LLC Conversions

So, you’d like to convert your limited liability company, which is taxed as a partnership, into a C corporation?

This is generally not hard to do from a pure mechanics perspective.  If your LLC is organized in Delaware, or certain other states, the conversion can be accomplished by what is known as a “state filed conversion” which simply requires filing a document with the state.

Of course, there are a number of other ways to convert, and amazingly, each method of conversion can have slightly different tax consequences.  The main rule, however, is the same for each—an LLC to C corp conversion is generally tax-free under tax code Section 351, but can cause tax if:

• the outstanding debt at the time of the conversion is greater than the LLC’s basis in its assets (see tax code Section 357(c));
• there are negative capital accounts or an LLC member has taken losses that should have been suspended;
• the new C corp issues nonqualified preferred stock, i.e., preferred stock that is puttable or callable, or that has a dividend rate tied to interest rates or commodity prices; or
• the LLC interest being exchanged is an unvested capital interest for which no tax code Section 83(b) election was filed.

Compensatory Options

Options granted by an LLC to service providers are nonstatutory stock options.  These can be assumed by the C corp and retain the built-in appreciation.  The assumption will require adopting an equity plan at the C corp.  If the conversion isn’t occurring on a 1:1 basis, some math will need to be done to adjust the number of underlying shares and the exercise price to comply with applicable tax rules.  These options will remain nonstatutory stock options at the C corp.  If these options are not in-the-money, it likely makes sense to just cancel and regrant as fair market value incentive stock options at the C corp.

Profits Interests

The distribution hurdle applicable to profits interests usually results in a profits interest holder receiving fewer C corp shares in the conversion than he or she would have received had the interest been a capital interest.  Said another way, the profits interest will convert into C corp equity equal to the appreciation of the profits interest above its distribution hurdle.  If the LLC equity value is not greater than the hurdle, the profits interests just disappear.  In any event, profits interests do not turn into stock options, but if desired, new fair market value stock options can be granted to such service providers to make up for any loss of ownership percentage caused by application of the distribution hurdle.

Section 83(b) Elections

Any LLC member receiving unvested C corp stock in exchange for profits interests, vested capital interests, or unvested capital interests for which a tax code Section 83(b) election was filed, should absolutely file a new tax code Section 83(b) election with respect to the C corp stock. Such election should be filed within 30 days after the date of the conversion. As long as the value of the exchanged LLC equity equals the value of the restricted stock, this new Section 83(b) election will cause no tax and will prevent tax at vesting. This is not a situation where the Section 83(b) election is protective, rather it’s obligatory if you want to avoid tax when the C corp stock vests.

If however, there are LLC members who hold unvested capital interests for which no Section 83(b) election was filed, beware. For tax purposes, such unvested capital interests are not considered “property.” This means that if a member exchanges them for new C corp stock, it’s as if they got the C corp stock for free, and the natural tax consequences will follow. Specifically, there will be tax on receipt of the stock if vested (or a Section 83(b) election is filed), otherwise tax at vesting. If the company has meaningful value at the time of conversion, it may be better to grant this individual incentive stock options to help him or her avoid taxable income at the time of conversion.

SAFEs and Investment Warrants

While LLC equity can generally be exchanged for C corp equity tax-free in these conversions, the same does not necessarily follow for other instruments.  As such, one needs to consider whether the value of the instrument being exchanged in the conversion exceeds the holder’s tax basis, in which case the exchange might cause the holder tax.

Some tax practitioners (including me) also worry that not converting a SAFE or investment warrant prior to a C corp conversion could cause the LLC tax.  This is due to an interplay between the noncompensatory option rules and tax code § 721.  See Treas. Reg. Section 1.721-2(d).

Convertible Debt

It may also be advantageous to convert any convertible debt into LLC equity prior to becoming a C corp.  This helps reduce debt for purposes of the “debt in excess of basis” test discussed above.  Be warned however, that converting debt in an LLC has tax consequences both to the debt holder and the other members.  Such tax consequences need to be considered.

Preferences in the LLC Liquidation Waterfall

Some LLC operating agreements have sections which specifically governs what happens to preferences on a conversion to a C corp.  Others do not.  Particularly for those LLCs that do not have such guidance, consideration needs to be given to how preferences will convert.

For example, if there is a capital-contributions-back prong in the waterfall, how do you determine how much stock to give LLC members?  Keep in mind that for the C corp conversion to be tax free, the LLC members need to be receiving C corp equity with a value not in excess of the value of the LLC equity exchanged.

Preferences can be handled one of several ways:

• Everyone receives common stock, but those with a preference receive more than those who do not have a preference;
• One or more new classes of preferred stock is created which provides a liquidation preference in the C corp intended to mimic that which existed at the LLC; or
• The LLC is left in place and merely becomes an owner in the new C corp so that all of the preferences can remain at the LLC.

A State-Filed Conversion

A state-filed conversion would result in the new C corp having a basis in its assets equal to the LLC’s basis in its assets and the stockholders holding period in their C corp shares tacking to the LLC’s holding period in its capital and §  1231 assets.  That’s likely fine.  However, if the LLC’s member’s basis in their LLC equity is substantially higher than LLC’s basis in its assets, or the holding period of their LLC equity is substantially longer than the LLC’s holding period in its assets (and there is a possibility that the C corp stock will be sold within one-year), consideration ought to be given to using the “Interests Over” method of conversion described below, as that may favorably improve post-conversion tax attributes.

Qualified Small Business Stock

The new C corp stock can generally be qualified small business stock regardless of which method is used, as long as all of the other QSBS requirements are met.  Note the favorable rates only apply to the future appreciation and the 5-year holding period starts on the date of conversion.  If the LLC was organized prior to Sept. 28, 2010 or holds assets with a holding period that starts prior to such date, special consideration needs to be given to the method of conversion, as it can affect the QSBS benefit.

Section 1244 Stock

If a state filed conversion is used the stock received will not be tax code Section 1244 stock.  Section 1244 allows up to $100K (for married filing jointly) of loss to offset ordinary income, so it is a benefit for downside scenarios, but it is of limited use because Section 1244 stock designation is only available where the corporation’s aggregate capital has not exceeded $1M when the stock was issued (the benefit is allocated in years in which this threshold is crossed).  Because of its limited benefit, this is usually not a sufficient reason by itself to use one of the more complicated conversion structures.

Conversion Methods

For tax purposes, there are only three ways to incorporate a partnership:

1. Assets Over (i.e., a state filed conversion, a check-the-box election, the LLC merges into a new C corp, or the LLC transfers assets to a new C corp in exchange for C corp stock and then the LLC distributes the stock up to its members and then liquidates).

2. Assets Up (i.e., the LLC’s assets are distributed to its members who then contribute to the new C corp in exchange for stock); and

3. Interests Over (i.e., members contribute their LLC equity to C corp in exchange for C corp stock).

The below chart summarizes the tax consequences of each conversion method:

Mike Baker frequently advises with respect to LLC conversions.  He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades.  For additional information, please contact mike@mbakertaxlaw.com.