Tag Archives: Florida LLC Act

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

Florida LLC Act Personal Liability (Surprise!)

We have previously written about Florida’s new Limited Liability Company (LLC) Act. Section 605.0205 of the Act creates new personal liability exposure for LLC members and managers. What is the exposure? How do you manage it?

Section 605.0205 applies when an LLC filing with the Florida Department of State is incorrect and a person suffers a loss as a result of the inaccurate statement. This is most likely to occur when an annual report filing results in the Sunbiz website inaccurately showing a person as having authority to act on behalf of the LLC, and then that person improperly causes the LLC to contract with a third party or otherwise improperly acts on the LLC’s behalf.

Section 605.0205 imposes personal liability on a person signing a filing knowing it is inaccurate. That is not surprising.

But Section 605.0205 also imposes personal liability on certain LLC members or managers who had notice of the inaccurate filing and failed to remedy it despite having an opportunity to do so. The problem is that notice and opportunity to cure are factual issues evaluated in hindsight. Circumstances could exist to suggest that a passive investor had notice even though the investor had no actual knowledge of the inaccurate filing. For example, some companies send copies of filings to all their members, which might create a presumption of notice, even though in the real world few if any passive investors would actually inspect such documents to verify their accuracy.

What should you do to manage this risk?

First, if you manage an LLC, pay more attention than you have in the past to your Florida Department of State filings. Verify that annual reports are accurate, and create periodic calendar ticklers to verify that no inaccurate or fraudulent filings have occurred between annual reports.

Second, if you are a passive investor who does not have management responsibilities, inquire whether the LLC can be “manager-managed” under the Act. If the LLC is “member-managed” under the Act, inquire whether the LLC operating agreement contains a clause making only the active members with management duties liable for improper filings. Under an exception in Section 605.0205, either circumstance may protect you.

Third, rather than managing or owning an LLC individually or through another entity with separate assets, use single-purpose LLCs you own and control as managers and members in operating or investment-holding LLCs. This may provide additional protection if the other safeguards fail.

This is, of course, yet another risk business owners and investors would prefer not to spend precious time managing. The Legislature has nevertheless decided that time commitment is now part of the price for limited liability. Don’t shoot the messenger!

Here is a link to Section 605.0205 of the Act:  http://www.leg.state.fl.us/statutes/index.cfm?App_mode=Display_Statute&Search_String=&URL=0600-0699/0605/Sections/0605.0205.html.

Here is a link to our prior, more comprehensive post regarding the LLC Act:

E. John Wagner, II

Florida’s New LLC Law: Who Cares?

Who should care about Florida’s new limited liability company (“LLC”) law? By now someone also has told you to revisit all your LLC operating agreements, because pre-existing operating agreements are not permanently grandfathered under the old law. Unless you are an attorney, three things probably came to mind:

1. I didn’t know the old law was broken; was it broken?

2. I don’t want to pay an attorney to revisit an agreement I already paid for once.

3. I don’t want to spend time rehashing complicated, long forgotten issues with the other owners; that was painful enough the first time.

Consistent with our “just the facts” focus, we won’t comment further on those thoughts about the new law. Over the course of this year we will, however, note practical steps you can take to manage the new law. We also will highlight salient real-world issues most deserving a slice of your limited available attention.

For those attempting triage, today we offer this:

1. Since the new act is largely a “default” act and the rules applicable to manager-managed LLCs are not dramatically changed, the new law is less likely to affect existing manager-managed LLCs with comprehensive operating agreements. But if there are gaps in an operating agreement, an operating agreement has terms conflicting with new non-waivable provisions, or the LLC is member-managed, changes in the new law are more likely to materially affect the legal status and operations of the LLC.

2. The new act increases personal liability for claims arising out of incorrect public filings. It is now more important to make sure that public filings, including Annual Reports filed with the Secretary of State, are accurate.

There will be more to come later, but for those with interest now, here is a broader overview of the new law:

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