Tax Implications of Converting an LLC to a Corporation | John R. Dundon
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Tax Implications of Converting an LLC to a Corporation

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Tax Implications of Converting an LLC to a Corporation

Recently a husband/wife owned 3 LLC’s that each successfully elected to be treated as S-corporations for federal income tax purposes by filing IRS Form 2553 – Election by a Small Business Corporation. Subsequently, this great couple found themselves entertaining a rather complicated buyout offer of all 3 of their LLCs. This post addresses the tax implications of converting an LLC to a Corporation as part of a buyout strategy…

Their fundamental question: can the LLCs do a tax-deferred corporate reorganization under IRC 351-368?

What are the tax consequences of converting an LLC to an S Corp? 

The husband-wife team was concerned that their LLCs electing S corporation status might not be able to engage in a corporate reorganization because the LLC’s were comprised of ‘member interests’ and they did not have any “stock†– which is a key term in IRC 368 governing statute. 

This drove them into the weeds of IRC 708 pertaining to the merger of two or more partnerships. Fortunately, they came to me and turns out the main concern here is converting the legal form of the businesses from LLCs to a corporation which can require a state-licensed business attorney.

Keep in mind, however, the husband/wife converted each of their LLC’s tax status from a partnership to a corporation without changing the LLC’s legal form in Colorado. As such they only needed to:

A note on navigating regulations. 

There is no separate IRS tax category for LLCs and fortunately for these taxpayers they successfully elected ‘S’ corp status, so it turns out ultimately that they were fine as structured for a tax-deferred reorg under IRC 368. Nevertheless, this conundrum allowed me the opportunity to drill down into the ‘check the box’ regulations.

Check the Box Regulations

Like most things, these regulations start with eligibility.

Any entity that is not a corporation may ‘check the box’, as it were, requesting the election to be treated as an ‘S’ corporation or ‘C’ corporation. There is a BIG difference well beyond the scope of this post.

As per Treas. Reg. 301.7701-3(a), if ‘eligible’ one of the election possibilities is to be classified as an “associationâ€Â 

As per Treas. Reg. 301.7701-2(b) “for federal tax purposes†the term corporation means:  

  • (1)  A business entity organized under a federal, state or tribal statute, if the statute describes or refers to the entity as incorporated or as a corporation. . . . [or]
  • (2) An association (as determined under §301.7701-3.â€Â 

Treas. Reg. 301.7701-3(c)(1)(v)(C) states that “[a]n eligible entity that timely elects to be an S corporation . . . is treated as having made an election under this section to be classified as an association . . . .â€

What does this collectively mean?

  • An LLC is an “eligible entity,†and it can elect to be an association.
  • An LLC electing “association†status is treated “for ALL federal tax purposes†as a corporation.

The term “for federal tax purposes†appearing in both 301.7701-2 and 301.7701-3 means that the entity is electing corporate treatment for ALL federal tax purposes. 

Basically, when husband/wife’s LLCs in question were granted S elections, they were electing to be associations, which in turn means that they were classified as corporations “for ALL federal tax purposes.â€

Treatment under IRC 368 of LLCs that Have Elected Corporation Status

The IRS has issued a number of private letter rulings that approve IRC 368 transactions involving LLCs that elected corporation status. The four PLRs below indicate that the IRS deems LLC ownership interests as “stock†for IRC 368 purposes. 

Although a PLR is only relied upon by the specific taxpayer, it is a reasonable indication of how the IRS may view an issue.

  1. PLR 200204004 – An LLC classified as a corporation was the acquirer in a Type A merger.  A Type A merger requires that the target shareholders receive stock of the acquiring corporation.
  2. PLR 200633008  – This PLR will qualify as reorg under Code Sec. 368(a)(1)(F) as a Type F exchange where no gain or loss will be recognized by either corp. for exchange or receipt of assets and liabilities.
  3. PLR 201127004 – Deemed transfer by a subsidiary of substantially all of its assets to parent solely in exchange for parent voting stock and parent’s assumption of subsidiary’s liabilities, followed by distribution by subsidiary of parent voting stock to parent in complete liquidation, will ALSO qualify as Code Sec. 368(a)(1)(C) reorganization, which won’t be disqualified or recharacterized by reason of reincorporation. Subsidiary and parent will each be “party to reorganization†under Code Sec. 368(b); , with no gain or loss being recognized by either.
  4. PLR  200009026 – In this PLR an LLC classified as a corporation owned another LLC, also classified as a corporation, in a Type C exchange.

In a Type C exchange, shareholders of the target must receive “voting stock†of the acquirer or its parent.  In the fourth PLR above, target shareholders were to receive voting membership interests in the “Acquiring Parent.â€Â  The IRS ruled as follows:

The acquisition by Acquiring of substantially all the assets of Target, solely in exchange for Acquiring Parent voting member interests and the assumption by Acquiring of liabilities of Target, followed by the distribution by Target of the Acquiring Parent voting member interests to its shareholders in complete liquidation, will be a reorganization under section 368(a)(1)(C).

The PLR in particular indicates that the IRS regards membership interests in LLCs that have elected corporate status to be “stock†for purposes of IRC 368.

PLR  200009026

The IRS’s Approach to Transfers of Assets and Interests

In Revenue Ruling 84-111, the IRS briefly describes three more specific methods of converting an LLC to a corporation when using nonstatutory conversion. Each of these three methods has a shorthand name, as follows:

  • “Assets-over†conversion: the LLC transfers all of its assets and liabilities to a newly-formed corporation in exchange for all outstanding stock of the corporation. Then the LLC terminates by distributing all of the corporation’s stock to the LLC members. Assets transfer over to the new corporation.
  • “Assets-up†conversion: the LLC distributes all of its assets and liabilities to its members to terminate the LLC. Next members transfer all the assets received from the LLC to the corporation in exchange for all outstanding stock of the corporation plus the corporation’s assumption of all of those LLC liabilities. Assets transfer “down†to LLC members and then “up†to the new corporation.
  • “Interests-over†conversion: the LLC members transfer their LLC interests to the newly-formed corporation in exchange for all the outstanding stock of the corporation, which terminates the LLC, with all of the LLC assets and liabilities becoming assets and liabilities of the corporation. “Interests-over†because LLC members transfer their “interests over†to the new corporation.

Revenue Ruling 84-111 does not address how the IRS views statutory conversions or statutory mergers.

However, a 2004 IRS bulletin clarifies that absent a declaration, the IRS will treat these types of conversions as essentially equivalent “asset-over†conversions. More specifically, as stated in the 2004 bulletin, the IRS will assume that LLC members contribute “all LLC assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the LLC liquidates distributing the stock of the corporation to its members.â€

Business Structures Involved

The factors to consider when converting your small business from an LLC to a corporation vary depending on multiple factors outside of the realm of taxation. It is a best practice to bring in a business attorney to work with your tax adviser in addressing together the following:

  • LLCs taxed as partnerships
  • LLCs taxed as corporations
  • LLCs taxed as “disregarded entitiesâ€
  • C corporations (which pay corporate taxes)
  • S corporations (pass-through taxation, shareholders pay tax)
  • multiple methods for converting your business—including statutory

General Methods for Converting Your LLC

  • Statutory conversion
  • Statutory merger
  • Non-statutory conversion

Why is this important from a tax perspective?

The tax differences between converting an LLC taxed as a partnership to a C corporation and converting an LLC taxed as a corporation to an S corporation through a statutory conversion are complicated. Most recently I took a closer look at the tax implications surrounding multi-member LLCs taxed as S corp converting to a publicly traded C corporation.

Bottom line, the only part of the deal subject to taxation that I am currently researching is the cash the seller takes out of the deal. For more on this contact me anytime at your convenience.