Conversion of C corporation into an LLC.

• Author: Polakov, Adam
• Position: Limited liability company

The major advantage of a limited liability company (LLC) over a C corporation is the absence of double-level taxation of the LLC and its members. However, the tax consequences of converting a C corporation to an LLC could have deleterious effects on both the liquidating corporation and its shareholders. But, if such a conversion is structured correctly within specific boundaries, it could result in significant tax advantages to the ultimate shareholders.

Example: C corporation R is a profitable closely held C corporation (i.e., under Sec. 542(a)(2), more than 50% of its outstanding stock's value is owned by five or fewer individuals during the last half of the tax year). R does not have significant goodwill or other intangibles. It has net operating loss (NOL) carryovers. It anticipates business development to increase substantially in the near future and expects profits to grow rapidly. R wishes to restructure to avoid double taxation and, thus, decides to convert to an LLC.

Contributing C Assets and Liabilities to an LLC

In the example, R can form an LLC with an unrelated third-party investor by transferring its assets and liabilities in exchange for an ownership interest in the LLC. Under Sec. 721(a), neither R nor its shareholders will recognize gain or loss on contributing property to the LLC. R will take a carryover basis in its ownership interest, matching the basis of the assets contributed. However, if R transfers intangibles (i.e., goodwill) to the partnership, it will recognize gain based on the difference between the intangibles' fair market value (FMV) and their basis; see Sec. 721(d). This is a result of the deemed corporate liquidation (discussed below).

R's tax basis in the new LLC will automatically decrease under Sec. 752(b) for any contributed liabilities that the LLC assumed, because debt relief is a deemed cash distribution for tax purposes. At the same time, R's tax basis will subsequently increase for its allocable share of LLC debt, which is a deemed cash contribution for tax purposes, under Sec. 752(a). As long as debt assumed by the LLC on the contribution of assets under Sec. 721 does not result in a negative tax basis, a corporation will not recognize gain on contributing assets to the LLC. However, when the corporation is left with a negative capital account, it will recognize capital gain under Sec. 731(a), to restore the negative capital account back to zero.

Corporate Liquidation/Liquidating Distribution to...