Conversion of a C corporation to an LLC.

• Author: Owen, Sheila A.
• Position: Limited liability company

Only infrequently will it be beneficial for a C corporation to convert into a limited liability company (LLC). Although a conversion allows the C corporation shareholders to continue to have limited liability while acquiring the advantages of passthrough taxation, the tax cost of the conversion normally will be prohibitive. However, in certain situations, a conversion to LLC status may be beneficial.

Warning: The conversion of a corporation into an LLC classified as a partnership can have unexpected and unintended results. For example, in K.H. Co., LLC, T.C. Memo. 2014-31, the Tax Court disqualified an ESOP established by a corporation that subsequently converted to an LLC. Interests in the LLC did not meet the requirements to be qualifying employer securities.

The conversion of a C corporation into an LLC is treated as a complete liquidation of the corporation for tax. The liquidation of a C corporation with appreciated assets can potentially result in double taxation--a tax to the corporation on the distribution of assets under Sec. 336 and another tax to the shareholders under Sec. 331. Even with the lower 21% corporate federal income tax rate (effective after 2017), double taxation can be prohibitively expensive. The following is a brief general discussion of the tax treatment of a C corporation liquidation.

Taxation of C corporation liquidation

Tax on corporation

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 distributed. (Depreciation recapture and similar rules may also affect the character of the gain recognized.) Generally, corporations are allowed 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.

Non-pro rata distribution: Sec. 336(d)(1)(A) disallows corporate recognition of loss on certain distributions to a related person. A shareholder is related to the corporation under Sec. 267 if he or she owns, directly or indirectly, more than 50% in value of the outstanding stock. However, this rule does not apply if the property is distributed pro rata to all shareholders and the property was not acquired by the corporation in a Sec. 351 transaction or as a contribution of capital within the five-year period ending on the date of the distribution. Or, if the shareholders hold unequal percentages of stock, the loss assets can be distributed to the shareholders who do not meet the definition of a related person.

Distribution of disqualified property: Sec. 336(d)(2) covers distributions with a tax-avoidance purpose and can apply even if the loss property is distributed to a 50%-or-less shareholder. Built-in loss property acquired by the corporation in a Sec. 351 transaction or as a contribution of capital within two years of adopting the plan of liquidation is presumed to be tainted. If this anti-abuse rule applies, the basis of the distributed...