The owners of a C corporation might consider a conversion to a passthrough entity as a means to retain the limited liability and transferability of ownership that the corporate entity provides, while avoiding the double taxation of corporate earnings. As a profitable corporation matures, it becomes more difficult to “zero out” corporate taxable income through shifting devices such as salaries, fringe benefits, and interest payments.
In the conversion of a C corporation to a limited liability company (LLC), the transaction is treated as a liquidation of the corporation under Secs. 336 and 331, followed by a liquidating distribution of the net proceeds to the shareholders. The assets are then contributed to the new LLC. An actual liquidation may not be required, as many states facilitate such a conversion by allowing companies to simply file a few forms and pay a processing fee.
After the conversion, the new LLC takes its assets with a fair market value basis. Other corporate tax attributes are eliminated. Operating results going forward, as well as the eventual liquidation of the LLC, are now single-taxation events.
Motivations for a C to LLC Conversion
Most shareholders would consider a conversion to an LLC when one or more of the following tax and financial goals are desired:
- Avoid double taxation: This is an important consideration when the owners of a successful entity want to receive tax-favored distributions of the business profits.
- Retain limited liability protection: Conversion to a general partnership may not be the right move.
- Minimize the tax costs of the conversion: As a corporate liquidation is a double-tax event, the conversion can be expensive to the owners. Converting during an economic downturn—i.e., when asset values are depressed and recognized gains are reduced—seems appropriate. Further, a realized loss may be recognized as ordinary under Sec. 1244.
- Unused or expiring capital or net operating loss carryovers: The conversion can allow such losses to be used to reduce the tax cost of the transaction. Such tax attributes usually are eliminated upon the liquidation.
- Likely higher future tax rates: Applicable tax rates for C corporations and individual investors almost certainly will increase in the near future, through tax rate changes, an expanded tax base, and/or the expiration of existing tax incentives. A single-tax model limits the negative effects of these increases.
- Higher taxes on dividend income: Also at risk from future legislation is the low tax rate on dividend income. This can be another reason to remove the entity from the double-tax structure of the C corporation.
Potential Disadvantages of Conversion
A C to LLC conversion might be subject to some negative tax consequences:
- Liquidating distribution rules: The liquidation of a C corporation is a double-taxed event. If the entity holds assets with sizable realized gains, the conversion could trigger significant and immediate income (and transfer) tax costs. However, no immediate income tax is triggered if a C parent converts its 80% controlled subsidiary (under Sec. 332) or if the C corporation is a non-U.S. entity (i.e., lacking effectively connected U.S. income to tax).
- Self-employment taxes: An LLC member is liable for the full amount of self-employment taxes on any guaranteed payments, plus its share of any passthrough ordinary income. Thus, future federal tax liabilities may increase.
- Goodwill effects: The C corporation may hold large amounts of goodwill, which could increase the gains recognized on the conversion. This may be the case particularly for successful service-oriented businesses.
Evaluating Tax Costs and Benefits
The C corporation shareholders must take into account various legal and other nontax consequences of a conversion to an LLC structure. Key tax considerations include the following:
The transaction should reduce lifetime tax liabilities of the entity and its owners in a present value sense. Taxes incurred in the current period (with a present value of 1.00) must be compared with future tax savings, perhaps in the form of higher cost recovery deductions, reduced current income taxes on operating profits, and reduced costs on the ultimate liquidation of the LLC. State, local, and payroll taxes must be included in this analysis.
The recommendation about conversion can be made only with full information as to the fair market values of the entity’s assets, including goodwill and other intangibles. A reasonable after-tax discount rate should be used in the present value computations, and the analysis period should be at least as long as the owners plan to be involved with the new LLC.
Conversion by a C corporation to a single-taxation entity probably is limited to the LLC structure because the desire for limited liability may rule out a partnership, and limitations on the number and type of shareholders and the possibility of entity-level taxes eliminate an S corporation. Analysis of a C to LLC conversion can be a detailed, fact-oriented undertaking, but one that the tax professional can complete with good technical knowledge and spreadsheet skills. Several broad observations of the likelihood of a tax-savvy C to LLC conversion follow:
- The present value of tax savings generated by the conversion increases, making the conversion more attractive, as one assumes higher future tax rates and higher asset bases relative to depreciation and amortization deductions.
- In the analysis, include projections of both corporate and individual tax rates, for income and payroll taxes, at the federal and state/local levels. Also include reasonable estimates of future price level increases, especially concerning depreciable assets.
- Payroll taxes will increase as the owners make up a larger portion of the entity’s workforce and as they take larger compensation amounts.
- Take into account any costs associated with the conversion itself, including legal and consulting fees, transfer taxes, and sales/use taxes on the deemed liquidation.
It may be difficult to show that the present value of tax savings from the C to LLC conversion outweigh the current tax costs, especially if the corporation holds assets with significant realized gains. The chances for a positive recommendation of the conversion increase with projections of greater tax rate increases and with a longer time frame for the analysis.
John Everett is a professor at Virginia Commonwealth University in Richmond, VA. William Raabe is a tax professor at the Ohio State University in Columbus, OH. Cherie Hennig is a professor at the University of North Carolina–Wilmington. For more information about this case study, contact Prof. Everett at email@example.com, Prof. Raabe at firstname.lastname@example.org, or Prof. Hennig at email@example.com.