Category: Corporations
Subject: Conversion of S Corporation to LLC
Title: Effect of Debt Assumption on Shareholder Liquidation Gain
IRC Sections: 331, 358.
Filename: 1218.html
Date Produced: 04/95

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Background
Taxpayers held interests in a partnership which owned real property. The partners incorporated their interests and immediately made an election to be an S corporation. After a few months of operation as an S corporation, the parties have decided to convert the entity to an LLC. Conversion of a corporation into an LLC amounts to a liquidation of the corporation followed by a contribution to the newly formed LLC.

The real property is and was at all time subject to indebtedness. The S corporation assumed the debt of the partnership on incorporation. The S corporation shareholders will assume the debt on liquidation of the S corporation, and the LLC will assume the debt on recontribution of the property to the LLC.

The fair market value of the property inside the S corporation is approximately equal to its inside basis.

Issue
Does the liquidation of the S corporation give rise to shareholder level gain?

Answer
The answer depends upon the amount of debt outstanding at the time of the incorporation versus the amount at liquidation. Also, any stock basis fluctuations stemming from the S corporation pass-through must be taken into account. Assuming that the amount of indebtedness decreased over the period during which the S corporation held the property, gain would result to the extent of the decrease plus or minus any S corporation basis fluctuations.

Discussion
Normally when assets are transferred to a controlled corporation under Section 351, the basis of the stock in the hands of the transferors is simply the basis of the assets contributed to the corporation. However, if the corporation assumes any shareholder debt in connection with the transaction, the shareholder's resulting stock basis is reduced by the amount of debt assumed. See Internal Revenue Code (IRC) Sections 358(d)(1) and 358(a). Based on the figures provided, the partners had basis of approximately $1,080,996 at the time of incorporation, and the S corporation assumed approximately $330,318 of debt associated with partnership property. Accordingly, the partners' initial basis in S corporation stock is the net of these two figures, $750,678.

We have already discussed the corporate-level ramifications under Section 311(b).

The shareholder level tax consequences of the liquidation of the S corporation are controlled by IRC Section 331 which in general provides that a shareholder in a complete liquidation is treated as if he sold his stock in exchange for the liquidation proceeds. It is well settled that any corporate debt assumed by the shareholder in connection with a liquidation reduces the stockholder's liquidation proceeds thus decreasing any gain on the transaction. See, for example, Lam, 8 BTA 785, Dec. 2942, T.V. Symington & Son, Inc., 35 BTA 711, Dec. 9608 (Acq.), Gravley, 44 BTA 722, Dec. 11,854 (Acq.), and F.H. Ford, (Ct. Cls.) 63-1 USTC ¶9193, 311 F2d 951.

In order to determine a shareholder's gain or loss in this case, it is necessary to compare the net proceeds of liquidation (i.e., the fair market value of corporate property net of any debt assumed by the shareholder) against the shareholder's stock basis at the time of liquidation. If the shareholder's stock basis has remained static over the brief period of the corporation's existence, then any decrease in corporate debt would make the net liquidation proceeds exceed the shareholder's stock basis and a gain would result. [Note: don't forget to take into account any stock basis fluctuations resulting from S corporation operations.]