S corp adds additional owner & converts to LLC/partnership

Technical topics regarding tax preparation.
#1
damcpa  
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My single owner S corporation IT client is adding a partner. The new partner is mostly contributing sweat equity in the early years. He will be buying into the business at 1% the first year, 8% the second year, but nowhere near 50/50. The current owner wants to give him distributions equal to his own. This seems to be fairly common in the IT consulting world.

The attorney doesn't want to form a new entity because it will mean having to renegotiate the current vendor contracts. The attorney wants to somehow do an automatic conversion of the S corporation to the LLC. Like a Check the Box option, which my reading, isn't an option.

We agree with the attorney that a multi-member LLC is a better entity choice. My research says the only way to accomplish this change is to liquidate the existing S corporation and have the owner reinvest this money in a new LLC.

The question is - if the S corp is liquidated and the proceeds are revinvested in the new LLC, is the liquidation a taxable transaction for the existing shareholder? He has equity of about $50K in his his business now. If it is not taxable, how is the liquidation and reinvestment reported?
 

#2
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I'll try to help.
The current owner wants to give him distributions equal to his own. This seems to be fairly common in the IT consulting world.

Why not make their compensation equal vs. doing it through distributions? Too much FICA?
The question is - if the S corp is liquidated and the proceeds are revinvested in the new LLC, is the liquidation a taxable transaction for the existing shareholder?

Yes, taxable liquidation. Sale of assets on final S corp return. 721 contribution of assets into new partnership.
My research says the only way to accomplish this change is to liquidate the existing S corporation and have the owner reinvest this money in a new LLC.

Maybe F reorg the S corporation's assets into a disregarded SMLLC 100% owned by the S corp, then have the new member/partner contribute money into the SMLLC in exchange for LLC units, thus creating a partnership underneath the S corp. This may require the current vendor contracts be renegotiated due to the S corp contributing its assets into the SMLLC.
 

#3
damcpa  
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Permanently-Diff, thank you for your help. Equalizing the compensation sounds like the simplest solution by far. Bottom line is that they are trying to find the easiest path.

Really appreciate your answer on the tax ability of dissolving the S Corp.

Tell me more about reorganizing the S corp’s assets into a SMLLC owned by the S Corp. I know that if the business chooses to terminate the S election, it becomes a C corporation by default. How are the assets separated out?
 

#4
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Tell me more about reorganizing the S corp’s assets into a SMLLC owned by the S Corp.

Step 1: S Corp forms a SMLLC and makes QSUB election, making the new SMLLC a disregarded entity (DRE).
Step 2: S Corp contributes all its assets into the QSUB. No tax effect, as the QSUB is disregarded for tax purposes.
Step 3: New partner contributes money or assets into the QSUB, which changes the tax classification of the DRE QSUB into a partnership for tax.
Step 4: Now you have a partnership with all the assets, which is owned by the new partner and the still existing S corp. The S corp hasn't been liquidated, so tax hasn't been recognized.
 

#5
Nilodop  
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Or:
S corp and new partner form a MMLLC, defaults to partnership treatment.
S corp contribute its assets.
New partner contributes cash or other assets.
"Now you have a partnership with all the assets, which is owned by the new partner and the still existing S corp. The S corp hasn't been liquidated, so tax hasn't been recognized."
No QSUB, no DRE.

But can the vendor contracts be contributed to the MMLLC? If not, does either approach get the attorney what he wants, as the vendor contracts are with the S corp, but the business is conducted by the new MMLLC, of which the S corp is only a partner.
 

#6
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Converting to a partnership not only triggers tax on liquidation, but both partners would be subject to employment tax on all the partnership income.

An alternative which avoids changing contracts with third parties and potentially reduces employment taxes would be for new partner to form an S which contracts with the existing S using a formula for compensation.
Steve
 

#7
damcpa  
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These are all excellent suggestions. Learned a lot from them and will do more reading. Thanks!
 

#8
damcpa  
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One more question - most of the equity in the existing S corporation is from cash in the checking account. Is there anything that prohibits the single shareholder from distributing the cash to himself before (and in anticipation of) an S corp dissolution? It would nearly eliminate the taxability of the dissolution.
 

#9
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damcpa wrote:It would nearly eliminate the taxability of the dissolution.


It shouldn't have any bearing on the taxability of the transaction.
A withdrawal of cash will decrease basis in the exact same amount the value decreases with the cash withdrawal.

Have you evaluated the value of any goodwill in the entity?
That's what I see most often ignored in liquidation.
~Captcook
 


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