S Corporation Conversion to a Limited Liability Company for Wealth Preservation
By: Morris Law Group - February 13, 2014
Use of an S corporation as an operating business entity has become a common practice given certain tax advantages over operation as a C corporation or an limited liability company ("LLC") taxed as a partnership. Namely, use of an S corporation avoids the double taxation of a C corporation and can provide savings with respect to self-employment taxes when compared to an LLC taxed as a partnership, as income from an LLC is subject to self-employment taxation, whereas dividends from an S corporation are not. However, operating as an S corporation can have downsides from a wealth preservation perspective.
Stock in an S corporation or a C corporation is freely attachable by a shareholder's judgment creditor. This means that if you own run your business as an S corporation and you are personally sued outside of the business (for example, if you signed a personal guarantee on real estate which is foreclosed with a resulting deficiency judgment) then your creditor can take the stock you own in your S corporation to satisfy the judgment. Once the creditor has your stock, they can begin voting and, depending on the amount of stock they possess, they may even be able to gain control of your S corporation and force the sale of assets or liquidation of the entity. For purposes of wealth preservation, this is a terrible result.
Alternatively, the membership interest of a member in a multiple-member LLC cannot be levied by a creditor of such member nor can the creditor levy on the assets owned by the LLC. Instead, the creditor is limited to a "charging lien" on the debtor member's membership interest. In such case, the creditor does not become a substitute member and only has the rights of an assignee. The creditor will generally only be entitled to receive distributions made to the debtor member, but cannot compel such distributions, vote the member's interest or control the business operations of the LLC in any way. If the debtor member controls the distributions from the LLC, many times the charging lien will be worthless to a creditor.
Based upon the foregoing, conversion of an existing S corporation to an LLC for state law purposes is preferable from a wealth preservation standpoint; however, when doing so, adverse tax ramifications need to be addressed in order to avoid a deemed sale of the assets within the S corporation and associated potential taxable gains. The conversion can be treated as a tax-free F-reorganization under §368(a)(1)(F) if the conversion constitutes a "mere change in identity, form or place or organization of one corporation, however effected." Thus, if the conversion is done properly and the ownership does not change, the existing S corporation can be converted to an LLC, thereby deriving all of the asset protection benefits; at the same time, the LLC can continue to be taxed as an S corporation, thereby avoiding a deemed sale of assets with associated potential taxable gains and can continue the tax advantages regarding self-employment tax minimization. However, care must be taken to comply with §601.1112, the Florida conversion statute, as well as timely filing Form 8832 to tax the new LLC as an S corporation.
The converted S corporation will for all purposes be the same entity that existed prior to the conversion; the new LLC will be liable for all the existing liabilities of the converting S corporation and title of all assets will remain vested in the new LLC. As the new LLC will be treated as the same entity and title to real property remains vested in the new LLC, if there is any real estate with existing mortgages, the conversion can be argued not to violate such mortgages' due on sale clauses. Additionally, in Revenue Ruling 73-526, the IRS ruled that the taxpayer identification number of the original S-corporation would be continued by the surviving corporation, further facilitating the ease of conversion.
The information provided above is merely educational in nature and by no means complete or exhaustive and may need to be adjusted depending on each individual situation. If you have an existing S corporation which you would like to convert to an LLC to assist in wealth preservation for you and your family, please contact our office for further information.
** Disclaimer Required by IRS Circular 230** Unless otherwise expressly approved in advance by the undersigned, any discussion of federal tax matters herein is not intended and cannot be used 1) to avoid penalties under the Federal tax laws, or 2) to promote, market or recommend to another party any transaction or tax-related matter addressed.