In this week’s blog we will look at the US Federal Tax Implications of converting a Single Member Limited Liability Corporation (LLC) to a Corporation or Multi Member LLC.
In many situations where the owner of a new company does not have the resources to create a corporation, he or she may opt for an LLC instead. This could also be the best course initially due to the separation of company and personal assets and the usual option for less taxation to company revenue. However, remember that hindsight is 20/20 and at some point, it may be more beneficial to convert the business from an LLC to a Corporation.
This conversion should be carefully examined by business owners, both in terms of the change in legal form and in tax status. For purposes of this article, we will focus on the US Federal Tax implications of such a conversion.
We will broadly examine the pitfalls that local and global tax advisors should be cognizant of when a client wants to convert their business to a corporation.
When an LLC is first formed, the owner or partners elects a taxation status for the LLC. This election affects how the LLC will be taxed for US Federal Tax Purposes.
For Federal Tax Purposes, an LLC can be treated as either a corporation, partnership, or as a disregarded entity. The LLC business owner uses Form 8832 – “Entity Classification Election” to elect how they would prefer their business to be taxed.
There are separate tax scenarios your LLC could fall under, but we will focus on a single member LLC in this article. To read more about LLCs, click this link to go to our series.
A single-member LLC that does not file Form 8832, will file its taxes like a sole proprietorship which is the default tax status of single member LLCs. This means that, even though it is legally a separate entity from your person, you and your small business are one and the same for US Federal Tax Purposes.
It can also opt to file for C corporation tax status by submitting Form 8832.
Usually if clients want the liability protection of an LLC, but with the simple tax filing of a sole proprietorship, they will choose a single member LLC as the structure for their business.
CONVERTING YOUR SINGLE MEMBER LLC TO A CORPORATION
To change the status of a single member LLC to a corporation may be achieved by several methods as set out below:
- By filing a Form 8832, Entity Classification Election, for a disregarded entity to be treated as an association taxable as a corporation.
- By filing a Form 2553, Election by a Small Business Corporation, which is treated as a deemed election for a single-member LLC to be taxed as an S corporation association.
- The conversion of a single-member LLC treated as a disregarded entity into a corporation under the applicable state law formless conversion statute.
- The merger of a single-member LLC treated as a disregarded entity into a corporation under the applicable state law cross-entity merger statute.
FEDERAL TAX IMPLICATIONS OF CONVERSION
When converting your LLC to a corporation it is of upmost importance to understand what type of tax status already exists in the LLC. As determined above, a single member LLC that did not elect to be treated as a corporation will be a disregarded entity and taxed as a sole proprietorship. The tax status of the LLC will determine how the company is converted.
A conversion of a single member LLC to a corporation can have significant tax consequences based on the transactions that are deemed to occur as a result of the conversion.
If an election is made in terms of Form 8832 to change classification from a disregarded entity to a corporation, it will be treated as if the owner of the disregarded entity contributed all of the assets and liabilities to the corporation in exchange for stock.
When a business entity undergoes a change in elective classification status from a disregarded entity to a corporation, the change should be treated as the transfer of all the assets and liabilities held by the owner of a former disregarded entity to a newly formed corporation, with the owner of the disregarded entity treated as the transferor.
This could lead to quite unforeseen tax implications.
Should the tax consequences of a classification change be undesirable, the entity can change its classification through a structural modification rather than by means of an election.
The owner of the disregarded entity can transfer ownership of the disregarded entity to a new or existing corporation.
Equivalently, the change from a disregarded entity to a corporation could mitigate US Federal Tax implications by forming a new corporation and the disregarded entity could transfer all of its assets to the new corporation in a transaction described in IRC §351.
Under IRC §351, this is considered a tax-free contribution and you could avoid any gains or losses.
However, there are certain anti-avoidance measures in place to ensure that people do not abuse this provision. Specially under IRC §357(c), if the liabilities deemed assumed by the entity exceed the owner’s basis in those assets, then the transferor must recognize a gain equal to the excess of the liabilities over the transferor’s basis. Further, if the transfer of liabilities had a purpose to avoid federal income taxes or if the arrangement was not made for a bona fide business purpose, all of the transferred liabilities will be treated as boot received on a §351 exchange.
When converting a single member LLC to a corporation you should be cognizant of the conversion of the legal form as well as the conversion of the tax status. It’s not a straightforward process and one should always tread carefully when considering such a conversion and how to approach it.