Tag Archives: conversion

The S Corporation Inversion – How to Convert an S Corporation into a Tax Partnership Tax-Free

Tax inversions have been in the news for several years now, but almost always in the context of a public US company reincorporating in a foreign country to achieve lower tax rates on non-US source income. However, there is another type of inversion, the S corporation inversion, that does not involve any foreign countries but can be an elegant solution to a problem faced my many small and medium-sized businesses operated as S corporations.

Many businesses start as S corporations for good tax reasons, but later in their lifecycle want to convert to a tax partnership (such as an LLC taxed as a partnership) for a variety of business and tax reasons. For example, perhaps a private equity fund or foreign investor (which are both impermissible S corporation shareholders) want to invest in the business and become owners. Another example is where 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 tax partnerships can. Simply converting or merging the S corporation into an LLC taxed as a partnership is not satisfactory, because that transaction would trigger the taxable liquidation of the S corporation.

One 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 oftentimes requires the counterparty’s consent; (5) transferring or obtaining new licenses and permits for the new LLC to operate the business; and (6) obtaining lender consent.

These headaches can oftentimes 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 subchapter 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, by operation of the Florida merger statute, 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 that can take on new investors in a tax partnership format and without many of the headaches of migrating a business to a new legal entity. For guidance on this structure, see Treasury Regulation Section 1.1361-5(b)(c), Example 2.

Michael J. Wilson
mwilson@williamsparker.com
941-536-2043

IRS Confirms Advantages to Domesticating Instead of Merging when Relocating a Foundation

When families with foundations relocate to Florida, they oftentimes want to relocate their foundations too. There are several different structures for accomplishing the relocation (i.e., change in state of domicile) of a foundation or other non-profit corporation. For a variety of reasons, the best structure is oftentimes a domestication, which is also sometimes referred to as a “conversion” in jurisdictions outside Florida.

In a recent ruling, the Internal Revenue Service confirmed some of the advantages to using a state law conversion, especially when compared to a merger. The ruling concludes that a non-profit corporation that changes its domicile from one state to another by undergoing a state law conversion does not need to file a new application for tax exemption (Form 1023) and can keep the same taxpayer identification number. These benefits would be obtained in Florida by undergoing a domestication. The ruling also confirmed that this treatment would not apply if a non-profit corporation changed its domicile by forming a new non-profit corporation in the new state, and merging the non-profit corporation from the old state into the new non-profit corporation. In the case of a merger, the old non-profit corporation would cease to exist, and the new non-profit corporation would have to obtain a new taxpayer identification number and seek tax-exempt status by filing a new application (Form 1023).

A link to the ruling is here:
www.irs.gov/pub/irs-wd/201446025.pdf

Michael J. Wilson
mwilson@williamsparker.com
941-536-2043