GENERAL BACKGROUND

Last week we discussed the conversion of a Single Member LLC to a Corporation. In this week’s blog we will discuss the conversion of a Multi Member Limited Liability Company (LLC) to a corporation in legal form and the US Federal Income Tax Implications of such a conversion. 

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 mainly on the US Federal Income Tax implications of such a conversion and 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. 

INTRODUCTION 

The default rule pertaining to any LLC that has more than one owner is that it is taxed as a partnership. An LLC classified as a partnership is therefore subject to the same filing and reporting requirements as a partnership.

It is important for the reader to distinguish between the following conversions –  

  1. Conversion of a Multi Member LLC to a Corporation in legal form which will automatically trigger potential Federal Income Tax Implications; and
  2. Solely changing the tax status of the Multi Member LLC in terms of the Check the Box regulations, which means that you retain the LLC as an entity but elect to be taxed as a corporation for Federal Income Tax Purposes. 

The general methods available to convert your LLC to a Corporation will be either by way of a Statutory Conversion, Statutory Merger or Non-Statutory Conversion.

CHANGE IN TAX STATUS (“CHECK-THE-BOX”)

By default, the IRS taxes a multi-member LLC as a partnership and there is no separate IRS tax category for LLCs.

If you’re seeking to convert your LLC’s tax status from a partnership to a corporation without changing the LLC’s legal form, you only need to file IRS Form 8832 (to be taxed as a C corporation) or IRS Form 2553 (to be taxed as an S corporation). 

It’s important to note that, generally once an LLC has elected to change its classification, it cannot elect again to change its classification during the 60 months after the effective date of the election. 

An election to change the classification from a partnership to a corporation will be treated as if the partnership contributed all of its assets and liabilities to the corporation in exchange for stock and the partnership then immediately liquidated by distributing the stock to it partners.

THE APPROACH OF THE IRS WHEN CONVERTING AN LLC TO A CORPORATION

In Revenue Ruling 84-111, the IRS described three specific methods of converting an LLC to a corporation when using non-statutory conversion. 

  1. “Assets-over” Conversion:

    the LLC transferred all its assets and liabilities to a newly formed corporation and in exchange received all outstanding stock of the corporation. Subsequently, the LLC terminated by distributing all the newly formed corporation’s stock to the LLC members.

  2. “Assets-up” Conversion:

    Firstly, the LLC distributed all its assets and liabilities to its members to enable the LLC to terminate.  Secondly the members transferred all the assets received from the LLC to the corporation in exchange for all outstanding stock of the corporation plus the corporation’s assumption of all of those LLC liabilities. 

  3. “Interests-over” Conversion:

    the LLC members transferred their LLC interests to a newly formed corporation and in exchange received all the outstanding stock of the corporation. The LLC terminated, with all the LLC assets and liabilities becoming assets and liabilities of the corporation. 

This ruling however did not address how the IRS interprets Statutory Conversions or Statutory Mergers.2004 IRS bulletin provided some clarity and stipulated that the IRS will treat these types of conversions as essentially equivalent to “asset-over” conversions. 

The bulletin further stated that the IRS will assume that the LLC members contribute “all LLC assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the LLC liquidates distributing the stock of the corporation to its members.”

The conversion of a multi member LLC to a Corporation will therefore also be able to qualify as a tax-free contribution in terms of IRC §351 if it complies with all the requirements. 

TAX IS INEVITABLE, SUFFERING IS OPTIONAL

No one person is the same and the same applies to your Multi Member LLC. Irrespective of the reason behind the conversion, i.e., legal form or check the box change, you should always make sure you consult tax professionals on what the tax implications of your conversion could entail. 

Remember that as death, tax is inevitable but if proper planning is done, you do not need to suffer.

 

Shaun Eastman