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Lane
Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 4544
Experience:  Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
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Our company is currently organized as an LLC, but have elected

Resolved Question:

Our company is currently organized as an LLC, but have elected S-Corp status for tax purposes. We are in the midst of buying one of the unit holders of the company out. He has agreed to carry back a note for the purchase price. We are now wondering though whether we should convert to a C-Corp prior to doing so.

The reason for this thought process is that we have been approached by a Venture Capital firm that is interested in making a possible investment. In all likelihood, they would require that we convert from an LLC to a C-Corp prior to investing. The conversion is fairly straightforward from a legal standpoint (we are organized in Colorado and the Corporate and LLC statutes allow for a conversion without having to actually form another company and merge companies).

Since I'm not an accountant (but I am an attorney), I was unsure on whether we should be concerned about any potential tax liability? My preliminary research indicates that we may face a tax liability if we what to perform the conversion at a later date. The reason (or at least my understanding of current tax laws) is that we would be taxed on the difference between our liabilities and assets. The note the other owner has agreed to carry back for the purchase price would be a liability on our books and we don't have enough assets to offset the liability. Is my understanding correct? Does the outcome change at all since we are currently taxed as an S-corp rather than a partnership? Thanks for any clarification you can provide.
Submitted: 1 year ago.
Category: Tax
Expert:  Lane replied 1 year ago.

NPVAdvisor :

Hi,

NPVAdvisor :

Goind the direct you mention is not normally a problem (given that all gains have been passed through to shareholders already)

NPVAdvisor :

You MAY be thinking of the extension of the waiver of the 10 year wait on taxation of gains in C-corps that have converted to S-Corps an not yet realized the gainn that were in the C-Corp?

NPVAdvisor :

sorry for the previous typo ... meant to say "Going in the direction ..."

NPVAdvisor :

For C-corps that had previously converted to S-Corps that wanted to, say, sell to a venture capital firm WOULD have to recognize the built in gains (but that was changed to a 5 year period in 2011 and extended to taxable events in 2013 and 2014 as part of TRA)

Customer:

That's okay....it wasn't the extension of the waiver I was thinking about. I would have to look back through my notes, but I found something that talked about a gain that would be realized by an LLC converting to a corporation on liabilities that exceeded the assets.

NPVAdvisor :

That would certainly make sens for shareholder liabilities TO the LLC, as part of the basis

Customer:

The issue as I see it is that a VC firm is going to want us to be structured as a C-Corp. Correct me if I'm wrong here, but normally a conversion is tax free unless the aggregate liabilities assumed by the new corp exceed the aggregate tax basis of the assets contributed to the new corp. As it stands today, we would be okay. However, this all would change the minute we execute a promissory note to the unit holder we are buying out. At the time of conversion we'd then be required to recognize as a gain on our final tax return the difference between the tax basis of the assets contributed and our liabilities. If I'm correct, then this would result in a substantial tax liability and we should consider doing a conversion before the company buys the units.

NPVAdvisor :

would be the same for ANY pass through

NPVAdvisor :

yes

NPVAdvisor :

Ic

NPVAdvisor :

and again that also would be true for any pass through converting to C-corp

NPVAdvisor :

this would, ofcourse potentially affect the valuation the VC frim's willing to pay

Customer:

Right.....so the question remains......would we be better off converting to a C-corp prior to buying the other member out?

NPVAdvisor :

along with a plethora of other factors

NPVAdvisor :

Yes

NPVAdvisor :

Most certainly'

NPVAdvisor :

You have it

NPVAdvisor :

everything stays in the C-corp unless you distriute is as dividendsb

NPVAdvisor :

in terms of gains

NPVAdvisor :

(or salaries, of course) from the owner/employees perspective

NPVAdvisor :

You might also want to talk to VC about whether its done as an asset sale or a stock sale, (of the S-Corp) depending on the numbers

Customer:

Yeah....I understand how a C-corp works, I was unsure, however, on how the debt on the books of the LLC would be treated at the time of the conversion. If I'm understanding your answer, you are saying that, yes, it would be treated as a taxable gain at the time of conversion....and just to clarify.....this answer still stands even though we have elected to be taxed as an S-corp?

NPVAdvisor :

Yes and yes

NPVAdvisor :

through either 1065 k-1 or the 1120's k-1

NPVAdvisor :

both are pass through ebtities

NPVAdvisor :

would also be the same for a sole proprietor

Customer:

okay....thanks....I believe that tells me what I need to know. Is there any publication that lays this out in terms I can explain to the other members of the LLC?

NPVAdvisor :

Hang on just a sec

NPVAdvisor :

This one doesn't make the S-Corp link, but a good overview .... still looking .. le tme see if I can fins IRS guidance

Customer:

That's funny.....that's the exact same article that I found that led me to ask for the clarification in the first place ;)

NPVAdvisor :

Geez, can't find it specifically ... It's very same issue, as both are passthroughs and that excess has to unwind ..... hang with me if you can

Customer:

no problem....

NPVAdvisor :

Did you perchance stumble into section 356

Customer:

No

NPVAdvisor :

I'm going to backpeddle... it looks like, given certain conditions transfers from and to a corp can be done can be done with nontaxation through scetion 356 ... see this

Customer:

Okay....this is now as clear as mud :( I'm actually more confused now then I was when I asked the original question. I'm not sure how this pertains to whether or not a tax liability will flow through to the partner/member/s-corp shareholder at the time of conversion as a gain?

Customer:

You still there?

Customer:

Sorry, but like I said, I'm now more confused then I was before.

NPVAdvisor :

Did youi take a look?

NPVAdvisor :

Essentially, if you meet the requirements for 356, then it's a transfer of stock

NPVAdvisor :

nd although the basis changes, you don't have to unwind it the way you would from llc

NPVAdvisor :

QWHAT????

NPVAdvisor :

How about haning in here a second.... that not only hurts my ratings by mny pay

NPVAdvisor :

I'm working my fingers to the bone here ... and this IS NOT simple stuff

NPVAdvisor :

I'm trying to read this and pass the pertinent parts through

NPVAdvisor :

But i WILL NOT oversimlify

NPVAdvisor :

Will you hang with me here and rectify that rating?

NPVAdvisor :

Essentially, because you are rolling up stock to stock, the taxation of the excess liabilities does NOT apply

NPVAdvisor :

The basis will, however, change

NPVAdvisor :

I'm going to switch to "Q&A" mode here so that I can continue to research and distill the piece I was trying to get to you

NPVAdvisor :

I hope you'll give me the opportunity to make you a satisfied customer

NPVAdvisor :

Under general tax principals gain and loss has to be recognized when you DISPOSE of property, which is what you're doing here

NPVAdvisor :

But section 356 overrides this principle when certain transfers are made to a C-Corp SOLELY for sgares of stock

NPVAdvisor :

At the corporate level 1032(a) says that a corporation doesn't recognize gain or loss when it receives money or other property in exchange for stock

NPVAdvisor :

TYhe thinking there is that this simply changes the FORM of the shareholders' investment

NPVAdvisor :

To satisfy 351 two things have to happen:

NPVAdvisor :

there has to be something transferred to the corp

NPVAdvisor :

and it has to be done in exxchange for shares of stock

NPVAdvisor :

so the answer is, as my right brain was trying to tell me before when I mentioned talking tothe VC about stock vs asset sales

NPVAdvisor :

it depends

Customer:

ok....didn't mean to rush in giving you a bad service ding....more than willing to work with you here.

NPVAdvisor :

And again, given that you are alread s-corp, I'm not so sure (maybe you've gotten this indication) that the VC will necessarily want you to convert before the sale

Customer:

I hadn't heard from you and was thinking you'd given up.

NPVAdvisor :

... means I don't get paid

Customer:

I understand the complexity....thus the reason I was seeking advice.

Customer:

We're actually not an s-corp though....that affects the entire analysis.

NPVAdvisor :

What I was going to do was see if you'd be willing to move to Q&A so I could document it well for you (we can continue the dialogue there, just not in real-time) ardlessbut I thinkwe're very close now reg

Customer:

I'll happily change the service rating so you get paid.....I still don't feel like I have a definitive answer though as to whether we should be worried about converting now or can wait without worry about an unintended tax consequence.

NPVAdvisor :

Here's the answer

NPVAdvisor :

If you make the move FROM an LLC position, partnership, sole proprietor, where there are no SHARES involved your original asessment is correct ... however

Customer:

Yes....I'm more than willing to move to Q&A if that would help....I'm not worried so much about the time it takes as long as I can feel comfortable with the answer.

NPVAdvisor :

One thin you MAY want to look at is converting to S-Corp ... IF you think that there will be a requirement of going to C-Corp by making the 351 election

NPVAdvisor :

so that it's a stock conversion and there's no taxable event

NPVAdvisor :

to recap:

NPVAdvisor :

If you make the move FROM an LLC position, partnership, or sole proprietor, where there are no SHARES involved your original asessment is correct ... however you MAY want to look at is converting to S-Corp ... IF you think that there will be a requirement of going to C-Corp, because going from s_corp to c-corp CAN be done as a NON taxable event IF youmeet the requirements of 351

NPVAdvisor :

and the piece I linked should give your tax guty MORE than enough documentation to undersrtand

Customer:

That's where I got confused I suppose after reading that initial article you pointed to......we are an LLC that has elected to be taxed as an S-Corp.....so would this technically be considered a stock conversion? I would think not since we are still considered an LLC for all intents and purposes

NPVAdvisor :

The s-corp election only causes you to be taxed as an S-corp ... That is NOT a taxable event

Customer:

If making the election to be taxed as an s-corp is the important piece (which is really what my initial question boiled down to), then I guess we are in the clear.

NPVAdvisor :

you will need to do articles, decide a capital structure (depending on your state) you may need to issue or at lease get approve a number of shares to isse of stock

NPVAdvisor :

Yes, absoluelyt ... I thought you were focusing on the move to c-corp

Customer:

There seems to be some type of disconnect (and I'll take the blame for that). We are an LLC that has elected to be taxed as an S-Corp rather than a partnership. Both types of taxation are flow through. The original question was whether or not we would have a taxable gain (at the individual level) once we converted to a C-Corp if we had a large liability on the books of the LLC (i.e., the note to the member we are buying out).

NPVAdvisor :

BOTH are pass throughs

NPVAdvisor :

BUT

NPVAdvisor :

one of the pass through has stockholders, thereby allowing for a stock transfer

NPVAdvisor :

I understand that the LLC is where you started, but once you did the s corp election you now have an avenue open to you as a stock conversion to C-corp

Customer:

A true S-Corp....yes (i.e., a C-Corp that has elected S-Corp status), but what about an LLC that has only elected to be taxed as an S-Corp/

Customer:

?

Customer:

Okay....I think we are getting somewhere ;)

NPVAdvisor :

We aren't talking corporate (business entity law here) ... the IRS now sees your LLC as a corporation

NPVAdvisor :

and it's title 26 that says stock transfers aren't taxable events

Customer:

Since we elected S-Corp treatment, even though we are an LLC that technically has interests vs shares of stock, we should be able to do a stock conversion to a C-Corp (as a non-taxable event).

NPVAdvisor :

bingo

NPVAdvisor :

under section 351 because NOW (if y are transferring stockou elect it) you

NPVAdvisor :

sorry, typing too fast

NPVAdvisor :

let me get you the citation

NPVAdvisor :
(a) General rule.--No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in section 368(c)) of the corporation.


26 U.S.C.A. § 351 (West)

Customer:

Excellent....thanks!

Lane, JD, CFP, MBA, CRPS
Category: Tax
Satisfied Customers: 4544
Experience: Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986
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Lane
Lane
JD, MBA, CFP, CRPS
3669 Satisfied Customers
Juris Doctorate, CFP and MBA, Providing Financial & Tax advice since 1986