While a conversion from a C Corp to LLC status can have a high tax cost, in some cases, such a conversion can be beneficial.
Converting from a C corporation to an LLC allows the shareholders to reap the benefits of passthrough taxation while continuing to have limited liability. If the gains that will be recognized by the corporation on the distribution of its assets are limited by circumstances, or if the same holds true for gains that will be recognized by the shareholders from the liquidating distribution, such a conversion could be a good idea.
How to convert
In converting a C corporation to an LLC, under Secs. 336 and 331, the transaction is treated as a liquidation of the corporation and the net proceeds are distributed to the shareholders before the assets are contributed to the new LLC. However, it may be the case that an actual liquidation is not required, since many states allow companies to file certain forms and pay a processing fee in order to facilitate such a conversion. If the entity holds assets with sizable realized gains, the conversion could trigger significant and immediate income (and transfer) tax costs.
Once the conversion has taken place, the new LLC will take its assets with a fair market value basis and eliminate other corporate tax attributes. Going forward, operating results and the eventual liquidation of the LLC are single-taxation events.
When to convert
Shareholders might consider a conversion to an LLC in cases where their tax or financial goals include avoiding double taxation, taking advantage of pass-through taxation, retaining limited liability protection, reducing the tax burden for future years (if rates are anticipated to increase), and/or reducing paperwork. Converting during an economic downturn during which gains are reduced may also be beneficial for minimizing conversion costs in terms of taxation, and conversion may also help shareholders take advantage of losses like expiring capital or net operating loss carryovers.
Why not convert?
There are many disadvantages to converting to an LLC that C corporations should keep in mind. Liquidating a C corporation is considered to be a double-taxed event, which could trigger significant, immediate tax costs. Future federal tax liabilities may also increase, as LLC members are liable for the full amount of self-employment taxes on any guaranteed payments in addition to their share of any passthrough ordinary income. LLCs are also potentially not as attractive to potential investors, and it often becomes more difficult to transfer membership in an LLC than to transfer shares in a corporation. Corporations are also a better option for those who want to reward employees by offering shares of stock or stock options.
While LLCs are more efficient when it comes to taxes, the costs of converting from a C corporation to an LLC can be prohibitive. If you are considering such a conversion and have questions about the process and its benefits or drawbacks, the team at Sousa & Weber is happy to help. Get in touch with us today!