Conversion to and Formation of LLCs

Over years, I have had the experience of converting corporations (either S Corps or Corps) to a limited liability company (LLC).  The reasons are to achieve better asset protection from outside creditors and have less ongoing documentation (avoiding corporate minutes) but not to be considered to have liquidated for income tax purposes.

I have also converted general and limited partnerships to LLCs.  Conversion is a formless matter under California law that does not impact your business operations or how you hold your assets, if you still want to be tax as you currently are.

Some of my clients decided during the formation of a new business venture to be taxed as an S Corporation in order to take care of favorable tax treatment, but want from an operational standpoint to be an LLC compared to operating as a corporation as mentioned above.  Generally, LLCs are taxed as partnerships and more often than not that is the preferable choice, especially if you own real estate.

Formless Transaction.  It wasn’t until a couple of years ago that California allowed a corporation, similar to other business entities, (i.e., general partnerships, limited partnerships) to convert to an LLC.  The effect of a conversion is to merely change the form of how you do business, but it does not change any of your legal obligations.  This is a very key concept to understand.  You even keep your old employer identification number after a conversion.  More importantly, if you want to preserve favorable tax benefits as either a C Corporation or S Corporation you will not be subject to the gross receipt tax discussed below under the disadvantages of utilizing an LLC.

A major reason that an LLC is more attractive as a business entity is because you are not required under the Beverly-Killea Limited Liability Company Act (the “Act”) to have formal membership meetings compared to corporations.  Because of this benefit, you would not want your operating agreement to provide for annual or regular meetings.  If there was a requirement of annual or regular meetings and you did not do so, you may not avoid an alter ego attack by creditors.

Another reason why an LLC is more favorable under the Act compared to the corporate laws under the State of California and other states is the charging order protection.  Under a charging order, an outside creditor (did not deal directly with LLC) becomes only an assignee and will not to be able to vote your membership interest and dissolve the LLC compared to a corporation and being able to vote your stock.

LLC Taxed as a Corporation.  The solution is to make certain that the corporations that have converted to LLCs will still be taxed as corporations.  I previously mentioned the preservation of the NOLs and avoiding the double taxation.  You must be certain that before and after the conversion the equity interest remains the same.  This is particularly true regarding NOL limitations on a change of ownership.

However, there are other reasons why people would choose to want to remain as corporations or be tax as one on formation.  Family members may prefer the certainty of corporate tax treatment for their closely held business.  In a non personal service business that distributes almost all of the profits as salaries or other compensation the marginal tax rate for a corporation is lower, eg. 15% on the first $50,000 of income compared to the tax rate of each individual member.  Even in a personal service business, the marginal tax rate for a corporation of 35% is less than the maximum tax rate of the individual members ie. 39.6%.  Moreover, an LLC taxed as a corporation may deduct certain employee benefits, such as accident and health premiums, while avoiding state laws’ corporate governing provisions.

Conversion Concept.  Besides converting corporations, I have also converted general and limited partnerships into California LLCs.  The reason for the conversion with regard to the general partnership was to make certain that if an inside creditor (compared to an outside creditor) were to be successful in obtaining a judgment against the partnership, the general partner risk of loss would be to only the partnership asset and not any of their other personal holding.

Conversion of existing corporations or other business entities to LLCs via the statutory conversion provision is generally preferable to other conversion techniques, including statutory mergers.  The reason for this is a statutory conversion is in compliance with state law that legally allows the conversions without numerous conveyance documents.  The assets and liabilities of the corporation or other entities become the assets and liabilities of the LLC by operation of law.  Unlike the entities in a statutory merger, the converting LLC is treated as the same entity that existed before the conversion, thus avoiding conveyance or transfer tax which is particularly important in real estate holding.

Disadvantages.  Lastly, there are some disadvantages for conducting business under an LLC.  The first is a financial disadvantage regarding the graduated gross receipts fees that can be as high as $12,990 on gross receipts in excess of $5,000,000 a year.  If the gross receipts of an LLC were under a half a million dollars then the annual fee would be $1,700.  Some people would much rather be subject to the lower annual $800 imposed on C corporations and limited partnerships.  If an LLC is taxed as a C corporation you are not subject to the LLC gross receipts fees because the LLC will be filing a corporation rather than an LLC income tax return.

A second disadvantage has to do with the fact that if the converting entity owns real estate, a lender may construe this to be a type of transfer that would have to have lender approval and therefore may charge you an additional fee under the deed of trust. Generally this is not an issue because the conversion is done by operation of the law and mere a change of business form.

Conclusion.  With proper planning converting a business entity to an LLC, particularly a corporation or general partnership can be accomplished easily without adverse tax consequences.  When forming of a new business entity consideration can be given to forming an LLC, but have it taxed as a corporation rather than a partnership because of favorable tax rates.