I hate to plan for “might be” tax changes. Nonetheless, the situation we find ourselves in now requires it. There is a decent chance that there will be game changing tax legislation. It will probably not be on the scale of the Tax Reform Act of 1986, but we had a couple of months to react to that one. TRA 1986 was based on something called the Treasury II Proposals, which were fairly detailed. I had spent a lot of time studying Treasury II, so nothing in TRA 1986 was a surprise. This time, we will have little more than a week and the proposals floating around are pretty vague. I have one project that I think is worth doing to prepare, though. The project is to take a very hard look at S corporations. The idea is to consider conversions to LLC (taxed as a partnership) on December 31.
It is reminiscent of a project we went through at Joseph B. Cohan and Associates in the waning days of 1986. I got to lead the project, it being my idea. Senior accountants had to report on every C corporation they were responsible for. If it was not making an S election they had to explain why. It was a marvelous example of resistance to change. Things are different now. I expect that conversions to LLC or some variation will not generally be the way to go, but I still think it will be worth considering. A month is barely enough time to plan something like that. Going from zero to sixty on it in a week is fraught with peril. So let’s think about it now.
What Is So Great About An LLC ?
Limited liability companies can be taxed either as partnerships or corporations at the election of the entity. I’m talking about converting S corporations to LLCs that would be treated as partnerships, so from here on in I will be talking about S corporation versus partnership, for the sake of clarity. S corporations and partnerships both allow for a single level of tax on the owners by flowing all income and deductions through and allowing for tax-free distributions, within limits.
Partnerships have numerous advantages over S corporations. There is no limit on the number of partners. There is nothing equivalent to a the “single class of stock” rule. Just about any type of entity can be a partner in a partnership. You can have corporations, non-resident aliens, just about any type of trust and even other partnerships as partners, but not as S corporation shareholders.
Partners have basis in their share of the partnership’s liabilities, a lack which often causes heartburn for S corporation shareholders. When partnership interests are transferred at a gain, the basis in the partnership assets can be adjusted upwards. Assets can be distributed from a partnership without gain recognition.
So Why Are There Still S Corporations ?
One bad reason that there are still S corporations is that people think partnerships are too complicated. This is a bad reason, because partnerships don’t have to be more complicated. They tend to be more complicated because they can be and people want them to be. Investors want different classes of ownership with different distribution rights that the S corporation format does not allow. A good reason for an S corporation is a start-up where the end game is going to be a take-out by a public company. A partnership cannot be party to a tax-free reorganization.
The biggest good reason that there are still S corporations is that it is expensive to convert. The distribution of assets from an S corporation can trigger gain to the shareholders. The gain recognition is mitigated by the higher basis that the shareholders, now partners, have in the underlying assets. The higher basis will make for higher depreciation or amortization deductions or a lower gain on disposition of the assets.
So Why Convert Now ?
Given what is likely to be coming as Congress stamps on the brakes to stop us dropping off the fiscal cliff,
I am thinking about income acceleration techniques. I will have another piece on the logic supporting acceleration, which might be much more compelling than an 8+% marginal rate increase (Don’t forget the Obamacare investment income surcharge) would indicate. The S corporation to partnership conversion can be a doozy. It is treated as if the S corporation sold its assets for fair market value. It will step up the basis in underlying assets. In some cases the step-up might be greater than the gain. That would be the situations where S stock was inherited or purchased or assets are leveraged. As a bonus the partnership structure might be more congenial on a go forward basis, allowing for different types of equity and transfers to different types of shareholders.
Don’t Try This At Home ?
You know those clips you will see where it flashes on the screen something like “Professional driver on closed course”
That applies here. More than most tax planning strategies, this one is fraught with peril. I’m still working through my thinking on some of the hazards. How hard is the legal work to convert from a corporation to a limited liability company ? According to my friend Charles Egerton, it is not very hard in Florida. Great. One down 50 (Don’t forget DC) to go, as long as I don’t muck around with the possessions. You have to consider that some of the assets of the S corporation might have recapture or unrecaptured Section 1250 depreciation. Then there are the anti-churning rules about goodwill amortization. What are all the SALT (state and local tax) considerations including how differences in local property taxes might apply ? As a practical matter it may be too late to plan properly even for S corporations that would be good candidates. It may be that you will end up performing a half hour thought experiment and abandoning the idea. It is still worth doing, in my opinion. You sometimes have to consider bad ideas to come up with good ones.
All Or Nothing ?
A less dramatic strategy might be for the S corporation to cherry-pick assets, drop them into an LLC and distribute LLC units to shareholders. This would allow for modulation in gain recognition and avoidance of recapture and other nasty problems.
Start Thinking Now
The basic analysis can be done pretty quickly. Does the S corporation have very high income shareholders ? Does the S corporation have assets that will provide benefits from being stepped up ? If the answer to both those questions is yes, further analysis is called for. From there on in, the devil will be in the details. Of course, the biggest detail will be where will the cash come from to pay the liability that you are accelerating
You can follow me on twitter @peterreillycpa.
Originally published on Forbes.com Nov 24th, 2012