State entity-filing offices -- typically a division or department of the office of the Secretary of your state -- have made it simple to convert one type of entity to another. Many provide a simple entity conversion form for this purpose. Just check the appropriate boxes on the conversion form, add some simple boilerplate as explained in the instructions to the form, file the form, and you're done. The new business is formed, the assets of the old business are transferred to the new business, and the old business is dissolved. All of this happens automatically by operation of law according to each state's entity conversion statute. What could be simpler?
Of course, nothing is quite so simple when law and taxes are involved, and both come into play when a business is converted to a new legal form.
Let's look at a common type of conversion: the conversion of a co-owned LLC to a corporation. Normally, an LLC-to-corporation conversion is tax-free if the prior business owners are in control of 80% or more of the stock of the new corporation (see IRS Publication 542, Corporations, and my Nolo book, Incorporate Your Business: A Legal Guide to Forming a Corporation in Your State).
But there's more to it, as explained in IRS Revenue Ruling 84-111. This ruling puts partnership-to-corporation conversions into one of three slots, and applies to LLC-to-corporation conversions since co-owned LLCs are treated like partnerships. Here are the three conversion categories:
- "Assets-Over" conversion. The LLC transfers its assets and liabilities "over" to the new corporation, the corporation issues its stock to the LLC, the LLC transfers the stock to its owners in proportion to their LLC capital interests, then the LLC dissolves.
- "Assets-Up" conversion. The LLC distributes its assets and transfers it liabilities "down" to its owners in proportion to their capital interests, the LLC dissolves, and then the owners transfer their individual share of received assets and liabilities "up" to the new corporation in return for a proportionate share of its stock.
- "Interests-Over" conversion. The LLC owners transfer their LLC capital interests "over" to the new corporation in return for a proportionate amount of corporate stock, and then the LLC dissolves.
Each of these conversion methods can have a different effect on the corporation's tax basis and holding period in the assets it receives. Further, LLC owners can end up with a different tax basis in their corporate stock, and each can end up with a different immediate tax result depending on the conversion method used. For instance, an owner may have to pay taxes at the time of the conversion.
OK, this is already sufficiently complicated, but there's more to consider (clue: it's the subject of this article): Converting a co-owned LLC through the use of a state-provided entity-conversion form without an actual (legally documented) transfer of assets or interests. Let's call this type of conversion an "Automatic" conversion.
Revenue Ruling 2004-59 explains how the IRS treats an automatic conversion of an LLC to corporation through the filing of a state conversion form. This ruling says that when an entity treated as a partnership (again, which includes a co-owned LLC) is converted to a corporation through the filing of a state conversion form without an actual transfer of assets or interests, the IRS assumes the following steps occur, in this order:
- The partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation.
- The partnership liquidates, distributing the stock of the corporation to its partners.
This assumed sequence of events looks familiar, doesn't it? It matches the sequence of events described in the assets-over conversion described earlier, which means it's likely that the IRS will consider the conversion of an LLC to a corporation through a state conversion form filing to be an assets-over conversion. This leads to further complications that can have significant tax effects.
Here's one: Internal Revenue Code (IRC) Section 1244 allows business owners to treat worthless stock as an ordinary loss, which can be deducted against ordinary income on their tax returns. However, one of the requirements of using Section 1244 is that the shareholder claiming the loss must be the original owner of the stock. But if you re-read the description of an assets-over conversion, you'll see that the LLC entity, not its owners, is considered to be the original owner of the shares under that conversion scenario, and the corporation's shareholders are considered to be the second set of shareholders (they receive their shares from the dissolving LLC).
What this means is that the use of a simple state conversion form to convert an LLC to a corporation may eliminate the future ability of the corporation's shareholders to take a large deduction on their individual tax returns. Instead, the shareholders may be limited to claiming only a capital loss if their corporation fails. Since a capital loss can only be used to offset capital gains, the owners may be unable to deduct the loss on their capital investment, or may have to wait several years to do so.
Complications and unexpected tax results of this sort are why it's best to check with a tax advisor before making even the simplest type of filing with the state to form a business entity or convert an entity from one form to another.
Copyright 2008 by Anthony Mancuso
This article is provided as information and opinion. Please check with a legal or tax advisor for legal or tax advice.