Owners of a C corporation might consider a conversion to a pass through entity (Limited Liability Corporation) as a means to retain the limited liability and transferability of ownership that the corporate entity provides, while avoiding the double taxation of corporate earnings. Here are some basics.
Why would I convert from a C Corp to an LLC?
- Avoid double taxation: This is an important consideration when the owners of a successful entity want to receive tax-favored distributions of the business profits.
- Retain limited liability protection: Conversion to a general partnership (as opposed to an LLC) may not be the right move.
- Minimize the tax costs of the conversion: As a corporate liquidation is a double-tax event, the conversion can be expensive to the owners. Converting during an economic downturn (i.e., when asset values are depressed and recognized gains are reduced) may be a good move.
- Unused or expiring capital or net operating loss carryovers: The conversion can allow such losses to be used to reduce the tax cost of the transaction. Such tax attributes usually are eliminated upon the liquidation.
- Likely higher future tax rates: Applicable tax rates for C corporations and individual investors almost certainly will increase in the near future, through tax rate changes, an expanded tax base, and/or the expiration of existing tax incentives.
- Higher taxes on dividend income: Also at risk from future legislation is the low tax rate on dividend income. This can be another reason to remove the entity from the double-tax structure of the C corporation.
What are the potential disadvantages?
- Liquidating distribution rules: The liquidation of a C Corporation is a double-taxed event. If the entity holds assets with sizable realized gains, the conversion could trigger significant and immediate income (and transfer) tax costs.
- Self-employment taxes: An LLC member is liable for the full amount of self-employment taxes on any guaranteed payments, plus its share of any passthrough ordinary income. Thus, future federal tax liabilities may increase.
- Goodwill effects: The C corporation may hold large amounts of goodwill, which could increase the gains recognized on the conversion. This may be the case particularly for successful service-oriented businesses.
Deciding to convert from a C to LLC is a detailed, fact-oriented undertaking, but one that the tax professional can complete with good technical knowledge. A few things to consider:
- The present value of tax savings generated by the conversion increases, making the conversion more attractive, as one assumes higher future tax rates and higher asset bases relative to depreciation and amortization deductions.
- In the analysis, include projections of both corporate and individual tax rates, for income and payroll taxes, at the federal and state/local levels. Also include reasonable estimates of future price level increases, especially concerning depreciable assets.
- Payroll taxes will increase as the owners make up a larger portion of the entity’s workforce and as they take larger compensation amounts.
- Take into account any costs associated with the conversion itself, including legal and consulting fees, transfer taxes, and sales/use taxes on the deemed liquidation.
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