Dear Vuther,
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While it is easy to convert a Sole Proprietorship into a Corporation,
converting a Corporation back to a Sole Proprietorship is a complex process with
significant tax implications. To change your entity from a corporation into a
sole proprietorship, you must first evaluate and analyze the feasibility and tax
consequences.
We found a useful article from this site, which I am reprinting here: http://www.farmdoc.uiuc.edu/index.html
To convert from a Corporation to a different entity requires corporate
liquidation. That means two possible levels of tax for a C corporation and for
an S corporation. Conversion of a C corporation to an LLC can create significant
negative tax consequences. Liquidation can be taxable to both the corporation
and its shareholders. If the corporation's assets and/or stock have appreciated,
the tax cost of liquidation can be prohibitive. If the corporation has losses,
there may be little or no tax cost. Each situation must be analyzed to determine
feasibility. Assuming that state statutes allow the conversion and creditors are
agreeable, the tax cost of liquidation must be weighed against the benefits from
conversion to an LLC.
However, if the assets and stock have depreciated rather than appreciated, it
may be clearly advantageous to liquidate.
Liquidation of a corporation is generally a taxable event for both the
corporation and its shareholders. I.R.C. §336(a) states that a liquidating
corporation recognizes gain on the distribution of appreciated property,
recognizes depreciation recapture as if the corporation had sold each of its
assets at its fair market value, and generally recognizes loss on the
distribution of depreciated property. I.R.C. §331(a) provides that the
corporation's shareholder (s) also recognize gain or loss on the distribution
equal to the fair market value of the distribution received minus the basis in
the shareholder's stock.
If the tax cost associated with a complete corporate liquidation is too
great, alternatives include:
- Parallel operations
- Installment sale followed by liquidation
- Parallel
operations coupled with sale of assets
- Parallel operations coupled with
leasing and/or licensing of assets
- Joint venture
No matter what conversion technique is used to convert a business from pure
corporate ownership to substantial or complete LLC ownership, valuation of the
business is a key issue and potential point of attack by the IRS. Any corporate
conversion technique that does not involve liquidation of the corporation is an
invitation to the IRS to see whether it can come up with some variation of a
substance-over-form argument that would result in more tax being due. The most
dramatic argument for the IRS is that there has been a constructive liquidation
of the corporation.
The IRS has ample weapons-the accumulated earnings tax, the personal holding
company tax, and the S corporation passive income limitation-to keep taxpayer
advantages from the operation of passive corporations within reasonable bounds.
All alternatives to complete liquidation carry significant risks.
We strongly recommend that you consult a lawyer if you are really determined
to make the conversion. It is always best to be well-advised by the
professionals who specializes on these lines.
Good luck.
Nach M Maravilla
Publisher/CEO
http://www.powerhomebiz.com
The opinions expressed in this column are those of the
author, not of PowerHomeBiz.com. Users should not treat the Guide's response as
legal, accounting, or professional advice as all answers are intended to be
general in nature. Such advice can only be properly given by qualified
professionals who are fully aware of a user's specific geographical areas or
circumstances, such as an attorney or accountant.
