Many states allow one business entity type, like a Limited Liability Company (LLC), to convert to a corporation. This is called a formless conversion. It makes it easier for business owners wanting to switch because they don’t need to create a second entity and transfer all of the assets and operations. In other words, it’s administratively easier.
As with any transaction, there will be tax consequences to consider. These consequences will depend on how the LLC is currently taxed and the condition of its balance sheet. Let’s begin.
Single-member LLC (SMLLC) to Corporation
Because a SMLLC is disregarded for federal tax purposesa, the LLC member is deemed to contribute the LLC’s assets in exchange for its stock. §351 governs this transaction. If the liabilities of the SMLLC exceed the adjusted basis of the assets, gain will be recognized under §357(c) for the difference.
Two types of liabilities are excluded from this calculation, which areb –
- Liabilities the payment of which would give rise to a deduction
- Liabilities for payments to retiring partners as described in §736(a)
Multi-member LLC Taxed as a Partnership to Corporation
Rev. Rul. 2004-59 provides that when an LLC taxed as a partnership converts to a state law corporation, two events are deemed to happen –
- The partnership contributes all of its assets and liabilities to the corporation in exchange for stock
- The partnership then distributes the stock to the partners in a liquidating distribution
§357(c) would apply to this scenario and gain would be recognized to the extent that liabilities exceed the adjusted basis of the assets.
EIN Retention
Under both scenarios above, the LLC would keep its EIN. If the SMLLC did not have an EIN it would need to obtain onec.
Footnotes
a §301.7701-3(b)(1)(ii)
b §357(c)(3)
c §301.6109-1(h)(2)(ii)
Good Post! But I have a question.
Okay so let’s say that i start a SMLLC. I take out 200 from the bank. Interest free financing for the first two years and no principle payments due for two years. Cash = 200. Liability = 200.
Then, in year 1, I spend 50 on office supplies. Cash = 150. Liability = 200. Retained Earnings = -50.
Year 2 I convert to a Corporation. So since liabilities > cash by 50, i recognize a 50 gain correct?
Well, if I had been a C-Corp the whole time, I would have a -50 NOL that can be used against future income. My question is do I get that NOL upon my conversion from SMLLC to C-Corp? If I don’t, the law isn’t putting the “converted” C-Corp and the “inception” C-Corp on equal grounds correct?
I am still trying to wrap my head around this.
Taking your example, if no gain was recognized upon contribution of the assets to the corp., what would your basis in the stock be? It would be negative and that isn’t allowed.
If you’d been a C-corp. the whole time you’d have $0 stock basis because you never put anything in. This leaves you with $0 basis and ($50) of retained deficit.
Upon contributing your assets from the SMLLC, you have $0 stock basis and ($50) of equity. Same place.
The rub here is that you used $50 of borrowed money to fund a loss. When the corporation assumes the liability from you, you’re no longer liable to repay the loan. You’ve now generated a tax loss with no corresponding economic outlay. The gain recognition fixes this by undoing the loss you previously deducted.
That makes sense. Thanks for the clarification. I have never read something that lays out the tax consequences of formless conversions so well. This is a very common issue and I am glad you addressed it. If I have any clients who have issues with formless conversions I am referring them to you!
Your advice on the retention of EIN for a multi member LLC(partnership) to a Corporation flies in the face of IRS https://www.irs.gov/businesses/small-businesses-self-employed/do-you-need-a-new-ein.
Thoughts?
B
Thanks for your comment. Here’s my line of reasoning –
Rev. Rul. 2004-59 governs the treatment of formelss LLC conversions to corporations. It says “For federal tax purposes, a partnership that converts to a corporation under a state law formless conversion statute will be treated in the same manner as one that makes an election to be treated as an association under § 301.7701-3(c)(1)(i).” This is the election made on Form 8832 if an LLC wanted to be taxed as a corporation.
§301.6109-1(h)(1) says “Any entity that has an employer identification number (EIN) will retain that EIN if its federal tax classification changes under § 301.7701-3.”
I believe the IRS page you cite is talking about a different scenario where a completely separate entity, a corporation, is formed and the partnership’s operations are transferred to the new corporation. In my scenario, there’s only ever one entity involved.
David
Thank you for a very concise and understandable explanation of the formless LLC conversion from a Partnership to S Corporation.
Would having a negative balance sheet, e.g. net negative cash have the same result of capital gain?
What if the partner distribution in a prior year resulted in a capital gain recognized by the partner outside the partnership, would it still result in capital gain?