Tax Consequences of Changing Business Entity
Current businesses may consider changing their type of entity for a number
of reasons. It is very important that they consider the tax consequences
of making the change. This material discusses the various types of change
and what tax liability can be expected.
2: INCOME TAX CONSEQUENCES OF CHANGING BUSINESS ENTITY
an existing entity, the decision to change the business form and operate
as a different business entity must be analyzed to determine the feasibility
and tax consequences.
Feasibility. First, is it even possible to
get from the current entity to the new entity? Whether it is possible
to convert an existing business to a new form of entity refers to the
need for an enabling statute, an allowable number of owners (two in most
states), and the cooperation of creditors. A second statute may be required
whenever the particular form of business being conducted is restricted
to specific forms of entity, such as the conduct of professions such as
law, medicine, or public accounting. Also, if the business has secured
creditors who may object to the transfer of assets, they must be appeased.
the feasibility requirements are met, does it make sense? Do the tax and
nontax strengths outweigh the tax and nontax costs of the conversion?
Tax costs are dramatically different for each of the different tax entities.
With few exceptions, proprietorship and partnership conversions can be
accomplished tax-free. Conversions from a corporation to a different entity
can involve a corporate liquidation. That means two possible levels of
tax for a C corporation and for an S corporation. However, if the assets
and stock have depreciated rather than appreciated, it may be clearly
advantageous to liquidate.
CONVERSION OF A SOLE PROPRIETORSHIP TO AN LLC
sole proprietor has unlimited liability for his or her business debts
and action. An LLC can protect the business owner’s personal assets
states have amended their statutes to allow one-member LLCs, but
some states still require two or more members.
a sole proprietorship is converted to a one-member LLC, the LLC is disregarded
for tax purposes unless the member elects to have it taxed as a corporation.
The sole proprietor can contribute all of the assets of the business,
subject to the associated liabilities, to the newly formed entity. Although
the legal owner of the asset changes, the transfer has no tax effects
if the LLC is a disregarded entity, since the sole proprietor remains
the owner of the assets for tax purposes. When a sole proprietor forms
an LLC with another member or a one-member LLC converts to a two-member
LLC (whether by selling an LLC interest to the new member or by having
the new member contribute cash or property to the LLC), the transaction
is treated as a partnership formation. (Rev. Rul. 99-5, 1999-5 I.R.B.,
I.R.C. §§721; 722; 723; 1001; 1223).
may be issues other than federal tax issues to consider, depending
on state law. Other issues may include homestead exemption, franchise
tax, filing new articles of organization, and filing new mortgages
or other documents to secure debt.
general, contributions to an LLC taxed as a partnership are tax-free
under Code §721. There are exceptions and special rules for contributions
of debt and contributions of services. If an interest in an LLC is issued
in exchange for services, the exchange is taxable if the interest is
an interest in capital and may be taxable if it is an interest in profits
How a sole proprietorship
converted to an LLC will be treated for federal tax purposes depends on
the number of members and the check-a-box election. A one-member LLC is
a disregarded entity reported on the member’s Schedule C or F. A two-or-more-member
LLC is treated as a partnership. An LLC (whether it has one member or
more than one member) can elect to be taxed as a corporation by filing
Form 8832, Entity Classification Election.
that convert to an LLC may also need to consider at-risk recapture under
I.R.C. §465(e), application of self-employment tax, application of state
unemployment, and workers compensation.
Smith operates a vegetable growing enterprise. He grows and delivers vegetables
to the local grocery. He has operated in the past as a sole proprietor
reporting taxable income and expenses on Schedule F. He is considering
starting a pick-your-own enterprise and wants the added liability protection
of an LLC. Joe’s state statute provides for a one-member LLC. He has the
following assets and liabilities:
|| Tax Basis
With the approval
of Joe’s creditors, Joe will contribute the above assets and liabilities
to Joe’s U-Pick, LLC.
Joe recognize any of the $87,500 taxable gain by forming Joe’s U-Pick?
his basis from the debt is the same as the deemed distribution resulting
from the LLC’s assumption of his debt.
will Joe report income and expenses for tax purposes?
will continue to report on Schedule F, unless he elects to be taxed as
a corporation on Form 8832.
OF A PARTNERSHIP OR LLC TO A CORPORATION
A partnership or
LLC can be incorporated three different ways: (1) a transfer of assets
and liabilities from the partnership or LLC to the corporation in exchange
for corporate stock and any other consideration, followed by the liquidation
of the partnership; (2) a distribution of partnership or LLC assets and
liabilities to its partners or members, who then transfer the assets and
liabilities to the corporation in exchange for stock and other consideration;
or (3) the contribution by the partners or members of their partnership
or LLC interests to the corporation in exchange for corporate stock and
The IRS has ruled
that the tax consequences with regard to partnership incorporation are
determined by the method that is used. (Rev. Rul. 84-111, 1984-2 C.B.
88). Incorporation of an LLC that is taxed as a partnership will be subject
to the same rules. As a general rule, any of the methods will result in
tax-free incorporation, but the method may affect the tax consequences.
Thus, practitioners must determine the tax implications at each step of
Jones and his dad have operated as a farm partnership for many years.
They are equal partners. They bring you their records for 1999. They tell
you that they incorporated their farming business in February 1999 because
their insurance agent told them they needed to limit their liability from
the farming operation. The balance sheet for the new corporation for 2/28/99
reflects the following:
Accumulated Depreciation (160,045)
Note - Vendor # 1
Note - #234
Note - #345
the initial contribution to a corporation in exchange for corporate stock
a tax-free exchange?
as explained below. I.R.C. §351 states:
Sec. 351. ransfer
to corporation controlled by transferor.
rule. No gain or loss shall be recognized if property is transferred
to a corporation by one or more persons solely in exchange for stock
in such corporation and immediately after the exchange such person or
persons are in control (as defined by §368(c)) of the corporation.
Thus, it appears
that the above transaction would be tax free, if the individuals making
the transfers control the new corporation. However, I.R.C. §357(c) must
Sec. 357. Assumption
Liabilities in excess of basis.
In general.In the case of an exchange—
To which §351 applies, or
To which §361 applies by reason of a plan of reorganization within the
meaning of §368(a)(1)(D), if the sum of the amount of the liabilities
assumed exceeds the total of the adjusted basis of the property transferred
pursuant to such exchange, then such excess shall be considered as a gain
from the sale or exchange of a capital asset or of property which is not
a capital asset, as the case may be.
Excluded. Since the amount of total liabilities transferred to the new
corporation exceeds the basis of the assets transferred, Jim and his father
must report taxable gains on their 1999 individual tax returns.
of the Taxable Gain on Transfer
liabilities transferred to corporation
Chemical Note which, if paid, is deductible
Basis of assets transferred to corporation
of taxable gain on the conversion
Jim and his father
would each report half of the gain, or $38,622, in Part II on their 1999
Forms 4797, Ordinary Gains and Losses.
OF A C CORPORATION TO ANOTHER ENTITY SUCH AS AN LC
Conversion of a C
corporation to an LLC can create significant negative tax consequences.
Liquidation can be taxable to both the corporation and its shareholders.
If the corporation’s assets and/or stock have appreciated, the tax cost
of liquidation can be prohibitive. If the corporation has losses, there
may be little or no tax cost. Each situation must be analyzed to determine
feasibility. Assuming that state statutes allow the conversion and creditors
are agreeable, the tax cost of liquidation must be weighed against the
benefits from conversion to an LLC.
Liquidation of a
corporation is generally a taxable event for both the corporation and
its shareholders. I.R.C. §336(a) states that a liquidating corporation
recognizes gain on the distribution of appreciated property, recognizes
depreciation recapture as if the corporation had sold each of its assets
at its fair market value, and generally recognizes loss on the distribution
of depreciated property. I.R.C. §331(a) provides that the corporation’s
shareholder(s) also recognize gain or loss on the distribution equal to
the air market value of the distribution received minus the basis in
the shareholder’s stock.
If the tax cost associated
with a complete corporate liquidation is too great, alternatives include:
- Parallel operations
- Installment sale
followed by liquidation
- Parallel operations
coupled with sale of assets
- Parallel operations
coupled with leasing and/or licensing of assets
- Joint venture
No matter what conversion
technique is used to convert a business from pure corporate ownership
to substantial or complete LLC ownership, valuation of the business is
a key issue and potential point of attack by the IRS. Any corporate conversion
technique that does not involve liquidation of the corporation is an invitation
to the IRS to see whether it can come up with some variation of a substance-over-form
argument that would result in more tax being due. The most dramatic argument
for the IRS is that there has been a constructive liquidation of the corporation.
The IRS has ample
weapons—the accumulated earnings tax, the personal holding company tax,
and the S corporation passive income limitation—to keep taxpayer advantages
from the operation of passive corporations within reasonable bounds. All
alternatives to complete liquidation carry significant risks.
should be given before converting a C corporation to an LLC.
of an S corporation to another entity such as an LLC has similar
tax consequences at the corporate level—gain or loss is recognized
on sale or distribution of assets at fair market value. However,
gain recognized by the corporation passes through to the shareholders
and increases the shareholders’ basis in their shares of stock,
which reduces their gain upon liquidation of the corporation.
© 2001 Copyrighted
by the Board of Trustees of the University of Illinois