You take the time to select the perfect business entity for your startup professional services business. Competent tax and business advisors are consulted. The tax, limited liability and other factors are thoroughly weighed. You rest well after the decision is made with full confidence at least one sound decision concerning the business is settled. Then, out of the blue, the laws in place that prompted you to select a particular entity change.
The scenario above is an all too common experience for a business owner today. In the wake of the none too distant Great Recession, the American Taxpayer Relief Act of 2012 (“ATRA”) was passed, which contains a slew of federal tax law changes designed to keep our United States economy on a post-recession track. President Barack Obama signed the Protecting Americans from Tax Hikes Act (“PATH”) in December 2015. PATH contains additional tax provisions designed to further stimulate economic growth. In March 2015 the Securities Exchange Commission adopted Jumpstart Our Business Startups Act (JOBS) based amendments to help businesses raise funds through public offerings. Lurking in the ATRA, PATH and JOBS are adjusted tax rates, modified tax credits, and relaxed securities laws, among other changes, most advantageous to companies equipped with the right business entity for the circumstances.
The prospect of saving taxes or raising easy capital will inevitably lead some business owners to ponder whether the pastures are greener on a different type of entity. Does changing entities make sense? Will the net benefits outstrip the costs of converting to a new entity? The purpose of this two part article is to provide general guidance on the cost component of that question. In part one the logistical, i.e., transactional, costs of changing from one entity to another is examined. Costs such as legal fees fall under this category. The focal point in part two are the costs imposed in the form of taxes.
Before a decision to convert is made the transactional costs associated with an entity change should be carefully weighed. A significant cost driver of converting an entity is state law which sets the requirements for making a change. At one time federal law was also a major cost contributing factor. Today we have the check the box rules.
December 18, 1996 marks the day the Internal Revenue Service dramatically changed the way business entities establish their tax identities. On that date the IRS adopted its so-called check the box regulations. Prior to December 1996 entity tax classifications were based on a multi-factor test, which necessitated a painstaking and yet unpredictable analysis of an entities’ traits relative to the following characteristics: limited liability, continuity of life, free transferability of interests, centralized management, and an objective to carry on a business for joint profit.
The process was susceptible to abuse and often lead to unintended consequences.
Under the check the box rules, as codified in Treas. Reg. § 301.7701-3, a business entity may chose or change its federal tax classification by simply completing and filing IRS form 8832. An entity with two or more owners may choose to be taxed as a corporation. Otherwise the entity will be taxed as a partnership by default. An entity with one owner can choose to be taxed as a corporation or a disregarded entity.
One relative disadvantage of a regular (“C”) corporation is double taxation. A corporation can avoid this tax if it elects to be taxed as an S Corporation. An S election is made by corporations and unincorporated entities by completing and filing IRS Form 2553. Treasury Regulation 1.1362-6 requires the consent of all of the owners of the entity at the time of the election. It also imposes a deadline. Form 2553 must be mailed within 2½ months of the close of an entity’s year to be considered timely filed.
To reverse an S election an entity files a written statement with the IRS Service Center where the election to be taxed as an S Corporation was filed. The letter should state (1) that the corporation is revoking its S-election, (2) the number of shares of stock issued and outstanding and (3) the date the revocation will be effective.1 Treas. Reg. 1.1362-6(a)(3).
Not to be outdone most states today also permit businesses to freely determine the tax status of their entity. As of 2016 virtually all states conform, at least in part, to the federal check the box rules2.
Sometimes a change a company desires cannot be accomplished by simply completing a check-the-box application. One example is a desire for a C Corporation, because it can issue different classes of stock. Perhaps an entity was formed in a state that lacks a particular desired check the box option. In these cases a change to a different organization form may be required.
Each state has its own laws governing how organization form changes can be made. Generally, however, they are effected in one of three ways: statutory conversion; non-statutory conversion or interspecies merger. Let us consider each alternative in greater detail.
A statutory conversion is a change from one entity type to another effected by a single entity being converted as authorized by a statute. The primary benefit of a typical conversion statute is that no assets are actually required to be transferred in the transformation.
In a statutory interspecies merger the owners of one type of entity form a second entity of a different type. Subsequently the owners merge the two entities and cause the desired entity to emerge as the survivor. The merger occurs pursuant to a state merger statute, which in most cases requires the preparation of a plan of merger and having the plan approved by the shareholders.
A non-statutory conversion requires the creation of a new entity, the transfer of assets to the new entity and the dissolution of the old entity. The end result is a new entity.
The method chosen for a conversion will naturally depend on the options made available by the state in which an entity was formed. Statutory conversions are generally the most cost effective way to change entities. The fewest steps are required and no new entity has to be formed to change entities. Statutory mergers generally are the most complex of the three transactions. Unlike statutory conversions, statutory mergers do require the formation of a separate corporation before the conversion, i.e., merger. They also require compliance with a complicated statute.
However an entity is ultimately converted the costs associated with the following miscellaneous steps should also be considered. Company contracts should carefully reviewed to make sure an entity change would not violate any contractual terms. Counterparty consent to an entity change should be obtained if a potential violation is discovered. Bank account records may have to be updated to reflect the new entity’s legal name. In some cases assets will need to be retitled to the new entity.
To determine whether a conversion is cost-effective it is crucial to consider the tax consequences. Even if a conversion makes sense in light of the professional fees and other expenses, the undertaking of a conversion may be too costly if the taxes to pay to convert are substantial. While the details of how a conversion will be taxed will vary depending on the specific situation general guidance on the tax implications based on the most typical transactions are as follows:
An unincorporated entity (e.g., a limited liability company)3 can be converted tax free into a corporation by means of a conversion statute. As explained in Revenue Ruling 2004-59, when an unincorporated entity is converted into a corporation pursuant to a conversion statute the following steps are deemed to occur: “The unincorporated entity contributes all of its assets and liabilities to the corporation in exchange for the stock of the corporation. Immediately thereafter, the unincorporated entity liquidates, distributing the stock of the corporation to its partners.” Thus, there are two steps with potential tax implications to overcome.
The deemed contribution step may escape taxation under Internal Revenue Code (“IRC”) Sec. 351(a). Generally, Sec. 351(a) allows tax free exchange of assets for stock, so long as 80% control of the converting company is acquired. Unincorporated entities can generally liquidate tax free pursuant to 26 U.S.C. § IRC 731, governing partnership distributions,4 provided the unincorporated entity has not elected to be taxed as an S Corporation.5
Like unincorporated entities taxed as partnerships, S electing unincorporated entities can convert tax free into a regular corporation. Unincorporated S filers simply look to the corporate reorganization provisions of the Internal Revenue Code, not 26 U.S.C. § IRC 731, for guidance in structuring the transaction. Generally the liquidation of an S Corporation is a taxable event. However, IRC Section 368 allows for an exception for the liquidation of unincorporated entity selecting to be taxed as S Corporation. This exception applies, as the IRS discusses in private letter ruling 200528021, when the unincorporated S filer is converted pursuant to a conversion statute and the transaction can be structured under IRC Sec. 368(a)(1)(F). Such transactions are colloquially knows as type F reorganizations. They constitute a mere change in identity, form, or place of organization of one “corporation”.
To recap, the following conversions of an unincorporated entity can be structured in a tax free manner pursuant to a conversion statute:
Changing a corporation into a partnership can have serious tax consequences. Corporation liquidation is deemed to occur. When a corporation liquidates 26 U.S.C §§ 331 and 336 both come into play. The result is double taxation. Under Internal Revenue Code (“IRC”) Section 336 the corporation is required to report gain or loss as if it sold all of the property it holds at fair market value. The shareholders are taxed pursuant to IRC Section 331 as if they sold their shares back to the corporation.
The outcome is more favorable if the unincorporated entity has made an election to be taxed as an S Corporation. The transaction can then possibly be structured as a tax free reorganization under IRC Sec 368(a)(1)(F).6 Otherwise, the conversion will be subject to a single, shareholder, level of taxation.7
In sum, a corporation to partnership conversion is a taxable transaction unless the partnership is taxed as an S Corporation.
Another cost to assess of converting a regular corporation is the potential loss of valuable tax attributes. Sometimes a business spends in a year more than it earns giving rise to a net operating loss (“NOL”). Some corporations have business tax credits on their books which they have been unable to use in prior years. These NOL’s and business credits represent valuable assets that can be utilized to reduce future taxable income. If a company ceases to be taxed as a regular Corporation, these tax attributes can be lost or greatly limited.8
In states that lack a conversion statute entity change often results in tax consequences. Tax sensitive owners of entities formed in these states should consider the following when contemplating entity change: (1) whether the laws of the state make available a check the box option suitable to the owners’ needs; and (2) whether the conversion a company seeks would involve changing to or from a corporation.
If an organization form change is required for the type of entity change desired a company will typically undergo an interspecies merger or non-statutory conversion. On the federal level IRC Section 368 governs mergers and other types of reorganizations involving corporations. Section 368 generally limits tax free reorganizations to transactions between or among corporations. Therefore, in the absence of a conversion statute, an organization form change from an unincorporated entity into an incorporated entity, or the reverse, will typically be subject to taxation.
It should be recalled, however, IRC Section 368 does not apply to transactions between unincorporated entities. Mergers and reorganizations of unincorporated entities with more than one owner are governed by 26 USC § 701 et. seq., (“Subchapter K”). Under Subchapter K, a merger or non-statutory conversion between two or more unincorporated entities can generally be transacted without the incurrence of taxes. An example is a conversion through merger of a limited liability company (“LLC”) into a limited partnership. In Revenue Ruling 1995-37 the IRS confirmed that even a partnership can metamorphose into an LLC in a non-taxable reorganization.
Often times entity change of an unincorporated entity takes the form of a LLC taxed as a partnership electing to be taxed as an S Corporation. Companies that desire to remain unincorporated can become S corporation filers without tax consequences by filing IRS form 2553. An S election by a regular corporation is also generally a non-taxable transaction. So too is it true that a corporation having experienced the pass-through tax glory of an S-election can choose to be taxed as a regular corporation without paying tax to convert. Thus, if a desired change can be made pursuant to a check the box option the existence of conversion statute is typically irrelevant.
State and local taxation of conversions vary widely depending on the laws of the governing jurisdiction. In many instances the taxation of conversions on the state and local tax level is similar to the federal. An analysis of the state and local tax implications is beyond the scope of this article but should be considered.
When will a conversion make sense? The answer depends on the facts and circumstances. A number of key factors to consider are whether the state in which an entity was formed affords the convenience of a desired check the box rule or a conversion statute and to what extent tax savings can be procured by changing entities. Nonetheless, given the complex tax and legal issues involved in changing an entity type it is recommended that you speak with the proper professional before undertaking any conversion.
1. Treas. Reg. § 1.1362-6(a)(3)
2. RIA Checkpoint, Thompson Reuters/Tax & Accounting
3. Other examples of “unincorporated entities” include partnerships, limited partnerships and limited liability partnerships.
4. More specifically, 26 U.S.C. §§ IRC 731 and 708(b)(1)(A).
5. See also Revenue Ruling 1984-111, and Revenue Ruling 2004-59.
6. See IRS Letter Ruling 200548021.
7. If a corporation distributes property in liquidation, the corporation is required to recognize gain and loss under § 336 as though the property were sold at fair market value and any resulting gain or loss is passed through to the shareholders. If an S corporation sells assets and then distributes the proceeds in liquidation, any gain or loss recognized by the corporation on the sale of such assets is passed through to the shareholders.
8. Unless an S Corporation contains assets subject to built-in gains tax it generally cannot utilize C Corporation net operating losses. IRC Sec. 1371(b). The NOL 20 year period continues to run, however, and the NOL’s can be used upon re-converting to C corporation status.
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