Converting a C Corporation into an LLC

If you're considering converting from C-corp to LLC, it's important to follow the process carefully. This conversion gives the company owners or shareholders the limited personal liability of a corporation, along with the benefits of the pass-through taxation structure. However, the costs associated with changing the business entity are often prohibitive for small business owners. If a corporation is carrying over significant losses in net operation or has lost many of its assets, it may be a financial benefit to convert the business to an LLC.

In order to convert a C-corp to an LLC, the first step is liquidation. This process requires the payment of taxes on both the shareholder distribution as well as the asset distribution.

C Corporation Liquidation and Tax Regulations

According to the laws in Section 336, any C-corp that is in the process of liquidation has to recognize all losses and gains on the distribution of corporation property to its shareholders as though the property was sold at the rate of fair market value. The recognition of the gains' character, either ordinary or capital, will depend on the property distributed by the corporation. Rules related to depreciation recapture could also have an impact on the gains' character.

Laws under Section 361 grant permission to a corporation for loss recognition during the distribution of property to shareholders as part of the liquidation process. However, if the corporation distributes liquidated assets to someone who is related, the rules outlined in Section 267 state that the corporation can't recognize that loss if distribution of disqualified property occurs or distribution isn't pro rata.

Any property that has been disqualified refers to property acquired by the corporation under a Section 351 transfer or contributed to the capital within a five-year period, which ends on the date of distribution. Additionally, disqualified property may refer to anything with an adjusted basis decided by reference to similar property with an adjusted basis. According to Letter Ruling 200613027, converting the LLC to a corporation followed by incorporation rescission doesn't require taxable liquidation of the corporation. Instead, the business would be treated like an LLC throughout the tax year, ignoring the transaction of incorporation. 

The rules found in Section 331 outline how liquidated distributions will be taxed at the level of corporation shareholders. These rules require that liquidated distributions must be exchanged for the stocks held by the shareholder and treated as a full payment. All corporation shareholders are required to recognize losses or gains at a rate that is equivalent to the difference between the surrendered stocks' adjusted basis and the assets' fair market value. When stocks that are being surrendered are capital assets, this transaction will recognize capital losses or gains.

The basis for the shareholder relates to the fair market value of the property received as part of the liquidation process, at the time the distribution takes place. This applies if the loss or gain has recognition based on the property receipt, according to Section 334(a).

Determining If Conversion Is Desirable

The tax costs associated with converting a C-corp to an LLC can be high, so it's important to think about this option only when the circumstances are lessening the gains recognized by the shareholders or by the corporation. The process of converting a corporation may be more appealing if the business has assets that are depreciating or simply not appreciating in value. In a situation where this applies, the distributed property's fair market value cannot be higher than the transferred assets' basis and the business can't recognize any gains. 

Another aspect that might make a conversion from a C-corp to an LLC more desirable is if the shareholders and/or the business itself holds carry-forwards of capital loss or net operating losses that may absorb some of the gains during the liquidation distribution process. Converting a corporation to an LLC could also be more appealing if a business holds real estate, intellectual property, or other types of assets that may experience rapid appreciation in the future.

How to Structure C Corporation Conversion?

When starting the conversion process, all shareholders within the corporation will form an LLC when they transfer any stocks they own in return for membership in the new business. When this occurs, the previous shareholders become members and own LLC interests, with all stock from the corporation being owned by the LLC.

If you need help with converting c-corp to LLC, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.