Changing the Form Of
To A Limited Liability Company
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- 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.
of these materials
are subject to the terms of our
Cautions & Warranties
which may be found at www.proguide.com
I. Conversions of Partnership
For many years the IRS has recognized that
general and limited partnerships could
from one form to the other without causing a
termination under IRC section 708 if the
business of the old partnership is continued
the new. See Rev. Rul 84-52, 1984-1 C.B. 157
The considerations set forth in that
are equally applicable to a
conversion to an LLC and the IRS has
stated that they are analogous under
circumstances where the LLC is
classified as a partnership.
B. The conversion of
the partnership to an LLC may
take several forms:
It can be a merger - prohibited in
Wisconsin PLR 9210019, PLR 9412030
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,
Contribution of partnership assets to the
LLC, followed by a distribution of the
interests in the LLC to the partners of
the liquidating partnership.
Merely "converting" the partnership into
See PLR 9029019
Having the partnership entering into an
Agreement under the LLC Act.
See PLR 9010027
Regardless of the form, the IRS has applied Rev
Rul 84-52, 1984-1 CB 157, and treated the
as a contribution of property to
the LLC in exchange for an interest in it.
The effect is:
Under section 721 of the Code, no
or loss is recognized by the LLC
or any of its partners
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.
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
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
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.
a conversion of a general or
limited partnership to an LLC,
the change from being liable for
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
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
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.
Watch out - subsequent transfers (after
the LLCs organization) will not be exempt
under this provision.
nature and format of the transfer,
other exemptions may exist.
Watch real estate tax impact.
A professional practice - law, accounting etc,
organize themselves in a manner such that
they may use the cash method of accounting.
II. Conversion of a Corporation to an LLC
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
liquidation of the corporation is
likely to be taxable and the contribution to
the LLC should be tax free under IRC section
If the basis of the interest in the stock
is high enough (Sub S or newly formed
corp), the tax impact could be minimal.
Other formats can also be used - see the
discussion of partnership conversions
The corporation may incur gain on the
distribution of its appreciated assets
to IRC section 336.
Wisconsin does not permit the merger of a
corporation with an LLC
If the LLC will be taxed as a corporation,
and possible reorganization statutes.
Also consider using foreign LLC which has more
If a Parent-Subsidiary relationship exists and
the objective is to convert the subsidiary
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
"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
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.
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
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.
The C corp. is then given an interest in
the LLC which is preferred as to both
profits and distributions.
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
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.
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
Valuations and a legitimate
business purpose are crucial if the
transaction is to withstand scrutiny.
The flexibility and other characteristics
of the LLC itself
may provide a basis for
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
Entity Would Be Too Expensive.
It may be possible to cease any additional
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
no business purpose.
It may also be possible for the current
shareholders and their corporation to form
LLC in which they each are members.
The corporation could contribute cash and
other property to the LLC in exchange for
its interest - no tax under IRC 721
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).
If a capital interest is
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
interest is contingent or subject
to a substantial risk of forfeiture.
See IRC 61 and 83.
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
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
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.
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.
Consider having the LLC transfer some assets to
a newly formed subsidiary corporation in a
free IRC 351 exchange.
The new corporation could then undertake
the activities which must occur in the
corporate formalities should be
adhered to and the subsidiary
corporation should have substance.
If it does not, the corporate veil
Appreciating assets should not be
placed in the C Corp and neither
should a portion of the business
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
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