S corporation business moves to LLC
By James F. Schultz, Cendrowski Corporate Advisors
This article will follow a path where the business ends up in an LLC with room to expand its business and have all future appreciation attributed to the new investors.
Move assets from S corporation to partnership/ LLC
Essentially, the business and its necessary assets are transferred to a subsidiary partnership/LLC (“LLC”). Once the assets are transferred into the sub-LLC, the subsidiary can issue membership interests to new investors of many types. The new members in the LLC and the business are not stuck with the restrictions of an S corporation. The new members need not be shareholders or invested in the S corporation, opening new avenues for the business to grow. It is likely that the original shareholders will contribute to the LLC and become members to share in the part that is not S corporation restricted. Albeit, the original shareholders still are the owners of shares of an S corporation, which is a member of the LLC.
The aforesaid transfer of assets to a wholly-owned subsidiary LLC is not a taxable event since it is a disregarded entity. If the subsidiary subsequently opens the membership to new investors, which could include the S corporation shareholders individually, the entity is no longer wholly owned by one entity and becomes a taxable LLC. The change to a taxable LLC does not usually cause any taxable event.
Another step could include turning the S corporation’s membership interest in the LLC into a preferred equity with a limited income return to the S corporation. This would freeze the S corporation’s value in the LLC and block any appreciation from being attributed to that interest. New members would then have the excess income and all appreciation attributed to them under LLC rules, without the limitations of an S corporation status. This process is also applicable to other types of transformation to an LLC and will be noted where applicable.
F reorganisation process
If the above transfer of business assets is not feasible due to other legal or financial restrictions, an F reorganisation may be workable over time, since the process requires three steps. The reorganisation of the S corporation requires the transfer of assets such that the transaction qualifies as a “reorganisation” for federal purposes, and additional capital is included in the process.
The three step process is as follows:
The owners of the original S corporation (“OSC”) create a new corporation that elects to be an S corporation (“NSC”).
- The OSC shareholders transfer their OSC stock to the NSC as a capital contribution. NSC files an election on IRS Form 8869 to have the OSC classified as a qualified subchapter S subsidiary.
- The OSC files a certificate of conversion to an LLC with the Secretary of State for its formation as an LLC. The result is that the OSC LLC is treated as owning the OSC’s assets by operation of law, and without any required transfer or assignment of the assets.
- The end results for income tax purposes is that the NSC is treated as a continuation of the OSC, and the OSC LLC is treated as a disregarded subsidiary.
At the end of these three steps, the business is wholly owned by the NSC, and the OSC LLC is the disregarded entity for tax purposes, and not subject to S corporation restrictions.
Following the steps in the first transfer concept above, the NSC could allow the OSC to open membership to new members expanding the business. At this point, the OSC LLC becomes a taxable entity.
Another possibility is to create a preferred equity freeze like above. The NSC converts its ownership interest into a preferred equity interest that receives a limited income return on its investment. Simultaneously, the NSC allows the OSC LLC to issue new common equity membership interests to the shareholders and/or outside new investors.
The result of becoming a taxable entity with a preferred interest creates a fixed value with limited return to the S corporation (NSC), and allows the excess income/appreciation go to the original shareholders/ new investors under the LLC common equity umbrella.
James F. SchultzGGI member firm
Cendrowski Corporate Advisors
Advisory, Corporate Finance, Fiduciary & Estate Planning, Tax
Bloomfield Hills (MI), USA
T: +1 248 540 5760
Since 1983, Cendrowski Corporate Advisors (CCA) has provided expert client service from their offices in Bloomfield Hills (MI) and Chicago (IL). With expertise in tax planning/ consulting, family offices, dispute advisory, business valuation, forensic accounting, and risk management, CCA is a CPA firm with a different perspective™.
As a Director at Cendrowski Corporate Advisors (CCA), Jim Schultz leads the firm’s Chicago business valuation practice. In this role, he focuses on providing management and consulting services, including business valuations, litigation support, expert witness testimony, and financial advisory services.
Published: Trust & Estate Planning Newsletter, No. 11, Spring 2023 l Photo: P. Meybruck - stock.adobe.com