Converting S Corporations to LLCsJacob Stein Esq.
January 8, 2008 — 19,675 views
1. Why Convert?
It is easy to grasp why one would want to convert a C corporation into an LLC. The ugly double tax. With an S corporation there is no double tax, so why convert? There are a couple considerations.
One is a non-tax, business reason. In almost all states, membership interests in limited liability companies are shielded from creditors by the so-called “charging order” statutes. Under these statutes, a creditor of a debtor-member of an LLC does not just get the member’s interest in the LLC, the creditor only gets the charge against the economic interest of the member. This does not confer on the creditor any management or voting rights, but simply diverts the debtor-member’s distributions and allocations to the creditor. For business entities that hold substantial assets, the charging-order protection is a valuable benefit.
S corporations may also wish to convert for a tax reason. The shareholders may be planning on liquidating the corporation sometime in the future. As the corporation continues to accumulate assets, and continues to depreciate assets, the eventual tax on the liquidation of the corporation continues to grow. The shareholder may thus want to liquidate the corporation earlier, when the tax on the liquidation is relatively small.
It is also possible that the existing shareholders may want to bring in an additional investor. If that investor is a corporation or an LLC or a foreign entity, in its capacity as a shareholder, the investor will cause the termination of the S election, with the resulting negative tax consequences. Accordingly, conversion of the S corporation to an LLC ahead of time may be desirable.
2. Tax Treatment of S Corporation Liquidations
The S corporation provisions of the Code treat S corporations as flow-through entities, similar to partnerships. However, in certain circumstances, subchapter C provisions also apply to S corporations. One of such circumstances is the liquidation of the S corporation.
In an S corporation liquidation, similar to a C corporation liquidation, Code Section 331 will apply and treat the distribution of property from the corporation as in exchange for the stock of the corporation. Code Section 301 (dividend treatment) will not apply. Code Section 1368 distribution treatment will also not apply.
Shareholders will thus recognize a capital gain on the surrender of their stock equal to the difference between the amount of property distributed to them, and their basis in the corporate stock.
Pursuant to Code Section 336(a), the liquidating S corporation will recognize gain or loss when distributing appreciated or depreciated property. The gain or loss is determined as if the corporation sold the property to the shareholders at full fair market value. Consequently, the shareholders take the property at full fair market value basis.
Any capital gain or loss recognized by the corporation flows through to the shareholders, increasing or decreasing their basis in the corporate stock.
Thus, S corporations are technically subject to the same tax treatment on liquidation as C corporations, i.e., gain recognition on the corporate and shareholder levels. However, because of the flow-through nature of the S corporation, the gain recognized at the corporate level increases the shareholders’ stock basis, and is thus not recognized a second time. (An S corporation would recognize two levels of tax on a liquidation is when it has built-in gains from C years, and possibly in certain other basis disparity cases.) This is consistent with the overall intent of subchapter S.
3. Converting to an LLC
Because S corporation shareholders are subject to a tax on the liquidation of the corporation, converting an S corporation to an LLC is not a straightforward exercise.
Similar to the C corporation discussion above, the first method of converting an S corporation to an LLC is an outright liquidation of the corporation to a newly-formed LLC.
An outright liquidation of the S corporation will trigger the capital gain tax. There are two distinctions when compared to the C corporation liquidations. First, S corporation liquidations are subject to only one level of tax. Second, care should be exercised when contributing the stock of the S corporation to the LLC. Because an LLC is not an eligible shareholder of an S corporation, contribution of the stock to the LLC will terminate the S election. Unless the corporation is liquidated on the same day, it will have a short S and C years.
An installment sale conversion of the S corporation may be easier to undertake than the comparable C corporation conversion. First, S corporations are not required to immediately recognize gain on the distribution of an installment obligations, unlike C corporations, if the shareholder is entitled to report his or her stock gain under the installment method of Code Section 453(h). This means that because of the application of Code Section 453(h) the receipt of the installment obligation by shareholders in a liquidation is not treated as payment for stock. Similar to the C corporation discussion above, the corporation must be liquidated within 12 months.
The distribution of the installment obligation does not defer any built-in gain tax at the S corporation level, only at the shareholder level.
Also, as discussed above, when the installment sale is to a related party, there is an immediate recognition of the depreciation recapture, negating the tax deferral benefits of the installment method. The exception to the immediate recognition of the recapture amount is when the taxpayer can establish that the disposition of property by the corporation was not done for tax avoidance.
With an S corporation, if the shareholders are planning on bringing in an investor that is an ineligible S corporation shareholder, that is likely to rebut the tax avoidance argument.
The S corporation may also be converted through the joint-venture vehicle discussed above in the C corporation context with similar considerations.
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Jacob Stein Esq.
Mr. Stein is a partner with the law firm Boldra, Klueger and Stein, LLP, in Los Angeles, California. The firm's practice is limited to asset protection, domestic and international tax planning, and structuring complex business transactions. The firm's goal is to provide the highest quality legal work that is usually associated with only the biggest law firms, in a boutique firm setting. Jacob received his law degree from the University of Southern California, and his Master's of Law in Taxation from Georgetown University. Mr. Stein has been accredited by the State Bar of California as a Certified Tax Law Specialist and is AV-rated (highest possible rating) by Martindale-Hubbell.