Businesses are often formed as limited liability companies for the tax benefits of pass-through tax treatment, which eliminates double taxation, and enables capital-contributing members to offset passive losses allocated to them, against other passive income or gains. Limited liability companies often desire to convert into a C corporation for various reasons, including, better access to capital. When an LLC converts into a C corporation, in addition to losing future pass-through tax treatment, the capital-contributing members lose the ability to deduct their share of existing passive losses against future passive income or gains. If there is a significant amount of accumulated losses, a member can lose significant tax write-offs.
Rather than engaging in a “straight” conversion, the LLC can form a new corporation (“Newco”), to which it transfers substantially all of its assets in exchange for all of Newco’s founder’s stock. As a result, the LLC remains intact, the capital-contributing members retain their existing passive losses, and the members hold their own in Newco beneficially, through the LLC. This stock-for-asset transfer will generally qualify as a tax-free exchange. An ancillary benefit is that a Stockholder Agreement for Newco will not be required, assuming the LLC’s Operating Agreement includes, rights of first refusal provisions, management control provisions, and other protections generally included in a Stockholder Agreement.
As an asset protection strategy, the LLC could retain patents, trademarks, source code or other intellectual property (“IP”), and license such IP to Newco pursuant to a license agreement that terminates upon the bankruptcy or insolvency of Newco. If properly done, this could provide a good argument that the IP would not be subject to creditor claims in the event of bankruptcy of Newco.
The specific tax implications of this structure can vary depending on the circumstances. Businesses should consult with qualified tax and legal professionals to fully understand the potential tax implications and to ensure that the conversion is executed in the most tax-efficient manner possible.
The information contained in this article is strictly for educational purposes and is not intended to be legal or tax advice or to be relied upon by anyone without doing their own research, and consulting with legal and tax advisors.