QUESTION ON How to Convert a Corporation to Sole Proprietorship
Hi! I had recently purchased a small business which was structured as a Corporation by the previous owner. I have determined that it would be more beneficial for myself and the business if I change the structure to a Sole Proprietorship but I have no idea what I’ll have to do to get that done or where I’ll have to go. Please help! Thank You
– Vuther – Florida, USA
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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: Income Tax Consequences of Changing Business Entity
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.
Nach M Maravilla
Recommended Resources on How to Form LLC:
- LLC or Corporation?: How to Choose the Right Form for Your Business
- Surprisingly Simple: LLC vs. S-Corp vs. C-Corp Explained in 100 Pages or Less
- Nolo’s Quick LLC: All You Need to Know About Limited Liability Companies
- Form Your Own Limited Liability Company
The information on this web site does not constitute legal advice. The law is constantly changing, and we make no warranty of the accuracy of information on this site or any site to which we link. If you need legal advice, you should contact an attorney.