Planning considerations when converting a C corporation to an LLC.

• Author: Everett, John O.
• Position: Limited liability company

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...