Converting a sole proprietorship to an LLC

Operating a business as a limited liability company (LLC) has many advantages, notably limited liability for its members or member, if it is formed in a conversion from a sole proprietorship. Consequently, sole proprietors, who do not have limited liability, may wish to operate instead as an LLC.

The conversion of a sole proprietorship into a single-member LLC (SMLLC) is accomplished by filing a certificate of formation (or other required document), paying the appropriate fee, and executing articles of organization and an operating agreement (if required).

The default classification for a domestic SMLLC is a disregarded entity, but the entity can elect to be classified as a corporation. In the past, individual sole proprietors who converted to an SMLLC typically used the default classification, which equated to continued sole proprietorship tax status because they achieved liability protection but were able to continue reporting the business income on Schedule C, Profit or Loss From Business (Sole Proprietorship). Choosing to be classified as an S corporation afforded no more liability protection and resulted in additional cost and complexity due to the need to report business income on Form 1120-S, U.S. Income Tax Return for an S Corporation. Classification as a C corporation was usually even worse, because, in addition to the corporate return requirement, the business’s income was potentially subject to double taxation. However, for tax years starting after 2017, the federal income tax rate on C corporations was reduced to a flat 21%, which means that, in some cases, C corporation status can save taxes compared to sole proprietorship status. However, C corporations are not entitled to the qualified business income deduction under Sec. 199A.

Observation: If a sole proprietor adds another member to a newly formed LLC, it will no longer be an SMLLC. Instead, a domestic LLC with more than one member is classified as a partnership (unless the owners elect corporate status). If a new member is added, the impact of the conversion on any transferred liabilities must be considered. Liabilities of an LLC classified as a partnership are shared between the proprietor and the new member for basis purposes. If the proprietor’s ownership interest in the business is substantially reduced by the conversion, the proprietor may have less basis available for deducting LLC losses or may recognize a gain on the contribution of assets and liabilities to the LLC.

One question that may arise is whether the owner of a de minimis interest in an LLC will be considered a second member, causing the LLC to be classified as a partnership rather than a disregarded entity. IRS Letter Ruling 199911033 provided that if an LLC is owned by two members, one of whom has no real beneficial interest in the LLC, that owner is disregarded for tax purposes, thereby creating an SMLLC. The ruling states that the determination of whether the parties came together to form a partnership is based on the facts and circumstances of the case. Factors to be considered, as indicated by the Office of Chief Counsel in the letter ruling (citing Luna, 42 T.C. 1067 (1964)), include:

• The parties’ agreement;
• Whether business is conducted under the joint name of the parties;
• Whether partnership returns or other indications of partnerships were filed;
• Whether the parties represented that they were joint venturers to any third party;
• Whether separate books were maintained for the venture;
• Whether each party made a contribution to the venture;
• Whether each party had a proprietary interest in the venture, receiving an allocation of income;
• Whether either party was the agent or employee of the other party;
• The type and degree of control each party exercised over the venture;
• Whether each party had the right to withdraw funds from the venture; and
• Whether the parties exercised mutual control and responsibility for the venture.

The ruling states that the IRS will rely on a facts-and-circumstances argument in determining whether an LLC has two or more members and is thus classified as a partnership for tax purposes. However, the IRS can also use the anti-abuse regulations (Regs. Sec. 1.701-2) to recharacterize a transaction that the parties treat as a partnership if it does not reflect the intent of the partnership rules.

In another ruling (Letter Ruling 199914006), the IRS ruled that where an LLC had two members but one member was not entitled to receive any distributions, income, gain, profit, loss, deduction, credit, or other allocation from the LLC and had no management, approval, voting, consent, or veto rights in connection with the LLC, the LLC was not a partnership but a disregarded entity. The two parties could not have a partnership if they did not enter into the agreement to operate a business and share profits and losses.

Taxpayer identification number

Generally, an SMLLC owned by an individual that is a disregarded entity (i.e., is treated as a sole proprietorship for tax purposes) uses the sole proprietor’s taxpayer identification number (TIN). However, if a sole proprietorship converts to an SMLLC and the SMLLC will be liable for employee payroll taxes, the SMLLC must obtain its own TIN.

Possible recapturen undern the at-risk rules

The conversion of a sole proprietorship into an LLC may result in the former proprietor’s 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 at-risk rules under Sec. 465 and if losses have been recognized in prior years.

A conversion may, but is not likely to, cause a proprietor to suffer a reduction in the amount at risk. The reason a reduction seldom occurs is because the proprietor generally remains liable for debts incurred prior to the conversion. Any reduction that does occur is a result of the rules providing that members are at risk for recourse debts but not for nonrecourse debts (except for qualified nonrecourse financing).

Because LLC debts typically are all treated as nonrecourse debts, the proprietor’s at-risk amount may be reduced if there is no liability with regard to the business’s debts after conversion. This reduction in at-risk amounts can result in a former proprietor recognizing gain to the extent losses previously deducted must 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 amount at risk.

Example. Sole proprietor recognizes gain because of at-risk rules: J owns a sole proprietorship that operates a retail shop. On the advice of his lawyer, J decides to convert the sole proprietorship to an SMLLC that is disregarded for tax purposes. The only debt of the proprietorship is a $100,000 loan from a local bank for which J has personal liability. At the time of the conversion, the bank agrees to substitute the SMLLC as the borrower and release J from personal liability on the note. So, after the conversion, the note is secured by the assets of the SMLLC.

Prior to the conversion, J had contributed $75,000 of cash to the operation of the retail shop and deducted $150,000 of loss from its operation. Because the $100,000 loan was recourse, it provided him with an at-risk amount. Consequently, J’s amount at risk in the activity prior to the conversion was $25,000 ($175,000 basis minus $150,000 losses).

After the conversion, J is no longer at risk for the $100,000 note, which is now exculpatory debt for which J is not personally liable. Consequently, J must recapture his previously deducted losses to the extent his at-risk amount has fallen below zero. The amount reported as income is $75,000, J’s $25,000 amount at risk, reduced by the $100,000 of debt assumed by the SMLLC.

Observation:The more likely outcome would be that the bank will not release J from personal liability for the debt, in which case his at-risk amount will not change from what it was when he operated as a sole proprietorship.

Contributing assets to the new LLC

If the sole proprietor contributes assets to an SMLLC classified as a disregarded entity, no transaction occurs for federal income tax purposes because the taxpayer is deemed to continue holding the assets as a sole proprietor. (However, for state law purposes, the LLC holds title to the assets of the business after the conversion.) If the sole proprietor contributes the assets to a new LLC that has an additional member (and is classified as a partnership), the taxpayer is deemed to contribute the assets of the business, subject to any liabilities, to the newly formed LLC under the general nonrecognition rules of Sec. 721.

Available accounting methods

A disregarded SMLLC must use the accounting methods of the owner. Because most sole proprietorships use the cash method, a sole proprietor considering conversion to an LLC classified as a partnership (because there will be one or more new members) needs to determine if the cash method will still be available. In many cases, the new LLC can continue using the cash method, provided it is not a tax shelter. If the new LLC has a C corporation partner or is engaged in a business where the production, purchase, or sale of merchandise is an income-producing factor, it must also meet the annual gross receipts test under Sec. 448(c) to continue using the cash method.

Self-employment tax

Net income from a business classified as a sole proprietorship for federal income tax purposes is generally subject to self-employment tax. If the business is converted into an SMLLC, this same rule will apply because the existence of the LLC is disregarded for federal taxes (unless corporate classification is elected). If an additional owner is admitted when the conversion from sole proprietorship to LLC occurs, the tax treatment of the owners may be different.

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide‘s Limited Liability Companies topic. Published by Thomson Reuters, Carrollton, Texas, 2024 (800-431-9025; tax.thomsonreuters.com).