My good friend and brilliant attorney, Steve, recently asked me the following question:
Q: Tom: I’ll assume you are aware (I wasn’t until 5 minutes ago) of amendments to the California Corporations Code (Sections 1150-1160) effective January 1, 2008. Basically, they provide that corporations can convert into an “other business entity”—LLC, LP, GP—and vice versa, on a no big deal basis. And the entities converting into other entities can be foreign corps, LLCs, etc.
My hopefully quick question: this is a provision of California Law. Are there provisions of the IRC that are violated by this? I mean, I tell a client “No problem—I can convert your Cal entity either way.” And then I find out WHAMMO!! We’re socked with adverse federal tax consequences.
Thanks, Steve.
A: There are three possible events that could happen here from a federal tax standpoint. First, you could have an entity, such as an LLC, that is being taxed as a limited partnership that is changed to an LLP, which is a limited partnership. Or, an LLC taxed as a GP converted to a GP. In these cases, there will be no tax consequence as you have not changed the nature of the taxable entity.
Second, you could have an entity that is taxed as a GP that is converted to an LLP or an LLC taxed as an LP. In this case, there may be some tax consequences for those partners/members who changed their tax status (i.e., GP to LP). The consequence comes from two levels. First, their income from the partnership could be converted from active to passive, subjecting them to the passive activity loss rules of Section 469. Second, their basis in the partnership would change if they were no longer on the hook for the recourse debt of the partnership. This could cause them to be limited on their losses or could even cause a gain to them as the relief of debt is considered to be a distribution for tax purposes.
Third, you could have an LLC that is taxed as a corporation (having previously made an election to do so) that is now taxed as a partnership because it was converted to an LLP or a GP. In this case, you would have a complete liquidation of the corporation and you would compute gain to the entity in an amount equal to the difference between the value of the assets and the basis of those assets.
Warmest regards,
Tom