Tax & Business Insights

To C or Not to C?

Volume 22 Issue 2 -- March/April 2010

As a famous tax bard might have said, “To C or not to C, that is the question.” While there has been little amusing about the recent economic conditions, the widespread slide in asset values, coupled with likely changes in the tax law, make this an opportune moment to consider the previously unthinkable question: Should I consider converting a C corporation to a partnership?

In the past few years, many assets, particularly real estate, have declined significantly in value. If such assets are owned by a C corporation, now might be the time to think about removing them from the double-tax regime of C corporations and moving them into an entity, such as an LLC, taxed as a partnership.

Reduced asset values are not the only reasons why it might now be the optimal time for such a change. Many C corporations have accumulated losses that could be used to offset the potential tax bill for a C to partnership conversion. In addition, the current reduced capital gains and dividend tax rates are scheduled to expire at the end of 2010. If Congress does nothing, capital gain rates will increase to 20% next year. Of course, C corporations do not benefit from reduced capital gains rates.

Although there are a number of different ways to structure what amounts to a conversion of a C corporation to an LLC taxed as a partnership, all of the methods will be treated as a taxable liquidation of the C corporation. In some cases, reduced asset values coupled with accumulated losses may reduce or eliminate most of the tax cost of the “conversion,” but even where there is a tax bill for the “conversion,” it may make sense to incur the tax now, at lower asset values and at lower tax rates, than in the future.

As noted above, there are at least four or five different methods by which such a “conversion” can be achieved. The C corporation (“C Corp”) could transfer all of its assets and liabilities to a new LLC (taxed as a partnership) and thereafter liquidate.

Or, C Corp could first liquidate and distribute its assets and liabilities to its shareholders, who then would contribute those assets and liabilities to the new LLC. If C Corp is, in fact, a non-corporate entity that has elected to be taxed as an association, it might be able to become a partnership for tax purposes simply by changing its check-the-box election. Finally, now many state business entity laws permit corporations and non-corporate entities, like LLCs, to merge or to convert directly from corporate to LLC status.

While the choice of methods can produce some differences in tax consequences, regardless of which form is chosen for the transaction, the result will include a taxable liquidation of C Corp. The choice among the various approaches, however, can have significant consequences apart from income taxes. For example, some of the approaches require actual transfers of title to the assets, and that can result in added real estate transfer taxes and transaction costs.

Similarly, it is often advantageous to use either a direct conversion (if permitted by state corporate/LLC law) or a merger, because there is no need for re-titling any assets. State laws usually make the new entity the legal successor to C Corp and owner of all of its assets, without the need for any actual transfers.

Moreover, a direct conversion or merger approach can avoid other problems such as the need to transfer licenses or other similar assets. On the other hand, many leases, mortgages, and other legal agreements may provide that a conversion or merger might be a breach of the contract or require the consent of the other parties to the agreements.

Suppose C Corp is a Virginia corporation and wishes to become an LLC. Its real estate has declined in value to the point that there is little or no built-in gain in its assets. Virginia law permits a corporation to convert to an LLC by taking certain fairly basic corporate actions and filing articles of entity conversion. By completing the simple actions required in the state law, C Corp will become an LLC by operation of law.

In most cases, for income tax purposes, this will be treated as though C Corp liquidated and distributed its assets and liabilities to its shareholders who then contributed the assets and liabilities to a new partnership. The corporate liquidation is subject to all the usual rules for taxable liquidations, while the subsequent transfer of assets and liabilities will be tax free, unless possibly C Corp were insolvent.

Now may also be a good time to consider “converting” S corporations to partnership-tax entities, such as LLCs, particularly if the corporation owns potentially appreciating assets such as real estate or technology know-how. Because S corporations must recognize gain on any distribution of appreciated property, liquidation of an S corporation can result in adverse tax treatment. Entities taxed as partnerships can distribute most appreciated assets without having to recognize gain.

If you would like to discuss a possible corporate “conversion,” please give us a call.

While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.

Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.

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