Want an ESOP But Have an LLC? Convert!
Business owners frequently choose to operate as a limited liability company (LLC) because it provides for a less formal governance structure and the option to be taxed as a partnership. But, the downside for LLC owners considering an ESOP is that an ESOP must be invested primarily in “employer securities” and membership interests in an LLC taxed as a partnership don’t count.
One solution is to convert the LLC into a corporation. It can be done, but it has to be done carefully and planned with guidance from your ESOP attorney, corporate attorney and tax advisors. This article is an overview of the five most important considerations for an LLC conversion to corporate status:
- The 80% Continuity of Ownership Rule
- Timing
- Partnership versus corporate tax
- Mechanics of conversion
- Governance changes
Avoiding Taxation on Conversion – The 80% Continuity of Ownership Rule
The biggest potential pitfall is triggering income tax on the conversion. If certain Internal Revenue Code (Code) requirements aren’t met, the IRS may treat the conversion as a liquidation of the LLC and a taxable distribution of the LLC’s assets to its members.
This disastrous tax result catches people off guard because without a sale involved, why should a conversion be taxable? The reason is that for a conversion to be nontaxable, the Code generally requires that the company be owned by the same owners both before and after the conversion. [1]Specifically, the transfer of property (such as an LLC membership interest) to a corporation solely in exchange for stock in that corporation will not be taxable as long as the transferors are in control of the corporation immediately after the exchange. In this case, “control” means owning at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the outstanding shares of each class of nonvoting stock.
This rule can be a problem if one of the LLC members owns more than 20% of the company and wants to be cashed out. One solution is to buy that member out before the conversion (preferably, well before) so that the remaining members are the same group as the new corporation’s shareholders and the 80% continuity of ownership requirement is met.
The 80% ownership rule can also create conflict in a 1042 rollover in which the selling shareholder defers tax on the gain from the sale of qualifying employer securities to an ESOP by investing the sale proceeds in any security issued by a domestic operating corporation that meets certain requirements. One of the 1042 rollover requirements is that the transaction must result in the ESOP owning at least 30% of the company. The full 1042 requirements are beyond the scope of this article, but be aware that additional planning may be needed to satisfy the competing requirements that (1) at least 80% of the company must remain in the hands of the same owners both before and after the conversion from LLC to corporation, and (2) at least 30% of the company must be owned by the ESOP after a 1042 rollover transaction.
[1] This requirement is at odds with the point of the conversion — which is to change owners by selling to the ESOP. Further, the company can’t sell to the ESOP before the conversion because LLC membership interests aren’t “employer securities.” And, if the LLC converts to a corporation and the sale to the ESOP doesn’t close, the company has given up its LLC status. That may not be the end of the world, but it will require the company to adjust to life as a corporation.
This 80% ownership rule also comes into play if the plan is to sell more than 20% of the company to the ESOP immediately after the conversion. The requirement that the same owners own at least 80% of the company “immediately after” the exchange can be surprisingly fuzzy. What if the LLC is converted to a corporation effective 12:01 a.m. on January 1 and a sale of more than 20% of the company to the ESOP closes later the same day? How long does “immediately after” last? Because the answer is unclear, we generally recommend spacing out the conversion and the ESOP transaction. There may be a benefit to converting the LLC to a corporation in one tax year and then completing the sale to the ESOP in the next tax year.
As mentioned above, if the continuity of ownership requirement is not met, the IRS could treat the conversion as a liquidation and a taxable distribution of the LLC’s assets to its members by applying the step transaction doctrine. Part of the step transaction analysis is whether, at the time of the conversion, the buyer (the ESOP) has made a “binding commitment” to purchase the stock. ESOP fiduciary rules don’t permit an ESOP trustee to make a “binding commitment” until just before closing. However, the binding commitment test isn’t the only one courts use to determine whether the step transaction doctrine applies. This ambiguity is another reason we urge sellers to work with their advisors to assure that the appropriate rules are applied to their particular transaction.
Timing
After planning to avoid taxation on the conversion to an LLC, the next consideration is usually the timing of the conversion. How quickly the owner wants the ESOP to be up and running is usually the driver in this part of the conversation. Is the owner in a rush or willing to wait up to a year or longer to sell to the ESOP? If there are compelling reasons for the owner to sell now rather than later (health issues, need for cash), then the other timing drivers may be less important.
Another consideration is company revenue or other transactions that will be treated differently for tax and accounting purposes depending on whether the company is an LLC or a corporation. For example, there may be a pending asset sale or the possibility of having to file two separate tax returns for one tax year if the conversion is done mid‑year. As noted above, it can be done for an owner who can’t or doesn’t want to wait, but it will result in added expense.
Partnership Versus Corporate Tax
Most LLCs are taxed as partnerships. LLC members receive a Form K-1 reflecting each member’s share of the LLC’s gains and losses. These LLCs are “pass-through” entities – the LLC’s income is passed through to its members without first being taxed at the LLC level. If the LLC converts to a corporation, and does not make an S election, then company income will first be taxed at the corporate level and then again at the shareholder level when dividends are distributed.[2] The company and shareholders should work with their tax advisors to determine the impact of being taxed as a C corporation rather than a partnership.
If the company does want to make an S election, then the tax treatment of the company and its shareholders will not change significantly from when it was an LLC. However, make sure that all of the LLC members are eligible S corporation shareholders before the conversion is effected. The company will not be eligible for S corporation status if there are ineligible shareholders, such as corporations. If there are ineligible shareholders, and if the conversion decision hinges on the new corporation making an S election, then additional planning will be needed.
Mechanics of Conversion
The mechanics of converting an LLC into a corporation are governed by applicable state law and the LLC’s operating agreement. In California, for example, converting an LLC into a California corporation requires the members to approve a plan of conversion and file Articles of Incorporation with the California Secretary of State. The plan of conversion is a document describing the conversion and the issuance of shares in exchange for membership interests. Other states have different requirements and procedures – some more or less cumbersome – and corporate counsel should be consulted for help with this process.
The company will also need to check on the procedures involved for states in which it is registered to do business as those states will likely require paperwork be filed to update the company’s status from LLC to corporation.
The conversion may be a good opportunity to relocate the state of incorporation. For example, Delaware’s highly developed body of corporate law and specialized courts offer many companies a better option than their existing state of incorporation. A growing company with increasingly complex shareholder relations may find comfort in the Delaware judicial system’s expertise. Other companies may find that the benefits of incorporating in Delaware are not worth the additional (relatively minor) expense and administration. Either way, the conversion is a good time to consider the options.
In addition to the conversion itself, corporate counsel should be consulted with regard to any other legal housekeeping the new corporation should take care of. For example, the corporation will need to obtain a new federal employer identification number (EIN), and may need to register with the state franchise tax authority and the state employment department. The company will also want to consult with its tax advisors about filing an S election if desired.
Governance Changes
In a corporation, the shareholders elect the directors and typically have a vote in major corporate decisions such as whether to sell the assets of the company or participate in a merger. The directors appoint the officers and are responsible for making the “big picture” decisions about the direction of the corporation, such as reviewing the company’s finances, making budget decisions, setting executive compensation, and deciding to explore new markets. The officers report to the directors and are responsible for the day-to-day operations of the company in a way that comports with the directors’ vision.
An LLC’s less formal governance requirements are often part of the reason why business owners choose to operate as LLCs rather than corporations. But, it’s likely that the LLC is already following a pseudo-corporate format. For example, many LLCs have a board of directors and officers. Operating agreements often require a certain number of member and/or manager meetings per year at which minutes are kept to document decisions made. Operating agreements also typically dictate the percentage interests required to make a decision. These concepts all come from corporate law, so making the transition from LLC to corporation may not be as difficult as imagined.
The key is understanding what the applicable state law requirements are. How many directors and what officers does the company have to have? Do shareholders have cumulative voting rights? How much notice do board members and shareholders get before their annual meetings? The company’s corporate attorney can help by talking through these issues with owners and management and drafting the necessary bylaws and resolutions to bring the former LLC’s governance structure into the more formal corporate regime. It’s also a good idea to enlist your corporate attorney to provide a corporate governance primer for use in the early years when directors, officers, and shareholders need a refresher on their roles.
Conclusion
If you or your client want to explore an ESOP, but the company is an LLC, don’t write off the ESOP as impossible. Converting the LLC into a corporation can be done, and we’ve helped clients do it before. But, it must be done thoughtfully and in tandem with your other advisors. Call or e-mail us to talk about the specific situation.
[2] This scenario comes up when the selling shareholder wants to defer gain on the sale of stock to the ESOP in a 1042 rollover – treatment available only on sales to C corporations.
