Tax Issue In Conversion of S-Corporation To Limited Liability Company

Limited liability companies are generally better asset protection entities than corporation. A judgment debtor can levy upon the debtor’s stock in a corporation and in the case of a small corporation possibly stop the corporation business and liquidate corporate assets. In the case of a debtor’s limited liability company interest the judgment creditor’s remedy is limited to a lien on distributions, if any, and the creditor cannot stop the LLC operations or force the sale of the LLC’s assets. In the past, the corporation, and particularly Sub-S corporations, were the most common business entity for closely held small business. When owners of small corporations become concerned about asset protection they often want to convert their S corporations to LLCs, possibly LLCs taxed as S corporations for tax purposes.

This past week one such corporation owner discussed with me the procedures to convert his profitable corporation to a limited liability company. Florida statutes provide a means to convert a domestic or out-of-state corporation to a Florida LLC. The issue we discussed was whether the conversion of a corporation would be treated for tax purposes as a liquidation and would accelerate the owner’s income tax liability.

To be sure, I forwarded the tax question to a local account named Lonnie Young. Lonnie has years of experience accounting for small business clients. He responded by email as follows:” 

A conversion from S to an LLC can qualify as a tax-free reorganization under § 368-(a)(1)(F). In a Letter Ruling the basis and holding periods of the assets in new LLC are the same as in the prior Sub S. The S Corp status did not terminate as a result of the reorg since new LLC retained its S corp election and continued to meet S corp requirements per § 1361 (Ltr Rule 200528021).There will be issues if the ownership as a result of this re-org changes. Same owners, same percentages should not be a problem.” 

So, if a S Corporation owner wants to reorganize as an LLC taxed as an S corporation (by filing Form 8832) he should be able to do so without adverse tax effect as long as ownership does not change. I would be interested to know if the answer is the same if one spouse converts his S corporation to an LLC owned by the two spouses jointly when the spouses file joint tax returns- is this merger a change of ownership for tax purposes?

Last updated on May 22, 2020

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