Although converting a C corporation into a limited liability company (LLC) allows the C corporation shareholders to continue to have limited liability while acquiring the advantages of passthrough taxation, the heavy tax cost of the conversion normally will be prohibitive. However, in certain situations in which the corporation has depreciated assets or significant net operating loss (NOL) carryovers, conversion to LLC status may be beneficial. See the checklist to ensure that the significant issues have been addressed when converting to LLC status.
Conversion of a C corporation into an LLC involves the liquidation of the corporation, which results in a double tax—one on the corporation’s distribution of assets (Sec. 336) and one on the distribution to the shareholders (Sec. 331).
Taxation of C Corporation Liquidation
Under Sec. 336, a liquidating C corporation must recognize gain or loss on distributions of property to the shareholders as if the property had been sold to them for its fair market value (FMV). The character of the gain recognized (capital versus ordinary) depends on the character of the property the corporation distributes. (Depreciation recapture and similar rules may also affect the character of the gain recognized.)
Generally, Sec. 361(d) allows corporations to recognize losses when property is distributed to shareholders in complete liquidation of the corporation. However, a corporation making a liquidating distribution to a related person (under the rules of Sec. 267) cannot recognize the loss if the distribution is not pro rata or disqualified property is distributed. Disqualified property is any property the corporation acquires in a Sec. 351 transfer or as a contribution to capital during the five-year period ending on the distribution date, or any property whose adjusted basis is determined by reference to the adjusted basis of such property.
In Letter Ruling 200613027, the IRS ruled that the conversion of an LLC to a corporation followed by a rescission of the incorporation did not result in a taxable liquidation of the corporation. Instead, the entity was treated as an LLC for the entire tax year, and the incorporation transaction was ignored.
Sec. 331 governs the tax treatment of liquidating distributions at the shareholder level. The Sec. 331 rules require the liquidating distribution to be treated as full payment in exchange for the shareholder’s stock. The shareholders must recognize gain (or loss) equal to the difference between the FMV of the assets received and the adjusted basis of the stock surrendered. If the stock surrendered is a capital asset, the transaction results in the recognition of capital gain or loss. The shareholder’s basis in the property received in the liquidating distribution is its FMV at the time of distribution if gain or loss is recognized on the receipt of the property (Sec. 334(a)).
Determining If Conversion Is Desirable
Because of the tax cost of converting a C corporation, practitioners will probably want to consider conversion only if circumstances limit the gain that will be recognized by the corporation on the distribution of its assets and/or the gain that will be recognized by the shareholders on the receipt of the liquidating distribution. In general, a corporate conversion may be desirable if:
- The corporation holds assets that have not appreciated or that have depreciated. In such situations, the FMV of the property distributed does not exceed the basis of the transferred assets, and the corporation does not recognize gain. In addition, the FMV of the assets distributed to the shareholders most likely will not exceed the basis of their stock, negating any gain recognition at the shareholder level.
- The corporation and/or its shareholders have NOLs or capital loss carryforwards that absorb any gain recognized on the liquidating distribution. Shareholders may have capital loss carryforwards from other activities or investments that they can use to offset the gain.
- The corporation holds assets that will appreciate rapidly in the future (such as intellectual property or real estate). If rapid appreciation is expected, it may be preferable to recognize the gain on liquidation of the corporation now, rather than continuing to operate as a corporation.
Practice tip: If the converting corporation’s assets have depreciated and losses on the liquidating distribution will not be limited because of the related-party rules, the conversion of a C corporation to an LLC may actually have beneficial tax effects.
How to Structure C Corporation Conversion
There are three basic ways to structure the conversion of a C corporation into an LLC. All three result in the liquidation of the corporation and potentially a substantial tax cost. However, the choice may affect the shareholders’ bases in their interests in the LLC or the LLC’s basis in its assets.
Option 1: The shareholders form the LLC by transferring their stock to the LLC in exchange for membership interests. At that point, the shareholders own interests in the LLC, and the LLC owns the stock of the C corporation. The corporation then liquidates, which results in the LLC (as the sole shareholder) receiving the liquidating distribution. Generally, the shareholders recognize no gain or loss on the contribution of their C corporation stock to the LLC (Sec. 721). When the corporation liquidates into the LLC, it pays a tax on the difference between the FMV and the tax basis of the distributed assets. The LLC recognizes gain on receipt of the liquidating distribution, which it passes through to its members. The shareholders have a carryover basis in their LLC interests equal to the basis they had in the C corporation’s stock, increased by the gain passed through from the LLC. (Sec. 704(c) requires each member of the LLC to be taxed subsequently on the gain or loss inherent in their stock at the time of its transfer to the LLC.) The LLC will have a basis in the corporation’s assets equal to the FMV of the assets on the date of liquidation.
Option 2: The C corporation transfers its assets (subject to liabilities) to the LLC, and the shareholders transfer cash or other assets. The C corporation then liquidates and distributes its membership interest in the LLC to the shareholders. Again, under Sec. 721, neither the corporation nor the shareholders recognize gain or loss on the contribution of assets to the LLC. The corporation recognizes a gain on the liquidating distribution of the LLC interests to the shareholders equal to the difference between the FMV and tax basis of the distributed interests. The shareholders recognize gain on receipt of the liquidating distribution equal to the difference between the FMV of the distributed LLC interests and the basis in their stock. The LLC has a carryover basis in the corporation’s assets equal to the basis of the assets in the hands of the corporation prior to contribution. (However, the distribution of ownership interests in the LLC constitutes a transfer within the meaning of Sec. 743, and the LLC can adjust the basis of its assets if a Sec. 754 election is in effect; see Letter Ruling 9701029.) The shareholders have a basis in the LLC interests distributed by the corporation equal to the FMV on the date of liquidation. (The basis of the shareholders in their LLC interests acquired by contribution is the amount of cash and tax basis of property contributed for the interests.)
One advantage of this type of transaction is that significant discounts may be applied to the LLC interests distributed to the former shareholders, since the Sec. 2701–2704 limitations apply only for gift and estate tax purposes. Practitioners might consider adding restrictions to significantly increase the discount available. Another advantage is that transfer taxes imposed by some states on the transfer of real property are not assessed on a contribution, rather than a distribution, of real property.
Option 3: The corporation liquidates and distributes its assets to the shareholders, who contribute the distributed assets to the LLC in return for membership interests. The corporation recognizes income equal to the difference between the FMV and the tax basis of the distributed assets. The shareholders recognize income equal to the difference between the FMV of the distributed property and their stock basis. Under Sec. 721, the shareholders do not recognize gain or loss on the contribution of assets by the shareholders to the LLC.
The results of this conversion structure are the same as option 1. However, a disadvantage of this type of conversion is that the shareholders have liability for the corporation’s debts at the point in time they are considered to hold the corporation’s assets and liabilities.
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.
This case study has been adapted from PPC's Guide to Limited Liability Companies, 15th edition, by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, Gregory A. Porcaro, Virginia R. Bergman, William R. Bischoff, and Linda A. Markwood, published by Thomson Tax & Accounting, Ft. Worth, TX, 2009 ((800) 323-8724; ppc.thomson.com).