Please Note: Because of the ommission of a very important word ("no") in the March/April issue an erroneous statement appeared this article. The last sentence in the paragraph immediately below the heading "Basic LLC/S Comparison" should have read, "the formation of an LLC is governed entirely by state law, and NO federal income tax election is involved..." The mistake has been corrected in the text below and was not the fault of the authors. The editors apologize.
P R O B A T E   &   P R O P E R T Y
March/April 2000
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Converting an S Corporation to an LLC- and Conversion Bypass with Parallel Structure 
By B. Dane Dudley, Steven M. Fast and Myles J. Laffey

The S corporation, former darling of the family business tax adviser, is now the senior citizen of planning choices for most new operations-giving way to the more flexible limited liability company (LLC) or, in some cases, the limited liability partnership (LLP). Can the exiting S corporation park its Model T and take to the highway in an LLC? Is there another alternative? Yes, but only if counsel carefully chooses the route.

Basic LLC/S Comparison 

To be treated as a pass-through entity for tax purposes, a corporation must elect S status under Code § 1362, but an S corporation is an ordinary corporation under state law for nontax purposes. The formation of the LLC is governed entirely by state law, and no federal income tax election is involved (except in the unlikely event that there is a desire to have the LLC taxed as a corporation).

An S corporation is limited by Code § 1361 to 75 shareholders and one class of stock. As a result, it can-not make any special allocations of income, deductions, gain or loss among its shareholders, although it can permit different voting rights. The LLC, however, may have unlimited members, and it can make special allocations among its members so long as the allocations have "substantial economic effect."

Only individuals (excluding nonresident aliens), qualifying trusts and estates and tax-exempt organizations can own S corporation stock. Code § 1361. A transfer of stock to a nonqualifying member results in the loss of the S election. An S corporation cannot be an insurance company, a financial institution using the reserve method of accounting for bad debts, a company making the Puerto Rico tax credit election or a DISC (or former DISC). Code § 1361. No federal tax limitations govern who, or what entity, can own an interest in an LLC. 

Unlike a C corporation, an S corporation generally does not pay entity level federal income tax; its profits and losses are passed through to its shareholders. Code §§ 1363, 1366. An S corporation that was formerly a C corporation may face taxes on built-in gains and excess passive income. An LLC with more than one member is treated as a partnership for federal tax purposes and thus avoids any entity level tax. An LLC with a single owner is disregarded as an entity and will be treated as a sole proprietorship for federal income tax purposes. Treas. Reg. § 301.7701-3(b).

An S corporation shareholder does not receive an increase in the basis of his or her stock when the S corporation borrows money, unless the S corporation borrows the money from the shareholder. The tax basis of a member's interest in an LLC does, however, increase when the LLC borrows money from any source. Equally important, when an S corporation distributes appreciated property, the distribution is generally a taxable event that can cause gain. A distribution of appreciated property by an LLC usually is not a taxable event.

Although an S corporation can have a single shareholder, a single member LLC is not available in every jurisdiction (for example, California, the District of Columbia and Massachusetts all require that an LLC have at least two members). In those jurisdictions where it is permitted, a single member LLC still provides the liability protection of a corporation even though it is disregarded for federal tax purposes and is treated as a sole proprietorship.

  Basic Considerations in Converting 

States typically allow a corporation to merge into an LLC. See, e.g., Del. Code. tit. 8, § 264. If the participants in the merger do not specify otherwise, the conversion is likely to be treated as described in "method one" below. See PLR 9543017. Such a merger will not be a tax-free reorganization because the LLC is not treated as a corporation for tax purposes. Code § 368(a)(1)(A). (If the sole shareholder of an S corporation wants to form a single member LLC in a state in which two members are required, it may be necessary to find, or create, a second member or form the LLC in a state that allows a single member LLC.)

The key consideration, of course, is tax. Conversion will cause significant tax if the S corporation has appreciated property or good will because the S corporation (and thus the shareholder) will recognize gain. Any gain can be offset by losses.

Conversion to a Single Member LLC 

A single member LLC is treated as if its assets were owned directly by its sole member. Thus, the conversion of a wholly-owned S corporation into a single member LLC is treated as a liquidation of the S corporation. The S corporation will recognize gain or loss in most cases on the distribution of property as if its property were sold at fair market value. Code § 336(a). The S corporation will not, however, recognize loss in a distribution to its sole shareholder if the distributed property had been acquired within the prior five years through a contribution to capital by the shareholder. Code § 336(d). If the distributed property is subject to liabilities that exceed the actual fair market value of the distributed property, or if the shareholder assumes those liabilities in connection with the distribution, the fair market value of the distributed property will be treated as the amount of the liability itself. Code § 336(b). Gain or loss that is recognized by the S corporation is passed through to the shareholder. Code § 1366. Any gain will increase the basis of the shareholder's stock. Code § 1367. The amount that the shareholder receives in a liquidating distribution is treated as payment for the stock. Code § 331. Because the shareholder's basis has increased by the gain that the S corporation recognizes on the liquidation, the shareholder generally will not be subject to a second tax when he or she receives the property from the S corporation. Unless there are liabilities, the fair market value of the property received will be the basis of the membership interest in the LLC. Code § 334. The transfer of assets to a single member LLC has no tax effect at any stage because it is disregarded for federal income tax purposes.

Conversion to a Multi-member LLC 

Although there are many variations, there are three typical methods of converting from an S corporation to a multi-member LLC treated as a partnership for tax purposes. Each method has different consequences and, in some cases, a disastrous tax impact.

Method one. The first method is the formation of an LLC by the S corporation, followed by the liquidation of the S corporation (or merger of the S corporation into the LLC).  

  • Step one. The S corporation establishes the LLC and transfers its assets to the LLC in exchange for LLC membership interests. At this point, the LLC has only a single member, the S corporation, and the transfer will be ignored for federal income tax purposes. See PLR 199909054. 
  • Step two. The S corporation then distributes its interests in the LLC to the S corporation shareholders in liquidation. The S corporation will recognize gain or loss on the distribution of the LLC interests as if it had sold those membership interests at fair market value. Code § 336. The gain or loss that the S corporation recognizes is then passed through to its shareholders. Code §§ 1366, 1367. The LLC membership interests that the shareholders receive in the liquidating distribution are thus treated as payment for the shareholders' stock. Code § 331. Because the basis in the shareholders' stock is increased by the gain recognized by the S corporation on liquidation, the shareholders are not subject to additional tax when they receive the membership interests in the LLC from the S corporation.

Method two. The second method is a liquidation of the S corporation, followed by formation of the LLC by the former shareholders of the S corporation. 

  • Step one. The S corporation distributes its assets to its shareholders in liquidation. Gain or loss is recognized on the distribution of assets as if they were sold at fair market value. Code § 336. The gain or loss is then passed through to the shareholders and increases or decreases their basis. Code §§ 1366, 1367. The property that the shareholders receive from the S corporation in the liquidating distribution is treated as payment for the shareholders' stock. Code § 331. Again, because the basis in the stock is increased by the gain that the S corporation recognizes on liquidation, the shareholders are generally not subject to a second tax when they receive property in liquidation of the S corporation. The fair market value of the property is the shareholders' basis. Code § 334. 
  • Step two. The shareholders then contribute the assets to a newly formed LLC. Formation of this LLC will not result in tax either to the LLC or to its members. Code § 721. The fair market value of the property received in step one will then be the basis of each member's LLC interest. Code § 722.

Method three. The third method is the contribution by S corporation shareholders of their stock to a newly formed LLC, followed by liquidation of the S corporation and distribution of its assets to the LLC. This method results in a double tax and should clearly be avoided. 

  • Step one. The S corporation shareholders form an LLC and transfer their stock in the S corporation to the LLC in exchange for membership interests. The transfer of stock to the LLC by the S corporation shareholders generally will be tax free. Code § 721. Of course, to the extent that the fair market value of the S corporation stock exceeds its basis, the lurking gain will be allocated back to the contributing shareholders. Code § 704(c). The LLC will have the same basis in the S corporation stock as the contributing shareholders had in that stock, and the shareholders will have the same basis for their membership interests in the LLC as they had for their S corporation stock. Code §§ 722, 723. 

    So far, the tax results seem acceptable. The problem, however, is that the transfer of stock to the LLC will terminate the S corporation's S election because the LLC is not an eligible S corporation shareholder. The termination cuts off the pass through of gain and loss to increase or decrease shareholder basis. If the transfer of S corporation stock to the LLC and the S corporation liquidation do not occur simultaneously, the S corporation will also have a short tax year as an S corporation and a short tax year as a C corporation. Code § 1362(e). 
  • Step two. The S corporation liquidates and distributes its assets to the LLC. In the distribution, the S corporation recognizes gain or loss as if the property were sold at its fair market value. See Code § 336. Ordinarily, any gain or loss at the S corporation level is passed through to the shareholders of the S corporation, increasing or decreasing their basis in their stock. Code § 1366. Because the transfer of S corporation stock to the LLC terminates the S election, however, the S corporation reverts to a C corporation that provides no pass-through treatment. Thus, the LLC does not receive an increase in its basis in the S corporation stock to offset gain or loss.

The liquidation property that the LLC receives is treated as payment for the stock that the LLC holds. The LLC will recognize gain to the extent of the difference between its basis in the S corporation stock and the fair market value of the liquidation property distributed. In other words, the termination of S status causes the shareholders to pay a second level of tax because of the loss of a step up in basis.

Conversion Bypass:
 Parallel Structure

 An alternative to the conversion of an S corporation into an LLC is to establish the LLC as an entity parallel to the existing S corporation and then conduct business through the LLC. This approach requires very careful planning when the operations of the S corporation taper or terminate and the LLC begins to conduct business. The IRS might find that the S corporation transferred its goodwill to the LLC, even where no tangible assets were transferred to the LLC. In effect, the IRS would treat the S corporation as having made a constructive distribution of its assets to its shareholders, who then contributed those assets to the LLC-with the result that the S corporation would recognize gain.

Suppose, however, that the ongoing business needs the assets that are currently owned by the S corporation. One option would be for the S corporation to sell its assets for cash or other property, in which case the S corporation would recognize gain to the extent of the difference between the amount received and the S corporation's basis in the assets. Code § 1001. This gain, in turn, would pass through to the shareholders of the S corporation. The S corporation would not recognize loss because the S corporation and the LLC would be related. Code § 267.

Suppose the S corporation sold its assets to the LLC on an installment basis. The S corporation would then recognize recapture income (as ordinary income under Code § 1245) in the year of sale. Code § 453(i). Because the LLC and S corporation are related for the purposes of the installment sale as well as under Code § 453(g), the S corporation would recognize gain from the sale of depreciable property (including goodwill) unless it can establish to the satisfaction of the IRS that one of the principal purposes of the sale was not federal income tax avoidance. Code § 453(g). 

If the installment obligation is acquired during the 12 month period beginning on the date on which the S corporation adopted a plan of complete liquidation and the liquidation is completed within the same 12 month period, the S corporation shareholders may be able to treat the receipt of payments on the installment obligation (as opposed to the receipt of the installment obligation itself) as payment for their stock. Note, however, that installment obligations from the sale of certain types of property are not eligible for this treatment.

Another alternative is for the S corporation to lease or license its assets to the LLC. This is likely to attract IRS scrutiny. The IRS might take the position that the S corporation was, in effect, liquidated and its assets transferred to the LLC notwithstanding the lease.

The S corporation could also become a member of the LLC through the contribution of assets to the LLC. The S corporation could then remain in place, passing through its income and losses from the LLC to the S corporation shareholders.

If the S corporation is not liquidated and continues as an entity, and if it has C corporation earnings and profits (i.e., it converted at some time in the past from a C corporation to an S corporation), then the S corporation will be subject to the passive income limitation of Code § 1362. This in turn could terminate S status if the S corporation had C corporation earnings and profits at the close of three consecutive years and more than 25% of the S corporation's gross receipts for each of those years consists of passive income.

Conclusion 

Conversion to an LLC is definitely an appropriate consideration, especially when S corporation restrictions are incompatible with current circumstances. The conversion of an S corporation to an LLC obviously should be accomplished by either method one or method two. Conversion is most attractive if there has been little appreciation in S corporation asset value or if there is offsetting loss. Otherwise, a conversion bypass with a parallel structure LLC should be examined, with care taken to avoid an IRS claim of constructive liquidation based on the rounding up of the usual suspects-step transaction, lack of business purpose, form over substance and lack of economic reality-to attack the parallel structure. The best defense is to bring to the parallel structure some new parties or at least substantial new capital from old parties to dispel these arguments.

 


Steven M. Fast is a partner and B. Dane Dudley is an associate with Day, Berry & Howard LLP in Hartford, Connecticut. Myles J. Laffey is an associate with Tedford, Gianni & Jensen, P.C., in Mystic, Connecticut.

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