Converting a Sole Proprietorship into an LLC

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Arlington, VA

Editor’s note: This case study has been adapted from “PPC’s Guide to Limited Liability Companies,” 10th Edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II and Gregory A. Porcaro, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ((800) 323-8724; www.ppcnet.com).

The conversion of a sole proprietorship into a limited liability company (LLC) is accomplished by filing for a certificate of formation (or other required document), paying the appropriate fee and executing articles of organization and an operating agreement (if required). For a checklist of conversion issues, see the exhibit.

A sole proprietor considering adding another member to a newly formed LLC should analyze the conversion’s effects on any transferred liabilities. If the proprietor’s interest in the business is substantially reduced, he or she may have less basis available for deducting LLC losses or may recognize gain on the contribution of assets and liabilities to the LLC.

Possible Loss Recapture

The conversion of a sole proprietorship into an LLC may result in the former proprietor recognizing income, due to required loss recapture under the at-risk rules. Recapture may be required if the business activity and the proprietor are subject to the Sec. 465 at-risk rules and if losses have been recognized in prior years.

A conversion may—but is not likely to—cause a proprietor to suffer a reduction of his or her amount at risk. The reason no reduction occurs is because the proprietor generally remains liable for debts incurred before the conversion. Any reduction that occurs is a result of the rules providing that members get at-risk basis for recourse debts, but not for nonrecourse debts (except for qualified nonrecourse financing).

Because LLC debts are typically treated as nonrecourse, at-risk basis may be reduced if the proprietor has no liability for the business’s debts after the conversion. This reduction in at-risk basis can result in a former proprietor recognizing gain to the extent that previously deducted losses have to be recaptured. Gain recognition can only occur if the reduction in the amount at risk causes the previously deducted losses to exceed the member’s at-risk basis.

Example: Joe owns a sole proprietorship that operates a retail shop. On the advice of his lawyer, he decides to convert to an LLC. The proprietorship’s only debt is a $100,000 loan from a local bank for which Joe has personal liability. At the time of the conversion, the bank agrees to substitute the LLC as the borrower and release Joe from personal liability on the note; instead, the note would be secured by the LLC’s assets.

Before the conversion, Joe had contributed $75,000 to the operation of the retail shop and deducted $150,000 in losses from its operation. Because the $100,000 loan was recourse, it provided him with at-risk basis. Consequently, Joe’s at-risk basis in the activity before the conversion was $25,000 ($175,000 basis – $150,000 losses).

After the conversion, Joe is no longer at risk for the $100,000 note, which is now exculpatory debt for which no member is liable. Consequently, Joe has $75,000 ordinary income, equal to the losses he previously deducted ($150,000), less the current at-risk basis of his interest ($75,000).

Contribution of Assets

If a sole proprietor contributes assets to a single-member LLC (SMLLC) taxed as a disregarded entity, no transaction occurs for tax purposes, as he or she is deemed to continue holding the assets as a sole proprietor. However, for state law purposes, the LLC holds title to the business’s assets after the conversion.

If the sole proprietor contributes the assets to a new LLC that has an additional member (and is taxed as a partnership), the owner is deemed to contribute the business’s assets (subject to any liabilities) to the newly formed LLC under Sec. 721’s general nonrecognition rules. This transaction is now subject to Rev. Rul. 99-5. Under Sec. 721, no gain or loss is generally recognized.

Available Accounting Methods

An SMLLC taxed as a disregarded entity must use its owner’s accounting methods. A partnership or an LLC taxed as a partnership generally can use any method of accounting, as long as it clearly reflects income. However, there are certain limits on such use of the cash method. (Several recent IRS rulings permit certain small LLCs to use the cash method when they would otherwise be required to use the accrual method.) For instance, an LLC taxed as a partnership cannot use the cash method if it has a C corporation member or is a “tax shelter.”

Because most sole proprietorships use the cash method, a sole proprietor considering conversion to an LLC taxed as a partnership needs to determine whether the cash method will still be available. In almost all cases, he or she can continue using the cash method.

SE Tax

Prop. Regs. Sec. 1.1402(a)-2 generally provides that LLC members are not subject to self-employment (SE) tax on their share of LLC income (i.e., they are treated as limited partners), unless one of the following applies:

1. They have personal liability for the debts of the LLC or claims against it by reason of being a member.

2. They have the authority under state law to contract on the LLC’s behalf.

3. They participate in the LLC’s trade or business more than 500 hours during its tax year.

4. They are members in an LLC that provides professional services.

However, the Taxpayer Relief Act of 1997 placed a moratorium on issuing final or temporary regulations defining a limited partner for SE purposes, until July 1, 1998. At press time, no new regulations had yet been issued. While the general reasoning of the proposed regulations will most likely ultimately be adopted, those rules are not currently effective. Further, given the intense criticism the IRS and Treasury received after issuing the proposed regulations, they will probably not issue new regulations until Congress addresses the matter.