How to Convert an S Corporation into an LLC
Tax-Free Using an S Corporation Inversion

Many businesses start as S corporations for good tax reasons, but later in their life cycle want to convert to a tax partnership or an LLC for a variety of business and tax reasons. For example, an S corporation wants to grant an equity interest to a key employee in exchange for their past and future services. Oftentimes, the best approach in this case is to grant the employee a “profits interest” in the business, but S corporations cannot grant such interests, while LLCs can. Simply converting or merging the S corporation into an LLC taxed as a partnership is not satisfactory, because that transaction would trigger a tax on the deemed liquidation of the corporation.

These headaches can often times be avoided by utilizing an S corporation inversion. The S corporation inversion is accomplished by having the shareholders of the S corporation (“Old S”) transfer their stock to a newly formed S corporation (“New S”) in exchange for all the stock of New S. Old S immediately makes an election to be a qualified sub chapter S subsidiary, and so Old S will be disregarded for tax purposes. New S then forms a wholly-owned LLC, which is initially disregarded for tax purposes, and then merges Old S into the new LLC, with new LLC as the survivor of the merger. The merger is without tax consequences, because it’s a merger of two entities, Old S and LLC, that are disregarded for tax purposes. Furthermore, all of the assets, liabilities, contracts, and legal relationships of Old S transfer to LLC and in most circumstances no third party consents are required. Now the old business is in a new LLC in a tax partnership format and without many of the headaches of migrating a business to a new legal entity. This inversion technique avoids most (albeit not all) of the administrative burdens associated with the drop down of corporate assets into the LLC.

Notice, also, that because the conversion of the subsidiary corporation to LLC occurred at a time when the corporation was a Q-sub of another company, the conversion is from one disregarded entity to another disregarded entity.

This is yet another example of how to use disregarded entities creatively to advantage, to bridge the gap between a tax objective (accommodating an employee on terms that would result in a second class of stock which could be disallowed with an S corporation) with the client’s commercial objective of minimizing change.

Another method to convert to a tax partnership tax-free, without undergoing an inversion, is the “LLC drop-down,” which entails the S corporation forming a wholly-owned LLC, that is initially a disregarded entity for tax purposes, and transferring all of the S corporation’s assets and business to the new LLC. Once this is accomplished, the new investors can invest in the business by investing into the new LLC, which will become a tax partnership.

However, this restructuring is deceptively simple, because migrating the S corporation’s business to the new LLC can create many issues, including (1) migrating employees, payroll, and benefit plans to the new LLC; (2) opening new operating and payroll bank accounts for the new LLC; (3) consulting with insurance agents to obtain coverage for the new LLC; (4) assigning customer, lease, vendor, and other key agreements to the new LLC, which often times requires the counter party’s consent; (5) transferring or obtaining new licenses and permits for the new LLC to operate the business; and (6) obtaining lender consent. You may like the drop down idea instead, but the company probably has no interest in shifting payroll from the corporation to the LLC, obtaining consent to an assignment of the facilities lease from the corporation to the LLC, obtaining lender consent, obtaining consent from major customers and suppliers, etc. Clearly there are administrative burdens to what appears to be a simple drop down of operating assets into an LLC.