Conversion of a C corporation to an LLC

Only infrequently will it be beneficial for a C corporation to convert into a limited liability company (LLC). Although a conversion allows the C corporation shareholders to continue to have limited liability while acquiring the advantages of passthrough taxation, the tax cost of the conversion normally will be prohibitive. However, in certain situations, a conversion to LLC status may be beneficial.

Warning: The conversion of a corporation into an LLC classified as a partnership can have unexpected and unintended results. For example, in K.H. Co., LLC, T.C. Memo. 2014-31, the Tax Court disqualified an ESOP established by a corporation that subsequently converted to an LLC. Interests in the LLC did not meet the requirements to be qualifying employer securities.

The conversion of a C corporation into an LLC is treated as a complete liquidation of the corporation for tax. The liquidation of a C corporation with appreciated assets can potentially result in double taxation — a tax to the corporation on the distribution of assets under Sec. 336 and another tax to the shareholders under Sec. 331. Even with the lower 21% corporate federal income tax rate (effective after 2017), double taxation can be prohibitively expensive. The following is a brief general discussion of the tax treatment of a C corporation liquidation.

Taxation of C corporation liquidation

Tax on corporation

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 distributed. (Depreciation recapture and similar rules may also affect the character of the gain recognized.) Generally, corporations are allowed 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.

Non-pro rata distribution: Sec. 336(d)(1)(A) disallows corporate recognition of loss on certain distributions to a related person. A shareholder is related to the corporation under Sec. 267 if he or she owns, directly or indirectly, more than 50% in value of the outstanding stock. However, this rule does not apply if the property is distributed pro rata to all shareholders and the property was not acquired by the corporation in a Sec. 351 transaction or as a contribution of capital within the five-year period ending on the date of the distribution. Or, if the shareholders hold unequal percentages of stock, the loss assets can be distributed to the shareholders who do not meet the definition of a related person.

Distribution of disqualified property: Sec. 336(d)(2) covers distributions with a tax-avoidance purpose and can apply even if the loss property is distributed to a 50%-or-less shareholder. Built-in loss property acquired by the corporation in a Sec. 351 transaction or as a contribution of capital within two years of adopting the plan of liquidation is presumed to be tainted. If this anti-abuse rule applies, the basis of the distributed property for computing the loss is reduced by the built-in loss that existed on the date the property was contributed to the corporation. One obvious way to sidestep this rule is to wait until the two-year period has passed to adopt the plan of liquidation. Or the practitioner could attempt to overcome an IRS assertion that a principal reason for the transfer was to create a corporate loss, by proving a valid business reason for the original transfer of the property to the corporation.

Tax on shareholder

Sec. 331 requires a 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)).

Because there may be a high tax cost to convert a C corporation with significantly appreciated assets, practitioners probably will only want to consider conversion 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 from the liquidating distribution. In general, a corporate conversion may be desirable in the following situations:

The corporation holds assets that have not appreciated or 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. Additionally, the FMV of the assets distributed to the shareholders most likely will not exceed the basis of their stock, and gain recognition will not be required at the shareholder level.

The corporation and/or its shareholders have net operating losses (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 can be used to offset the gain. Furthermore, the corporation may have NOL or capital loss carryforwards that can offset some or all of the corporation's gain on the deemed sale of assets associated with its liquidating distribution.

The corporation holds assets that will appreciate rapidly in the future (such as a potential patent, intellectual property, or real estate): If significant appreciation is expected in the future, it may be preferable to recognize the taxable gain on liquidation of the corporation now to avoid double taxation on future appreciation.

Valuable corporate-related intangibles (such as goodwill) are owned by the individual shareholders: Because these intangibles do not belong to the corporation, they cannot be distributed and thus cannot trigger gain recognition at the corporate or shareholder levels.

Note: 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.

Two Tax Court decisions highlight one way to at least partially avoid double taxation on a corporate liquidation. The existence of goodwill or other valuable intangibles that are the property of the shareholders, not the corporation, is required for these strategies to work.

In Martin Ice Cream, 110 T.C. 189 (1998), the corporation distributed Häagen-Dazs ice cream to supermarkets, grocery stores, and food-service accounts. Arnold Strassberg was the 51% owner of the corporation and had long-standing relationships with owners and managers of supermarket chains. He did not have an employment contract with the corporation nor did he sign a covenant not to compete.

The Tax Court held that Strass-berg's oral distribution agreement with Häagen-Dazs and his relationships with the supermarket chains were not owned by the corporation. He owned these intangibles and made them available to the corporation by working for it. The Tax Court's decision may have been influenced by the lack of a written distribution agreement between the corporation and Häagen-Dazs and the absence of a contract preventing Strassberg from competing with the corporation.

In Norwalk, T.C. Memo. 1998-279, the IRS argued that a professional accountancy corporation owned approximately $580,000 of intangibles when it liquidated. However, the Tax Court concluded that any customer-based intangibles belonged to the firm's shareholders because their clients could be expected to follow them if they left the firm. According to the Tax Court:

[T]here is no salable goodwill where, as here, the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationships with clients become property of the corporation.

The goodwill associated with the practice was not a component of the corporation's value but rather was a personal asset of the shareholders. Further, the corporation's client list was held to have no value in the hands of the liquidating corporation because no noncompete agreement with the corporation was effective against the shareholders. Therefore, the shareholders were free to take the corporation's clients and serve them individually, rendering the client list valueless to the liquidating corporation.

In Howard, 448 Fed. Appx. 752 (9th Cir. 2011), the selling shareholder (a dentist) had long-standing employment and noncompete agreements in place with his corporation. Larry Howard sold his practice to another dentist under an asset purchase agreement providing that he would receive $549,900 for his personal goodwill and the corporation would receive $47,100 for its assets. Howard received an additional $16,000 for entering into a noncompete agreement with the buyer.

The key point in this case was that Howard had a covenant not to compete with his corporation, the seller. The IRS argued that an employee cannot own the goodwill if he has a noncompete agreement that effectively makes the employee's personal relationships with clients a corporate asset. The district court and the Ninth Circuit agreed with the IRS, finding that any goodwill from Howard's personal relationships or abilities was corporate goodwill. In short, while Howard developed the patient relationships, the economic value of those relationships belonged to his corporation.

The lesson from these cases is that shareholders can avoid double taxation on at least part of the proceeds of the sale of the corporation's assets by allocating some of the sales price to intangibles they own. Assuming the facts support this treatment, the shareholders avoid gain on the liquidating distribution that would otherwise result if the corporation is deemed to own the intangibles. Since the intangibles are owned by the shareholders, they can be contributed tax-free to the new LLC under Sec. 721(a). The same holds true if the intangibles are contributed to a new single-member LLC (SMLLC). The contribution is not a taxable event because the individual and the SMLLC are treated as the same taxpayer under the default entity-classification rules.

There are three basic ways to structure the conversion of a C corporation into an LLC. All three ways result in the deemed liquidation of the corporation for tax purposes and the resulting tax cost. However, the choice of method may affect the shareholder/members' bases in their interests in the LLC or the LLC's basis in its assets. The three methods are:

Stock transfer The shareholders of the C corporation transfer their stock to the LLC in exchange for membership interests. At that point, the shareholders own interests in the LLC, and the LLC owns all the stock of the C corporation. The corporation then liquidates, which results in the LLC (as the sole shareholder) receiving the liquidating distribution. Generally, no gain or loss is recognized by the shareholders on the contribution of their C corporation stock to the LLC (Sec. 721). When the corporation liquidates into the LLC, it recognizes gain on the difference between the FMV and tax basis of the distributed assets. The LLC recognizes gain on receipt of the liquidating distribution, which is passed through to its members. The shareholder/members 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 liquidation date.

Asset transfer

The C corporation and its shareholders transfer assets to form an LLC. 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, no gain or loss is recognized on the contribution of assets to the LLC by the corporation or shareholders under Sec. 721. The corporation recognizes a gain on the liquidating distribution of the LLC interests to the shareholders equal to the difference between the FMV and the 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 IRS Letter Ruling 9701029). The shareholders have a basis in the LLC interests distributed by the corporation equal to FMV on the liquidation date. (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 liquidation structure is that transfer taxes imposed by some states on the transfer of real property normally will not be assessed on a contribution of real property rather than a distribution of real property.

Corporate liquidation

The corporation liquidates and distributes its assets to the shareholders. The shareholders then contribute the distributed assets to the LLC in exchange for membership interests in the LLC. 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. No gain or loss is recognized on the contribution of assets by the shareholders to the LLC under Sec. 721. The results of this conversion structure are the same as the first structure discussed above, in which shareholders of the C corporation transfer their stock to the LLC in exchange for membership interests. However, a disadvantage of this type of conversion is that the shareholders are liable for the corporation's debts at the point in time they are considered to hold the corporation's assets and liabilities.

This case study has been adapted from PPC's Guide to Limited Liability Companies, 24th edition (October 2018), by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).