Question: How do I convert my corporation into a limited liability company?
Answer: Two ways – the easy way and the hard, but not too hard way.
Easy Way: If your corporation does not have assets that have substantial value or contracts that cannot be assigned or transferred to the LLC without the consent of the other party to the contract then simply form a new LLC, dissolve the corporation and start doing business under the new LLC. If your corporation is an Arizona corporation and you dissolve it before or concurrently with forming your Arizona LLC the new LLC’s name can be identical to the corporation’s name.
Harder Way: Form an Arizona LLC and merge the corporation into the LLC. The advantage of this method is that a merger causes the assets and liabilities of the corporation to become assets and liabilities of the LLC automatically as of the effective date of the merger. If the dissolution of the corporation would cause its shareholders to pay unwanted income taxes the merger method may avoid the tax.
Example 1: World Wide Widgets, Inc. owns property that has a value of $101,000. The sole shareholder’s basis in his stock of the corporation is $1,000. If the corporation assigned the property to its shareholder before dissolving the shareholder would have taxable gain of $100,000 ($101,000 value of property – $1,000 adjusted basis of the stock).
If the stock is a capital asset (held for more than one year) the shareholder in this case could be paying as much as 23.8% of the gain as federal income tax plus state income tax if the shareholder resides in a state that has a state income tax. Arizona’s tax rate for capital gains in 2016 is 4.5%. Therefore, if the shareholder is an Arizona resident and the stock is a capital asset the total federal and Arizona income tax on the $100,00 gain is $24,500 if the shareholder is not subject to the 3.8% federal surtax on net investment income or $28,300 if the shareholder is subject to the surtax. Yikes! Who wants to pay federal and state income tax if it can be avoided.
The good news is that if the corporation is taxed as an S corporation or a C corporation and the LLC is taxed as an S corporation or a C corporation the merger can be a tax free reorganization under Section 368(a)(1)(F) of the Internal Revenue Code. By carrying out the “F” merger the shareholder can eliminate the income tax.
Example 2: Same facts as example 1 except the corporation taxed as a C or an S corporation merges into an LLC taxed as a C or an S corporation. Result: $0 income tax instead of $24,500 or $28,300.
Conclusion: Ask your CPA to tell you in writing what would be the income tax consequences to you if you were to dissolve your corporation. If dissolution will cause you to pay federal and/or state income tax you do not want to pay then do an F reorganization, i.e. merge your corporation into an LLC that is taxed as a C or S corporation.
P.S. If your surviving LLC will be an Arizona LLC hire me, Richard Keyt to prepare the merger documents and to consummate the tax-free merger. Call me at 480-664-7478 if you have questions or to get started.