that this approach should not be undertaken by those who scare easily. The basic idea of this method is for the corporation and its shareholders to form a limited liability company. The corporation would then transfer its assets to the limited liability company in exchange for an interest in the entity. Under the normal partnership rules, this transfer would usually be tax-free. The shareholders would then transfer additional funds to the limited liability company in exchange for their interest (also usually tax-free). The goal of this alternative is not to completely convert the corporation to a limited liability company but to transfer a part of the business to a limited liability corporation format (the part of the limited liability company owned by the corporation's shareholders), without incurring any tax on the transfer. Note that the part of the limited liability company owned by the corporation will still be in the corporate format, as the corporation will have to report its share of the entity's income. In considering this method, it is extremely important that the corporation and the shareholders receive an interest in the limited liability company equal to the fair market value of the assets they transferred to the LLC.

The shareholders should not receive their interest for no consideration, but should, in fact, contribute funds or property to the new entity. While it is obviously tempting to give the corporation as small an interest as possible (the smaller the corporate interest the more of the business that is transferred out of the corporate format), this should be done with great care. Definite dangers lurk if the corporation receives an interest worth less than the assets transferred (including goodwill). The IRS could conclude that the excess value was transferred to the corporation's shareholders who then contributed it to the limited liability company. This deemed distribution could, for example, be considered a dividend to the corporate shareholders, with all the nasty consequences that implies. Accordingly, it is preferable for the corporation to obtain a professional valuation of the assets transferred, in order to build a case that an appropriate value in the limited liability company was obtained. Along with the above valuation considerations are numerous other potential traps the company may encounter.

For example, the IRS has the authority under certain circumstances to reallocate income and expenses among commonly owned or controlled entities. The government could also use a substance-overform argument, assignment-of-income doctrine, or partnership anti-abuse regulations to allocate income away from the LLC to the corporation. The consequence of this would be that the income would be subject to tax within the corporation and possibly subject the corporate shareholders to dividend treatment as well. I am sure that this is not giving the reader a warm fuzz feeling. However, it only gets worse. Some other considerations to take into account are as follows:

1. A C corporation may be more likely to be considered a personal holding company (as it now has less business income).

2. An S corporation with C corporation earnings and profits might be more likely to have too much passive income for the same reason as "1" above.

3. If the LLC is assuming debt of the corporation or taking property subject to debt from the corporation, the corporation might recognize taxable income if the partnership tax rules allocate an amount of debt away from the corporation and to the other members in excess of the basis of the assets being contributed by the corporation.

4. As this method will most likely be used where the corporation has appreciated assets and is contributing appreciated assets, the partnership rules require that special allocations be made to recognize that a partner is contributing assets with a built in gain. For example, if an asset that was contributed by the corporation is subsequently sold, with certain adjustments, the gain on the sale must be allocated to the corporation to the extent the asset had appreciated when the corporation contributed it.

Clearly the above approach is laden with dangers.

By the way, the alternative approach is itself a flexible creature and can be modified. The LLC may attract new investors and therefore result in members that are not shareholders of the corporation. Along with obtaining additional funds for the business, it greatly enhances the odds of the transaction being upheld from a tax point of view. Additionally the method may be modified by structuring it as a "partnership freeze." In a freeze situation, the corporation receives a small interest in the partnership and also a preferred return. The goal of a freeze is to keep any future appreciation in the business away from the corporation. The freeze structure has all of the tax considerations we discussed above as well as others such as the special valuation rules that apply where the parties involved are members of the same family.
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Title Annotation:limited liability corporation
Author:Borofsky, Jeffrey Mark
Publication:The CPA Journal
Date:Mar 1, 1998
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