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Changing the Form Of An Entity
To A Limited Liability Company
By ProGuide™

NEW - COMING 2011!

ProForms™ 2011 - Legal Forms - CD
By ProGuide - Practically A Complete
Business "Law Office On A Disk"™

  • a great business law forms collection in its own right

  • a "must have" supplement to your current legal forms collection

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ProGuide™ - Legal Forms is pleased to make these continuing legal education materials available to you. However, please note that while still quite useful, portions of the materials discuss issues which have been clarified by the "check_a_box" and other regulations subsequently adopted by the Internal Revenue Service. Thus, the materials, as set forth, should not be relied upon as reflecting the current state of the law and great care should be used to ensure that all legal references and all conclusions reached are still correct and have not been rendered obsolete by statutes, regulations, rulings and other pronouncements of the Internal Revenue Service, the courts, and various state agencies.

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               I.   Conversions of  Partnership to LLC.

                    A.   For many years the IRS has recognized that

                         general and limited partnerships could convert

                         from one form to the other without causing a

                         termination under IRC section 708 if the

                         business of the old partnership is continued by

                         the new. See Rev. Rul 84-52, 1984-1 C.B. 157

                         1.   The considerations set forth in that

                              ruling are equally applicable to a

                              conversion to an LLC and the IRS has

                              stated that they are analogous under

                              circumstances where the LLC is

                              appropriately classified as a partnership. 

                    B.   The conversion of the partnership to an LLC may

                         take several forms:

                         1.   It can be a merger - prohibited in

                              Wisconsin PLR 9210019, PLR 9412030

                         2.   Contribution of partnership interests to

                              the LLC in exchange for interests in the

                              LLC, followed by the dissolution of the

                              partnership and the distribution of its

                              assets to LLC  See PLR 9119029, 9226035,

                              9416028, 9417009

                         3.   Contribution of partnership assets to the

                              LLC, followed by a distribution of the

                              interests in the LLC to the partners of

                              the liquidating partnership.  See Rev.Rul.


                         4.   Merely "converting" the partnership into

                              an LLC.  See PLR 9029019

                         5.   Having the partnership entering into an

                              Operating Agreement under the LLC Act.

                              See PLR 9010027

                    C.   Regardless of the form, the IRS has applied Rev

                         Rul 84-52, 1984-1 CB 157, and treated the

                         transaction as a contribution of property to

                         the LLC in exchange for an interest in it.

                         1.   The effect is:

                              a.   Under section 721 of the Code, no

                                   gain or loss is recognized by the LLC

                                   or any of its partners

                              b.   There is no termination of the

                                   partnership since the business is

                                   continued by the partners in a

                                   partnership form and section

                                   1.708-1(b)(1)(ii) of the Regs

                                   provides that a contribution of

                                   property to a partnership does not

                                   constitute a sale or exchange for

                                   purposes of section 708 of the Code.

                              c.   The basis of the members in the

                                   interests of the LLC equal their

                                   basis in the property contributed by

                                   them. Section 722 of the Code

                              d.   The holding period of the members in

                                   the LLC is the same as their holding

                                   period in the partnership 1223(1).

                              e.   However, if as a result of the

                                   conversion, there change in the

                                   partners' share of liabilities, those

                                   whose share of liabilities is

                                   decreased receive a deemed

                                   distribution then the basis of that

                                   partner's interest shall, under

                                   section 733 of the Code, be reduced

                                   (but not below  zero) by the amount

                                   of such deemed distribution, and gain

                                   will be recognized by that partner

                                   under section 731 of the Code to the

                                   extent the deemed distribution

                                   exceeds the adjusted basis of that

                                   partner's interest in the LLC.

                                   (1)  In a conversion of a general or

                                        limited partnership to an LLC,

                                        the change from being liable for

                                        debts of the entity (in the case

                                        of a general partner) to not

                                        being liable for the debts

                                        because of the LLC's limited

                                        liability can cause such changes

                                        in the actual liability each

                                        member can have and changes in

                                        the economic risk of loss which

                                        can result in changes in the

                                        amount of liabilities allocated

                                        to each partner..  Care must be

                                        taken in drafting operating

                                        agreement to take this problem

                                        into consideration.

                    D.   The contribution of property to an LLC upon its

                         organization and solely for a membership

                         interest will not constitute a sale for

                         Wisconsin sales tax purposes. Wis. Stat.


                         1.   Watch out - subsequent transfers (after

                              the LLCs organization) will not be exempt

                              under this provision.  However, depending

                              on the nature and format of the transfer,

                              other exemptions may exist.

                         2.   Watch real estate tax impact.

                    E.   A professional practice - law, accounting etc,

                         can organize themselves in a manner such that

                         they may use the cash method of accounting. see

                         PLR 9412030

               II.  Conversion of a Corporation to an LLC

                    A.   In general, if the LLC will be taxed as a

                         partnership, the conversion will require the

                         liquidation of the corporation and a

                         contribution of the distributed property to the

                         LLC.  The liquidation of the corporation is

                         likely to be taxable and the contribution to

                         the LLC should be tax free under IRC section


                         1.   If the basis of the interest in the stock

                              is high enough (Sub S or newly formed

                              corp), the tax impact could be minimal.

                         2.   Other formats can also be used - see the

                              discussion of partnership conversions

                    B.   The corporation may incur gain on the

                         distribution of its appreciated assets pursuant

                         to IRC section 336.

                    C.   Wisconsin does not permit the merger of a

                         corporation with an LLC

                    D.   If the LLC will be taxed as a corporation,

                         consider "liquidation-reincorporation" doctrine

                         and possible reorganization statutes.

                    E.   Also consider using foreign LLC which has more

                         favorable provisions.

                    F.   If a Parent-Subsidiary relationship exists and

                         the objective is to convert the subsidiary to

                         an LLC for a business reason, eg. licensing,

                         consider using a foreign LLC which can

                         undertake a merger with a corporation and

                         follow the procedure in PLR 9404021, which

                         relied on Rev. Rul 69-6, 1969-1 C.B. 104

               III. Corporate Freeze Transactions

                         1.   "Freeze" transactions (re-capitalizations)

                              were popular estate planning devices prior

                              to the adoption of chapter 14 of the IRC.

                              However, they still serve some useful

                              purposes and may help to reduce the double

                              taxation of corporate distributions

                              occasioned by the repeal of the General

                              Utilities case.

                         2.   While partnerships have been used in

                              connection with freeze transactions, an

                              LLC classified as a partnership could be

                              used since either entity will avoid the

                              double tax on future appreciation.

                         3.   The essence of the transaction is the

                              transfer of assets which are likely to

                              appreciate from the C corporation to the

                              LLC in exchange for an interest as a

                              member. The shareholders of the C

                              corporation also contribute capital to the

                              LLC in exchange for interests.  All of the

                              transfers to the partnership for an

                              interest are tax free.

                         4.   The C corp. is then given an interest in

                              the LLC which is preferred as to both

                              profits and distributions.  Any

                              unrecognized gain attributable to the

                              difference between the fair market value

                              of the assets contributed by the

                              corporation and their adjusted basis is

                              allocated to the corporation. IRC 704(c).

                              However, other gain arising after the

                              formation of the LLC is allocated to the

                              other partners.

                         5.   The interest received by the corporation

                              has limited rights to share in future

                              appreciation but instead has a more secure

                              and perhaps higher rate of return.  The

                              other members receive a less secure

                              interest, but one that can more readily


                         6.   This transaction is risky and may be

                              recharacterized by IRS as a constructive

                              dividend rom the C corp. to its

                              shareholders.  Valuations and a legitimate

                              business purpose are crucial if the

                              transaction is to withstand scrutiny.

                         7.   The flexibility and other characteristics

                              of the LLC itself may provide a basis for

                              the change.

                         8.   All dealings between the and the C

                              corporation must be at consistent with

                              those which would be had with a third

                              party or the IRS may re-allocate income

                              and expenses pursuant to IRC 482.

               IV.  Obtaining Some Advantages of An LLC In Small

                    Business Operations When Liquidating a Corporate

                    Entity Would Be Too Expensive.

                    A.   It may be possible to cease any additional

                         expansion of an existing corporate business and

                         have shareholders carry out future business

                         plans through a new LLC.  Such an arrangement

                         should not be used if it is merely a sham with

                         no business purpose.

                    B.   It may also be possible for the current

                         shareholders and their corporation to form an

                         LLC in which they each are members.

                         1.   The corporation could contribute cash and

                              other property to the LLC in exchange for

                              its interest - no tax under IRC 721

                         2.   The shareholders could contribute services

                              (or perhaps funds or property distributed

                              from their subchapter S corporation which

                              are in an amount which did not produce a

                              tax at the time of distribution).

                              a.   If  a capital interest is received in

                                   exchange for services, the member

                                   will recognize ordinary income in an

                                   amount equal to the value of the

                                   capital interest shifted to the

                                   service member unless the receipt of

                                   the interest is contingent or subject

                                   to a substantial risk of forfeiture.

                                   See IRC 61 and 83.

                              b.   If a profits interest is received,

                                   cases such as Diamond V. Comm, 492

                                   F.2d 286 (7th Cir.) , holding a

                                   profits interest immediately taxable

                                   where it was disposed of shortly

                                   after the services were performed,

                                   Cambell v. Comm., 943 F.2d 815 (8th

                                   Cir. 1991), holding that a service

                                   contributing partner recognized no

                                   income upon the receipt of an

                                   interest in future profits because

                                   the interest could not be valued, and

                                   Rev. Proc. 93-27 which essentially

                                   provides that receipt of a profit

                                   interest for future services will not

                                   be taxed if the partnership is not

                                   publicly traded, the profits are not

                                   substantially certain, and the

                                   recipient does not dispose of the

                                   interest within 2 years.

                         3.   This is an arrangement similar to the

                              Corporate Freeze transaction, however, it

                              does not attempt to freeze the value of

                              the corporation. It merely moves some of

                              the future growth into the LLC.

               V.   Obtaining Some Limited Liability Protection in

                    States Which Do Not Have LLC Statutes.

                    A.   Consider having the LLC transfer some assets to

                         a newly formed subsidiary corporation in a tax

                         free IRC 351 exchange.

                         1.   The new corporation could then undertake

                              the activities which must occur in the

                              unprotected jurisdictions.

                              a.   All corporate formalities should be

                                   adhered to and the subsidiary

                                   corporation should have substance.

                                   If it does not, the corporate veil

                                   may be pierced.

                              b.   Appreciating assets should not be

                                   placed in the C Corp and neither

                                   should a portion of the business

                                   which will itself grow in value.  A

                                   trucking operation used to haul

                                   products of the LLC might be a good

                                   candidate (sales taxes might also be

                                   saved if a contract carrier permit

                                   were obtained).


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