Tax Issues in Converting an LLC to an ESOP

By Wendy Gilligan, Shareholder, Employee Benefits Law Group

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 LLC membership interests don’t count.

The 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. There are a variety of issues, including governance and the mechanics of conversion, but a key issue is taxes. 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.

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. This requirement is at odds with the point of the conversion, which is to change owners by selling to the ESOP. 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.

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 by reinvesting in qualifying securities. Section 1042 requires that the ESOP must own at least 30% of the company. 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.

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.

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. 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.

In short, the conversion can be done, but get good advice when doing it.