Conversion of C Corporation into an LLC

The major advantage of a limited liability company (LLC) over a C corporation is the absence of double-level taxation of the LLC and its members. However, the tax consequences of converting a C corporation to an LLC could have deleterious effects on both the liquidating corporation and its shareholders. But, if such a conversion is structured correctly within specific boundaries, it could result in significant tax advantages to the ultimate shareholders.

Example: C corporation R is a profitable closely held C corporation (i.e., under Sec. 542(a)(2), more than 50% of its outstanding stock’s value is owned by five or fewer individuals during the last half of the tax year). R does not have significant goodwill or other intangibles. It has net operating loss (NOL) carryovers. It anticipates business development to increase substantially in the near future and expects profits to grow rapidly. R wishes to restructure to avoid double taxation and, thus, decides to convert to an LLC.

Contributing C Assets and Liabilities to an LLC

In the example, R can form an LLC with an unrelated third-party investor by transferring its assets and liabilities in exchange for an ownership interest in the LLC. Under Sec. 721(a), neither R nor its shareholders will recognize gain or loss on contributing property to the LLC. R will take a carryover basis in its ownership interest, matching the basis of the assets contributed. However, if R transfers intangibles (i.e., goodwill) to the partnership, it will recognize gain based on the difference between the intangibles’ fair market value (FMV) and their basis; see Sec. 721(d). This is a result of the deemed corporate liquidation (discussed below).

R’s tax basis in the new LLC will automatically decrease under Sec. 752(b) for any contributed liabilities that the LLC assumed, because debt relief is a deemed cash distribution for tax purposes. At the same time, R’s tax basis will subsequently increase for its allocable share of LLC debt, which is a deemed cash contribution for tax purposes, under Sec. 752(a). As long as debt assumed by the LLC on the contribution of assets under Sec. 721 does not result in a negative tax basis, a corporation will not recognize gain on contributing assets to the LLC. However, when the corporation is left with a negative capital account, it will recognize capital gain under Sec. 731(a), to restore the negative capital account back to zero.

Corporate Liquidation/Liquidating Distribution to Shareholders

R will immediately liquidate following the contribution of assets and liabilities to the LLC. It recognizes gain or loss under Sec. 336(a) on the distribution of property in complete liquidation as if such property were sold to the shareholders at its FMV (including value of intangibles).

It will distribute the LLC ownership interests to its shareholders in complete liquidation. Sec. 331(a) treats this distribution as full payment in exchange for the stock. The gain or loss a shareholder recognizes under Sec. 1001 is determined by comparing the distribution to the shareholder’s stock basis. Consequently, shareholders will report either a return of capital, or capital gain income subject to a 15% rate.

Conversion Benefits

Under the example’s facts, R’s former shareholders will no longer face taxation on distributions from the new LLC, unless cash distributions exceed basis; see Sec. 731(a). Because a member’s allocable share of LLC liabilities is treated as a deemed cash contribution to the LLC for Federal tax purpose, this provides an additional cushion for the LLC member against Federal taxation.

The members of an LLC taxed as a partnership will be subject to the Sec. 469 passive activity loss (PAL) limit rules. Under Sec. 469(c)(1), “passive activity” means any activity involving the conduct of any trade or business in which the taxpayer does not materially participate. Material participation is defined, under Temp. Regs. Sec. 1.469-5T(a)(1), as participation in the activity for more than 500 hours during the tax year. If the C shareholders are passive investors in multiple flowthrough vehicles, the members could have suspended losses resulting from the PAL limit rules. PALs that have been suspended for nonmaterially participating investors can be used to offset Sec. 731(a) gain that could potentially be recognized by members on LLC distributions in excess of their basis. Sec. 731(a) gain recognized by nonmaterial participants will be treated as passive activity gross income and netted against their passive activity suspended losses, according to Rev. Rul. 95-5.

Initiating the conversion to an LLC before a significant increase in appreciation in the corporation’s assets will mitigate the gain that the corporation and the shareholders have to recognize on the deemed liquidation. Courts have ruled that goodwill and other customer-based intangibles in a closely held C corporation may very well attach to the ultimate shareholders, as opposed to the C corporation. Martin Ice Cream Co., 110 TC 189 (1998), showed that, within the context of a closely held C corporation, an entity may be able to liquidate without including the FMV of goodwill among its assets if it can prove that the ownership of the goodwill is attributable to the shareholders, not to the corporation. The Tax Court ruled in William Norwalk, TC Memo 1998-279, that goodwill does not pass from a liquidating corporation to shareholders if the goodwill was solely attributable to the shareholders’ personal abilities.

The taxpayer will be able to directly offset the Sec. 336(a) corporate gain recognized on dissolution against NOLs.

Conclusion

While typically, tax consequences can prevent an LLC conversion, the example illustrates when a conversion may be a viable long-term solution to double taxation.

From Adam Polakov, CPA, Porter Keadle Moore, LLP, Atlanta, GA