When a client starts a new business, the first question is choice of entity. The advice you offer is arguably the most important advice you will ever offer the client, given the wildly different ways that entities are taxed. The second question is, perhaps, the tax consequences of changing the original choice. Congress continues to amend the code (4,000,000 words and counting) and businesses morph. So what of flexibility? How tax easy (or hard) is it to change that original choice.
While there are many ways to do business, exploding from the collective brain of the ever inventive Congress, we will limit ourselves to four entities and, as said, the question of how tax easy (or hard) it is to change from one form to another.
– A single member limited liability company
– A limited liability company
– An S corporation
– A C corporation
A. A Single Member Limited Liability Company
As you know, this entity is commonly called a “tax-nothing” because it is a sole proprietorship chooses limited liability status solely for liability reasons and not for tax reasons. The gain or loss is calculated on Schedule C of Form 1040 (thus the words “tax nothing”). If a sole proprietorship wants to incorporate, such incorporation is generally tax-free under code section 351.
B. A Limited Liability Company
Wyoming enacted the first limited liability (LLC) statute in 1977 as special interest legislation for a mineral company. The LLC is now a general statutory entity in all 50 states and D.C. because the LLC combines a corporate-like limitation on liability with taxation as a partnership. (Remember that in a limited partnership there must be as least one general partner all of whose assets are subject to liability and not just partnership assets.)
LLCs can generally be converted tax-free to corporate status under Rev. Rul. 84-111. Because there are three ways to convert under Rev. Rul. 84-111, a careful review of the revenue ruling is mandatory. For example, one way to convert is “assets-over,” meaning that the LLC (taxed as a partnership) contributes the LLC assets to the newly minted corporation for its stock, which the LLC then distributes to the new shareholders (and former members) and dissolves. If the newly minted corporation elects S status, the LLC (taxed as a partnership) holds the stock for a nanosecond before distribution to the new shareholders and dissolution. Given that partnerships are ineligible shareholders, the S election may be invalid. Only practitioners who like the adrenaline rush from excessive risk taking will try “assets-over” for an S incorporation.
C. An S Corporation
While an LLC may generally convert tax-free to corporate status under Rev. Rul. 84-111, the reverse is not true. Converting a corporation to an LLC is deemed a liquidation with the resultant one level of tax for S corporations (and two levels of tax for C corporations).
D. A C Corporation
A client may want to convert a C corporation to S status. Unfortunately the built-in-gain tax (the BIG tax) may result in BIG gain shortly after conversion (sale of inventory held at conversion) and a BIG tax upon the disposition of other assets for a 5-year period (generally a 10 year period except for some relief legislation).
It would be too generous to suggest that this short review of flexibility is adequate. It is not. There is no mention of general partnerships and only an aside on limited partnerships. There is excessive use of the modifier “generally.” For an in-depth review of flexibility and other choice of entity questions, download our self-study course on how to choose the best entity structure under current tax laws.