Converting A C corporation into an LLC.

• Author: Ellentuck, Albert B.
• Position: Limited liability company

ALTHOUGH CONVERTING A C CORPORATION into a limited liability company (LLC) allows the C corporation shareholders to continue to have limited liability while acquiring the advantages of passthrough taxation, the heavy tax cost of the conversion normally will be prohibitive. However, in certain situations in which the corporation has depreciated assets or significant net operating loss (NOL) carryovers, conversion to LLC status may be beneficial. See the checklist at the end of this article to ensure that the significant issues have been addressed when converting to LLC status.

Conversion of a C corporation into an LLC involves the liquidation of the corporation, which results in a double tax--one on the corporation's distribution of assets (Sec. 336) and one on the distribution to the shareholders (Sec. 331).

Taxation of C Corporation Liquidation

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 the corporation distributes. (Depreciation recapture and similar rules may also affect the character of the gain recognized.)

Generally, Sec. 361(d) allows corporations 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. Disqualified property is any property the corporation acquires in a Sec. 351 transfer or as a contribution to capital during the five-year period ending on the distribution date, or any property whose adjusted basis is determined by reference to the adjusted basis of such property.

In Letter Ruling 200613027, the IRS ruled that the conversion of an LLC to a corporation followed by a rescission of the incorporation did not result in a taxable liquidation of the corporation. Instead, the entity was treated as an LLC for the entire tax year, and the incorporation transaction was ignored.

Sec. 331 governs the tax treatment of liquidating distributions at the shareholder level. The Sec. 331 rules require the liquidating distribution to be treated as full payment in exchange for the shareholder's stock. The shareholders must...