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. …