If you’re currently operating as a corporation, converting to a limited liability company (LLC) is a clear, good move unless you plan on going public or raising venture capital. The double taxation inherent in corporations is rarely helpful for a growing business. Unfortunately, as good a move as the conversion to an LLC is, especially where taxes are concerned, it can also be a pretty hairy process.
With a good accountant, and some in-depth brainstorming sessions, you can find multiple ways to accomplish your conversion with very little tax burden.
Navigating state taxes
Transferring assets from a corporation to an LLC without the help of a qualified accountant is like crossing a freeway wearing a blindfold. If you somehow manage to make it across the IRS obstacle course, you still need to take into account state and local taxes.
First, know your enemy: Find out what sales tax and transfer tax your state may hit you with. In high-tax states such as California, they can be astronomical, so you need to be aware of the worst-case scenario.
Knowing your many options
When you have an idea of what you’re dealing with, you and your accountant can structure the conversion in a way that minimizes (or even eliminates!) these taxes. If your state allows statutory conversions (converting a corporation into an LLC instead of dissolving the corporation and starting a new LLC), then this could be a viable option.
Or maybe you’re better off doing a merger, with your LLC remaining as the surviving entity. Or perhaps your state provides a tax exemption that allows you to go the conventional route of forming a new LLC and transferring the business assets in exchange for membership interests.
If, after looking with your accountant at all the routes available to you, you still can’t find a work-around, consider leaving your assets in your corporation. After all, no law says that a business’s assets need to be maintained in its operating company.
Actually, not having your business assets in your operating company is generally a good idea. Not only is isolating your assets from potential lawsuits a good asset-protection strategy, but it can also help you save taxes in the long run.
Converting smoothly with a merger
You may be able to save taxes when converting a corporation to an LLC by forming a brand-new LLC and doing a standard merger with it and your corporation. A merger is the combination of two existing entities into a single surviving one, and merging your corporation into an LLC is a great way to avoid sales and transfer taxes that are associated with moving assets from one entity to another.
All states have laws regarding mergers, so you have to research whether the laws of your state allow two different entity types (a corporation and an LLC) to merge into one with the LLC being the surviving entity. Some states provide no guidance at all; in this case, your attorney is the best person to direct you through the proper procedures.
Keeping the corporation
Sometimes the best thing to do is nothing at all. A dual-entity strategy is an arrangement in which a newly formed LLC serves as your operating company and leases assets from your corporation.
If your business assets are located in a corporation, separate from your operating company (in this case, a newly formed LLC), then you can lease those business assets to the operating company (the LLC) for a certain sum commensurate with the going rate in your industry.
When your LLC operating company makes those lease payments (a fully deductible expense) to your corporation, that income (which would otherwise be deemed profit) is then shielded from whatever hefty state taxes would otherwise be imposed.
For example, if you own a local pizza company and you want to convert your corporation into an LLC, you set up your new LLC, transfer your contracts to the LLC, and convert your business operations over to it. However, you leave your stoves and other equipment in the ownership of the corporation. Your corporation becomes a leasing company and leases the equipment to your operating LLC. This arrangement has two benefits:
If one of your customers gets food poisoning and sues your company (your LLC), your assets are protected in your old corporation.
If you want to retain profits without having to pay personal income tax and self-employment tax on them, you have a legitimate way of transferring them to a corporation (thereby subjecting them only to corporate income tax — usually a much lower amount — until you use them).
A dual-entity strategy is effective at saving you some tax dough only if your corporation is in a state that has low enough corporate taxes to make it worth it. If it isn’t, you can always relocate it to a more favorable state (called redomiciling), but check first with your accountant that this step wouldn’t inadvertently create a taxable event on either the federal or the state level.
Also, you have to make sure that you avoid what would be considered “transacting business” in your new state, otherwise you would be forced to register there, which would remove any tax benefit.
Creating a leasing arrangement between an existing corporation and a new LLC may be overkill if you aren’t too concerned with avoiding state taxes. If this is the case, then don’t worry so much about the state in which the corporation is located or about transferring profit.
However, if you happen to be one of those folks who cannot transfer your assets from your corporation to your LLC tax-free, then this arrangement may be your best bet. And don’t forget the added bonus of protecting your company by isolating your business assets from whatever entity is handling your company’s day-to-day operations and is most likely to be sued.
If your corporation is in a tax-free state, such as Nevada or Wyoming, you may want to lease the assets to your operating LLC at a standard lease rate (so the lease is legitimate and you don’t raise red flags). This way, that profit won’t be distributed to you at the end of the year and be subject to your personal income and self-employment taxes; it will safely sit in a corporate bank account free from hefty state corporate taxes and franchise fees.