Converting from an LLC to a C Corp is a common occurrence for many startups when they begin looking for outside financing. Two previous blog posts outline the paperwork that must be filed in order for a startup to successfully convert to a C Corp. Other than the filing requirements, it is important to know the tax treatment of the conversion.

 

Tax Consequences of an Assets-over transfer

A check-the-box election is usually treated as an “assets-over” transfer where there are two steps: (1) LLC contributes all of its assets to the corporation in exchange for stock, and then (2) the LLC liquidates and the corporation’s stock is distributed to the members.

If after conversion, at least 80 percent of the total combined voting power of all classes of stock in addition to 80 percent of total number of shares of non-voting class of stock retains control of the corporation, IRC § 351 governs the tax treatment of the transaction.

Generally, no gain or loss is recognized if property is transferred solely in exchange for stock in the corporation (IRC § 351). If other property or money is also given in exchange, gain must be recognized not in excess of the amount of money received plus the fair market value of any other property received. The LLC does not recognize any loss.

For exchanges where IRC § 351 applies, IRC § 357 states that gain must be recognized if the sum of the liabilities assumed is greater than the adjusted basis of the property transferred. The adjusted basis is the net cost of property after adjusting for improvement and depreciation of the property as well as any other tax-related items. This means that if the LLC transfers assets with a fair market value of $100,000 to the corporation along with debt worth $140,000 the LLC will have eliminated $40,000 of debt which is then treated as income. This $40,000 would be gain under IRC § 357.

One important thing to note for future tax calculations is the basis in each asset. The basis of something is simply the cost of the asset. The corporation takes the LLC’s basis in its assets, increased only if gain is recognized by the LLC. This is called the carryover basis (IRC § 362). The member’s basis in the corporation’s stock that is distributed to the member in exchange for liquidation of the member’s interest is the member’s adjusted basis in its LLC interest minus any money distributed to the member in the same transaction (IRC § 732).

 

Tax Consequences of an Assets-up Transfer

This transaction is different from an “assets-over” transfer because the members contribute the assets to the corporation instead of the LLC. This is a two-step process: (1) LLC liquidates and distributes its assets to its members and (2) the members contribute the assets to the corporation in exchange for stock.

A member must recognize gain on the money distributed to the extent that it is greater than the adjusted basis of the member’s interest in the LLC. If the only property distributed is money and the basis of any unrealized receivables and inventory, a loss should be recognized to the extent of the adjusted basis of member’s interest in LLC over the amount of the property distributed.

An LLC recognizes no gain or loss on distribution of its property to a member (IRC § 731).

The calculation of the basis for “asset-up” transfers is the same as for “asset-over” transfers. The member’s basis in the assets distributed in exchange for liquidation of member’s interest is the member’s adjusted basis in its LLC interest minus any money distributed to the member in the same transaction (IRC § 732). The corporation takes the carryover basis in the assets.

 

Tax Consequences of an Interests-over Transfer 

An interest-over transfer involves two steps: (1) members transfer their LLC interests to the corporation in exchange for stock and (2) the corporation dissolves LLC. Luckily, the tax treatment for an interest-over transfer is very similar to an assets-over transfer. The same sections dictate when a member must recognize a gain or loss. A corporation’s tax basis in the transferred assets equals the members’ aggregate tax basis. A member’s tax basis in the received stock is equal to the tax basis in its LLC interest minus the member’s liabilities assumed by the corporation.

The tax treatment of converting from an LLC to a C Corp can be complex and confusing. Startups should obtain legal advice from a tax attorney.