Business Entities (Part IV)

In previous posts (BUSINESS ENTITIES PARTS II AND III) we concluded that a Limited Liability Company (LLC) is usually the best choice of entity to conduct a business at least for a start up. If this is true for a start up, should existing businesses convert to an LLC? The advantage for an existing C Corp is of course lower taxes. The advantage for an existing S Corp is lower taxes without the strict S Corp eligibility rules. C and S Corps converting to an LLC would do so without sacrificing the personal liability protection of their owners. The conversion of a Sole Proprietorship or Partnership to an LLC would result in liability protection for the business owner without sacrificing the benefit of lower taxes. However, conversion of an existing Corporation to an LLC is treated as a liquidation of the existing entity and a recontribution of the converting entity’s assets to a new entity (the LLC) and may come at a tax cost. The question then for business owners is whether the advantages of an LLC are worth the tax cost.

Conversion of a C Corp to an LLC.

Upon such a conversion, the corporation is deemed to have sold all of its assets at fair market value usually resulting in a gain to the corporation taxed at corporate tax rates of approximately 35% and a liquidating distribution to its shareholders of the fair market value of the corporate assets also usually resulting in a taxable gain to the shareholders taxed at 15%. This is probably too high a tax cost for the benefit, but not in all cases. To the extent the corporate assets have not appreciated in value or to the extent the company or shareholder have unused tax benefits, the tax cost may not be prohibitive.

Conversion of an S Corp to an LLC

A converting S Corp is also deemed to have sold all of its assets at fair market value which usually results in a gain recognized at the corporate level, but in this case passed on to the shareholders to pay tax personally on the gain. There is usually no second level of tax (except in rare cases where the Built-In-Gain tax applies) reducing the cost of conversion significantly, but not eliminating it.

Conversion of a Partnership or Proprietorship to an LLC.

Unlike shareholders and Corporations, Proprietors, Partners and Partnerships have no tax cost when converting their businesses to LLCs. Upon conversion then, the Proprietors and Partners are no longer subject to personal liability for post conversion debts of the entity without a cost. There are issues though that should be considered before conversion. Proprietors and General Partners remain liable though for entity level debts incurred before conversion.

The conversion of a Limited Partnership can result in a reduction of tax basis (and a taxable distribution) for General Partners for non recourse liabilities. The conversion of a General Partnership may result in the former General Partners recognizing income due to the at risk recapture rules unless the entity has no recourse debt or as is usually the case, state law requires the former General Partners to remain liable for pre conversion debt.

Corporations and their shareholders should at least “run the numbers” to see whether conversion is feasible. Proprietors and Partners should probably convert to an LLC absent extenuating circumstances. Every entity (Corporation, Partnership or LLC) should have an agreement among their fellow owners for among other things, restricting ownership to those the current owners can comfortably deal with and to delineate exit strategies.