Thursday, April 30, 2015

Converting a C Corporation to an LLC: Two Scenarios That Make Sense -


One of our toughest challenges as tax advisers is what to do with closely held C corporations that should not be C corporations.  You know the ones I mean….the owner received questionable advice at some point in the company’s history and became a C corporation.  Or the company has always been a C corporation.
Now the owner is realizing that the double tax hit if the C corporation sells its assets is a nightmare. What can we do?

Often the best answer is a conversion from a C to an S corporation.  The owner thinks (or hopes) he or she can wait until the built-in gain recognition period expires before selling the significant assets.
But if conversion to an S corporation was a possibility, the company would probably have already converted.
Perhaps conversion to an S corporation is not possible.  Maybe there are ineligible shareholders, two classes of stock, or the assets would generate passive investment income, just to name a few of the more common impediments to electing S.

If conversion to an S corporation is not an option, should the C corporation consider converting to an LLC?
Converting from a C corporation to an LLC is a deemed corporate liquidation, immediately triggering two levels of tax.  This is more drastic than converting to S.  The S corporation Built In Gain tax is payable when the appreciated assets are disposed of during the BIG recognition period, not immediately upon conversion to an S corporation (see IRC section 1374).

Causing a deemed liquidation and triggering the two levels of tax when a C corporation converts to an LLC may sound prohibitive. Still, here are two scenarios where converting a C corporation to an LLC is worth considering.

The Young, Growing Tech Company

Let’s say a growing technology company is a C corporation.  The stock is owned by the founder, a few key employees, and some friends and family.  Until now, during the development stage, the company has generated net operating losses and R&D credits.   Their technology is close to commercial feasibility.  The company doesn’t need much additional capital to bring the product to market.

The founders have been approached by venture capital firms that want to provide financing.  But the founders have rejected the VCs’ overtures because they wanted too much equity, and because they would require the company to remain a C corporation. Instead, the founders are considering either angel investors or a mezzanine loan with warrants for the next round of funding.  They’re realistic enough to understand that the likely exit is an asset sale, not an IPO or stock acquisition.

This company is the perfect candidate to explore conversion to an LLC.  The key is the valuation.  They need to obtain a valuation to determine the current fair market value of their assets, including intellectual property.  If there are still hurdles to commercialization of the product, then the value of the assets of the business may be low enough to require only minimal tax on the deemed liquidation.  It’s even possible that the corporate level tax liability on the conversion will be insignificant after the utilization of corporate NOLs and R&D credits.
There will also be tax at the shareholder level measured by the difference between the FMV of the assets received in the deemed liquidation and the shareholders’ tax bases in their C corporation stock.
The assets receive a stepped-up basis to FMV for tax purposes since the conversion is a taxable liquidation.  Depending on the form of the conversion, a section 754 election may be needed to secure the benefit of this step-up for the LLC owners.

Admittedly, for this scenario to pan out, some luck and good timing is necessary.  If the technology never achieves its expected upside, then the owners may have paid tax unnecessarily.  If the worst happens, the owners will only recover the tax paid upon the deemed liquidation via a capital loss.
But if the stars align and the company’s assets are sold for a significant premium over the appraised FMV on the conversion date, then the owners will pay much less tax on the ultimate sale of the assets.

Real Estate in a C Corporation

Probably our most challenging conundrum as tax professionals is a closely held C corporation that owns real estate.  Conversion to an S corporation is often not possible due to the net passive investment income tax.
While commercial real estate valuations have inched back somewhat since the financial crisis, they are still depressed in many markets.  Interest rates remain at historic lows.  In the right fact pattern, converting a closely held C corporation to an LLC can be combined with a refinancing.  The refi proceeds can provide liquidity to the owners to soften the cash hit of paying tax on the conversion from a C corporation to an LLC.

The right fact pattern would include (1) commercial real estate likely to appreciate in value held in a C corporation (2) debt levels below what the property can support, and (3) owners willing to take a long term view.
A high quality appraisal is the first step.  Once the FMV of the real estate is known, the company’s tax advisers can compute the tax consequences of the deemed liquidation to the C corporation and its shareholders.  We can present the tax consequences to the owners so they can make an informed decision.

If the conversion to an LLC can be combined with a cash-out refinancing, then the cash distributed to the owners can be a source of funds to pay the tax on the deemed liquidation.
It’s smart tax planning to maximize tax depreciation on the property after the conversion to an LLC.  The tax savings from depreciation on the stepped-up value will result in future tax savings that will reduce the net present value of the tax cost of converting from a C corporation to an LLC.

A cost segregation study should be done to insure maximum allocation of tax basis to 5, 7, and 15 year MACRs assets. The tax preparer should also take full advantage of the new repair and capitalization regulations to identify units of property that are likely to be replaced in a shorter cycle than 39 years.

If the property is later sold, appreciation since the conversion to an LLC will be taxed at only one level.  If the LLC owners decide to pass on the property to future generations, the date of death step-up means the future appreciation escapes income tax altogether.  A section 754 election for the LLC will insure that the heirs realize the tax benefit from the step-up at death.

What I Hope You Got Out of This

Sometimes paying a little tax now to save more tax later can make sense.  It’s up to us to be proactive tax advisers and discuss all options with our clients.  There are no easy answers to the double tax problem facing owners of a closely held C corporation.  But we owe it to our clients to present conversion to an LLC as one way out.
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