So rather than get immersed in the mudslinging, let’s just stick to good ol’ fashioned tax law talk, shall we?
Fact: Converting from an S corporation to an LLC is generally a painful event. Why? Because in order to convert, regardless of the form the conversion may take, the conversion will generally require a taxable liquidation of the S corporation. And upon liquidation, an S Corporation recognizes gain under Section 336 as if it sold all of its assets, including any intangible assets (i.e., goodwill) for their FMV. This deemed sale usually creates gain at the S corporation level that is prohibitive.
Example: S Co. is owned 100% by A, who has a $300,000 basis in the S Co. stock. S Co. owns hard assets worth $1,000,000 with a $300,000 tax basis. S Co. also has intangible value of $500,000, making the total enterprise value $1,500,000.
If S Co. wishes to convert to an LLC by liquidating and then having its shareholders contribute the assets to the new LLC, S Co. will recognize $1,200,000 of gain under Section 336 ($1,500,000 FMV – $300,000 tax basis) upon distribution of the assets.
When S Co. then passes out the assets in liquidation, S Co.’s shareholders will treat the $1,500,000 FMV of the distributed assets as the amount realized in exchange for the shareholders’ stock under Section 331. Because the $1,200,000 corporate level gain flows through and increases A’s stock basis under Section 1367, however, A’s basis will be $1,500,000 after adjustment ($300,000 + $1,200,000). Thus, A will recognize no further gain or loss upon liquidation ($1,500,000 amount realized less $1,500,000 stock basis).
Nevertheless, the $1,200,000 of corporate level gain is often reason enough not to pursue the conversion.
But what if you have an S corporation that is in the business of property development or home building? These types of activities have two things going for them that may facilitate a conversion:
1).There is often no goodwill value, as the entities are typically special purpose entities designed for one piece of development, not an ongoing business; and
2) In the current real estate market, many property development or home builder S corporations have mortgages that exceed the FMV of the developed property.
Why is this important? Because given those two facts, now may be the opportune time to convert to an LLC, if so desired:
Assume instead, S Co. owns a property with a FMV and tax basis of $1,000,000. S Co. also owns other assets with a basis and FMV of $500,000. The property is encumbered by a mortgage of $1,500,000. A has a stock basis in the corporation of $0.
If S Co. decides to liquidate and convert to an LLC, Section 336 requires that in computing S Co.’s corporate level gain upon liquidation, the FMV of the property cannot be less than any liability encumbering the asset. As a result, S Co.’s gain will be $500,000 ($1,500,000 debt + $500,000 FMV other assets – total basis of $1,500,000).
This gain then flows through to A, and will increase his stock basis from $0 to $500,000.
Furthermore, when S Co. distributes the assets, the case law (See Ford) dictates that the amount realized on the liquidation is the $1,000,000 FMV of the building plus the $500,000 FMV of the other assets less the debt distributed along with it of $1,500,000. Thus, S Co. is treated as having received no value for the stock, and will recognize a $500,000 capital loss under Section 331 or Section 165. This loss may offset the $500,000 of gain passed through from the S corporation, resulting in no net gain or loss to A.
What’s the point? With the real estate market still suffering and many properties encumbered by debt in excess of the FMV of the property, now may be the time to correct the “mistake” of placing real estate in an S corporation. Provided intangible value is not a concern, distributing real estate encumbered by debt that exceeds the FMV of the asset may mitigate the normal pain of converting an S corporation into a more tax-friendly LLC.