ESTATE PLANNING ISSUES WHEN CONVERTING AN S CORPORATION INTO AN LLC

By Steven M. Etkind, LLM, CPA, Kleinberg, Kaplan, Wolff & Cohen, P.C.

The limited liability company (LLC) form of doing business has important tax consequences for estate planners, particularly those planning to transfer existing businesses currently operating as S corporations into LLCs.

An LLC will be taxed either as a partnership or a corporation. Therefore, the conversion of a partnership to an LLC which is taxed as a partnership should generally not have any tax impact. Some cash-method taxpayers may have to change to the accrual method if the LLC falls within the definition of a tax shelter. Similarly, the conversion of a C corporation to an LLC taxed as a corporation should not have any tax impact. There are, however, transactional tax issues and estate planning points that arise when an existing business operating as a S corporation is partially or completely converted into an LLC.

There are many reasons why an LLC is more advantageous from an income tax and estate planning perspective than an S corporation. Examples are the types of shareholders permitted, basis limitations, and the availability of an IRC Sec. 754 election. As explained below, there are numerous traps that are avoided by initially forming an LLC instead of electing to be taxed as an S corporation.

The flexibility of a shareholder to execute a financial or estate plan can be curtailed or very cumbersome under the IRC Sec. 1361 restrictions on shareholders. For example, a grandparent owns and operates a business in the form of an S corporation. For estate planning reasons, he desires to take advantage of the minority interest and the lack of marketability discounts which may arise for estate valuations in a family-owned business pursuant to Rev. Rul. 93-13. He proposes to transfer, on an annual basis, a relatively small percentage of some of the shares to his children and to his grandchildren. He desires that his grandchildren do not receive the shares outright, but are instead held in trust. Furthermore, he wants the trust to accumulate income until after the child has either graduated from college or has reached the age of 30. As there are only certain types of trusts that can be shareholders in the S corporation under IRC Secs. 1361(c)(2) and 1361(d), his planning flexibility faces severe limitations.

A trust having sprinkle provisions for multiple family beneficiaries will not be a qualified S corporation trust. In Rev. Rul. 89-45, a trust which allows part of trust corpus to fund a new trust for subsequently born grandchildren does not qualify as a qualified S corporation trust. The conversion of a grandparent's business from an S corporation to an LLC will greatly enhance planning opportunities.

Another area in which S corporations have proved difficult are when the business may typically break even on a cash basis but generate tax losses as a result of depreciable assets. The problem is that these tax losses are limited by the taxpayers' basis in their shares pursuant to IRC Sec. 1366(d). By transferring the business from an S corporation to an LLC, the taxpayer's basis in his partnership interest may increase pursuant to IRC Sec. 752 and 722.

The S corporation rules place form above substance by making it more advantageous for a shareholder to personally borrow money from a bank with the S corporation as guarantor and contribute the proceeds of the loan to the S corporation either as a loan to or as additional capital. In many instances where the S corporation is the primary obligor on the note with the shareholder being the secondary guarantor, shareholders are not able to take advantage of losses because of basis limitations. Economically, the two methods of borrowing money are similar, yet the limitation is a trap for ill-advised shareholders. Any losses or deductions not allowed under IRC Sec. 1366(d) before a shareholder dies will be lost if they cannot be deducted on his final income tax return.

When a shareholder dies, the S corporation stock will receive a new tax basis pursuant to IRC Sec. 1014. As there is no IRC Sec. 754 election for S corporations, the S corporation's basis of its individual assets are not stepped up to fair market value. If there is an IRC Sec. 1374 built-in gains tax, the built-in gains tax calculation will not be affected by the death of the shareholder.

If a shareholder dies leaving a trust as a shareholder that does not qualify as a qualified S corporation trust, that trust has 60 days to dispose of the S corporation stock IRC [Sec. 1361(c)(2)(A)(iii)].

Otherwise, the S election will be terminated. During the 60-day period, the estate is treated as the shareholder. If an inter vivos trust is included in the estate, then a two-year period is allowed instead of the 60 days. There are no similar time- period restrictions on estates and trusts holding interests in an LLC.

There are some disadvantages to LLCs, however. Some examples are the loss of IRC Sec. 303 redemptions and estate tax payment deferral under IRC Sec. 6166. Also, if the business becomes insolvent and debt is discharged, cancellation of debt income is not recognized at the S corporation level to the extent that the S corporation is insolvent under IRC Sec. 108(d)(7). Therefore, taxpayers who are considering workouts where some of the shareholders of an insolvent S corporation are solvent may wish to retain their S corporation status until the year after which the S corporation discharges its debt.

Perhaps the greatest impediment to converting to an LLC is IRC Sec. 336: When an S corporation liquidates, gain or loss is recognized at the corporate level. Under IRC Sec. 1361, the corporate-level gain flows through to the shareholders. Additionally, if the S corporation liquidates within 10 years of electing S status and has a history as a C corporation there may be a built-in gains tax under IRC Sec. 1374.

There is an additional taxable event at the shareholder level. Under IRC Sec. 331, gain or loss to the shareholder is measured by the difference between the fair market value of assets received compared to the shareholder's basis in its shares. Because the basis in the shares is adjusted to fair market value upon death pursuant to IRC Sec. 1014, it may be advantageous to defer the conversion of an S corporation to an LLC until after one or more majority shareholders have died.

As S corporations compute their gain and loss upon liquidation, many may find that the gain on liquidation is too high a price to pay for the benefits of LLC partnership treatment. These entities may want to consider setting up a brother-sister entity so that the old business continues to be operated as an S corporation and a new business is operated in a related LLC. This may not solve the existing S corporation's potential gain problems, but may work to avoid making the problem worse.

Pursuant to IRC Sec. 334, if property is received in a distribution in complete liquidation, and if gain or loss is recognized on receipt of such property, then the basis of the property in the hands of the distributee shall be the fair market value (FMV) of the property at the time of the distribution. Therefore, property received from an S corporation upon its liquidation which is contributed into an LLC or LLP will be contributed with no built-in gain or loss as the FMV of each asset will be equal to tax basis.

Shareholders of S corporations often retain certain depreciable assets, such as real estate outside of the S corporation so they can take advantage of depreciation deductions and avoid the loss limitations of IRC Sec. 1366(d). In these situations, the S corporations typically pay rent for the use of the depreciable asset. In the formation of an LLC, these assets would no longer have to be held in a separate entity from the rest of the business solely for tax purposes. These assets will typically have a tax basis different from fair market value.

Once taxpayers have reviewed the pros and cons of making the switch to an LLC and have computed the gain or loss upon liquidation of the S corporation, they must also be cognizant of the IRC Secs. 704(b) and 704(c) regulations to determine how income and loss is allocated among the shareholders. Differences between fair market value and basis of assets and built-in gains or losses must be allocated among the shareholders in accordance with these regulations.

IRC Sec. 704(b) Must Be Considered

Perhaps the most complex analysis in the decision of whether to convert an S corporation to an LLC arises because of IRC Sec. 704(b). According to the instructions to Form 1065, even though IRC Sec. 704(b) "book" amounts are not required to be used for purposes of determining a partner's capital account as reflected on Form 1065, if the partnership does not use the 704(b) "book" amount, it must still nevertheless maintain these capital account records and attach them as a statement to the return. If a partnership does not report partner's capital accounts under the 704 (b) "book" amounts, a reconciliation between the 704(b) "book" capital accounts and the entries shown on the return must be provided as part of the return.

Under IRC Sec. 704(b), if a partnership agreement provides for the allocation of income, gain, loss deduction, or credit to a partner, but such allocation does not have "substantial economic effect," the partner's distributed shares of such income, gain, loss, deduction, or credit shall be determined in accordance with the partner's interest in the partnership, as explained under the regulations. An allocation of income gain, loss, or deduction to a partner will have economic effect if, and only if, throughout the full term of the partnership, the partnership agreement provides 1) for the determination and maintenance of the partners' capital accounts in accordance with the rules of the IRC Sec. 704(b) regulations and 2) upon liquidation of the partnership of any partner's interest in the partnership, liquidating distributions are required in all cases to be made in accordance with the positive capital account balances of the partners as determined after taking into account adjustments made for the partnership taxable year during which such liquidation occurs. If a partner has a deficit balance in his capital account following the liquidation of his interest in the partnership, he is unconditionally obligated to restore the amount of the deficit balance to the partnership by the end of the taxable year.

A partnership agreement includes all agreements among the partners or between one or more partners in the partnership concerning its affairs and the responsibilities of partners, whether oral or written, and whether or not in a document referred to as the partnership agreement. Thus, the partnership agreement includes buy-sell agreements and any other "stop-loss" arrangement.
In addition to making sure that the allocations have an "economic effect," the allocations must be "substantial." The economic effect of an allocation is substantial if there is a reasonable possibility that the allocation will affect, substantially, a dollar amount received by the partners from the partnership, independent of tax consequences.

The regulations provide for detailed rules on how to maintain capital accounts in conformity with the regulations. In general, each partner's capital account is increased by 1) the amount of money contributed to him to the partnership, 2) the fair market value of property contributed to him to the partnership (net of liabilities secured by such contributed property that the partnership is considered to assume or take subject to under IRC Sec. 752), and 3) allocations to him of partnership income and gain or items thereof including income and gain that is exempt from tax. The capital accounts are decreased by the amount of money distributed to him by the partnership, the fair market value of the property distributed to him by the partnership net of liabilities, and allocations to him of partnership loss.

If there is a difference between a partner's fair market value and his or her basis in an asset which is transferred to the partnership, there will be a difference between a partner's "tax basis" capital account and his or her IRC Sec. 704(b) "book" capital. The capital accounts may be increased or decreased by certain events to reflect a revaluation of partnership property including intangible assets such as goodwill on the partnership books.

The LLC taxed as a partnership has numerous advantages over an S corporation. However, the allocation of debt of the former S corporation to the new LLC members pursuant to IRC Sec. 752 and a careful analysis under the IRC Sec. 704(b) rules is necessary to prevent unpleasant surprises upon conversion. Once converted, the LLC advantages, such as the IRC Sec. 754 election, can be utilized by estates and their beneficiaries. *

GIFT TAX: RULES PRODUCE LOWER TAX THAN ESTATE TAX FOR SAME DISTRIBUTION

By Gabe M. Wolosky JD, LLM, CPA, Prager & Fenton

A recent technical advice memorandum suggests the wisdom of a lifetime transfer of a taxpayer's shares of stock in X Corporation during the taxpayer's lifetime rather than holding onto the shares until the taxpayer passes away.

If there are multiple beneficiaries, the IRS permits a discount for each of the minority blocks gifted. This approach may not be taken if the beneficiaries inherit stock upon the taxpayer's death. The difference in approach, the IRS reasons, stems from the inherent difference between gift and estate valuation.

The facts under consideration in LTR 9449001 (FTC 2d P-603, TG 4964) are as follows: Prior to May 1990, the taxpayer owned all the issued and outstanding common shares of X Corporation, the corporation's only outstanding shares. In May 1990, the taxpayer gifted all of the stock in equal segments to each of his 11 children. Both the taxpayer and the IRS agreed on the value of the taxpayer's entire interest in the stock immediately prior to the gift. The stock was not subject to any voting trusts, contracts, or agreements prior to the gift. Any restrictions effecting the stock that existed at the time of the gift were those imposed by the certificate of incorporation, bylaws, or laws of the state of incorporation. None of these restrictions were uncommon.

Implicit in the question for consideration is whether multiple simultaneous gifts result in a lower total valuation than the transfer of an entire interest.

In analyzing the facts presented, the IRS was faced with the question of whether the principles of tax valuation apply uniformly to both the gift and estate tax realms. While there exists a unified estate and gift tax system, the focus of each tax is different, and, as a consequence in this instance, so is the result.

For estate tax purposes, all of the taxpayer's shares of X Corporation would be aggregated, regardless of whether they are bequeathed to one legatee or, as in this case, eleven. The fact that each beneficiary would, had that taxpayer bequeathed these shares, receive less than a ten percent interest in X corporation is not relevant. Estate tax focuses on the value of the assets at the moment of death. How the stock is to be divided has no meaning. The estate tax is imposed on the privilege of passing on property and not the privilege of receiving property.

The gift tax, however, is imposed on what passes from a donor to a donee. The value of what passes to the donee is the measure of the tax. If simultaneous individual gifts are made by the taxpayer of all the stock of X Corporation to each of his 11 children, the total tax is computed on the sum of these individual simultaneous transfers.

In support of its reasoning, the IRS cites IRC Reg. Sec. 25.2512-2(e) which provides that--

In certain exceptional cases, the size of the block of securities made the subject of each separate gift in relation to the number of shares changing hands in sales may be relevant in determining whether selling prices determine the fair market value of the block of stock to be valued. If the donor can show that the block of stock to be valued, with reference to each separate gift, is so large in relation to the actual sales on the existing market that it could not be liquidated within a reasonable time without depressing the market, the price at which the block could be sold outside the usual market may be a more accurate indication of value than market quotations. [Emphasis added.]

The courts, the IRS goes on to say, have consistently held in applying this regulation; that where a donor makes multiple gifts of the same security to multiple donees at the same time, each gift is to be valued separately. The basis for valuing property for gift tax purposes is what a willing buyer would pay a willing seller, neither being under a compulsion to buy or sell and each having a reasonable knowledge of the facts. The difference in result is a function of a difference in focus. For gift tax purposes, since the tax is on the particular gift, whether the donor owns 100% of the corporation or a less controlling interest prior to the transfer, and whether the donees are family members or various third parties, are not determining factors in valuing a block of stock transferred to a donee or in deciding whether a separate gift is subject to a minority discount.

The availability of discounts for lack of control or marketability for multiple simultaneous gifts of an entire interest in property is another vehicle that can be used to reduce ultimate estate taxes. Unstated in the technical advice memorandum is the fact that the transaction, in addition to reducing the tax on the ultimate transfer, can reduce the taxpayers' estate by the gift tax paid. This may be further reason to consider a lifetime transfer such as the one that is the subject of this technical advice memorandum. *

Editors:Marco Svagna, CPA, Lopez, Edwards, Frank & Company

Edward A. Slott, CPA, E. Slott & Company

Contributing Editors:Jeffrey A. Grossman, CPA, Goldstein Golub Kessler & Company P.C.

Richard H. Sonet, CP, Zeitlin Sonet Hoff & Company

Joseph V. Falanga, CPA, Goldstein Golub Kessler & Company P.C.

Larry M. Elkin, CPA,Own Account

AUGUST 1995 / THE CPA JOURNAL