Not So Fast – Consider the Income Tax Consequences Before Using an Entity Conversion Statute
Updated:March 20, 2016
Originally Published: Maryland Bar Bulletin December 1, 2013
Many states, including Maryland, have enacted statutes (“Conversion Statutes”) that allow business entities to convert into other forms of entities. For example, under Maryland’s Conversion Statute, a Maryland corporation can convert into a Maryland limited liability company, and vice versa.
Without Maryland’s Conversion Statute, the only means by which an entity could change its form was to merge with, or transfer its assets to, another entity. But under Maryland’s Conversion Statute, the new entity is deemed to be the same entity as the old entity for state law purposes. Thus, as compared to a merger or transfer of assets, utilization of Maryland’s Conversion Statute should result in fewer third-party consents and approvals, as well as the avoidance of other issues related to a transfer of assets. While the converted entity is deemed to be the same entity as the old entity for state law purposes, business owners and their advisors should be aware that a conversion may have federal income tax consequences.
With respect to the conversion of a corporation (taxed as a C corporation for income tax purposes) into a limited liability company (taxed as a partnership for income tax purposes), the corporation is deemed to liquidate for federal income tax purposes, which may result in two levels of tax. First, the corporation will be treated as if it sold all of its assets in exchange for consideration equal to the fair market value of its assets. Thus, to the extent the corporation has appreciated assets (i.e., assets with fair market values in excess of their bases), the deemed liquidation will result in a corporate-level tax. Second, upon receipt of the corporation’s assets, the shareholders will be treated as if their stock was redeemed in exchange for receipt of all of the corporation’s assets, potentially resulting in gain at the shareholder level.
After the deemed corporate liquidation has occurred, there are generally no adverse tax consequences upon the deemed transfer of former-corporate assets to the new limited liability company in exchange for interests in the limited liability company. Although the contribution of property to a corporation in exchange for stock often does not produce taxable income to the contributor or the corporation, the tax cost may be substantial when trying to transfer appreciated property out of the corporation. Thus, Conversion Statutes are not a remedy for a taxpayer that desires to remove appreciated property from a corporation.
With respect to the conversion of a limited liability company (taxed as a partnership for income tax purposes, and hereinafter referred to as a “partnership”) to a corporation, such conversion will be viewed for income tax purposes under one of three methods. Under the “assets-over” method, the partnership contributes all of its assets to the corporation in exchange for stock in the corporation and then the partnership distributes the stock to its partners in a complete liquidation. Under the “assets-up” method, the partnership liquidates by distributing all of its assets and liabilities to its partners, who then contribute the assets and liabilities to the corporation in exchange for stock in the corporation. Under the “interests-over” method, the partners contribute their interests in the partnership to the corporation in exchange for stock in the corporation, which results in a termination of the partnership and causes all of the partnership’s assets and liabilities to be owned by the corporation. While each of the three methods generally will not result in an immediate income tax liability, the choice of a particular method may have differing effects on the tax basis of the assets in the hands of the corporation.
When a limited liability company converts to a corporation in accordance with a state law conversion statute, the Internal Revenue Service has stated that the conversion will be treated as an “assets-over” transaction. Thus, while Conversion Statutes simplify the process of converting a limited liability company into a corporation for state law purposes, taxpayers must realize that such ease of conversion will prevent them from choosing the form, and the associated tax consequences, of how the conversion will be treated for tax purposes. If the “assets-over” form associated with the utilization of the Conversion Statutes does not produce the desired tax results, a taxpayer may wish to forego use of the Conversion Statutes and incorporate a limited liability company by following the steps involved in either of the “assets-up” or “interests-over” methods.
Conversion Statutes are intended to simplify the process for business entities to convert into other forms of entities. Before utilizing a Conversion Statute, however, business owners should consider the income tax consequences of the conversion and consult with their tax advisors.