Conversion to a Disregarded Entity
Corporations are often today converted into “disregarded entities” for tax purposes, such as avoiding “double taxation”. A disregarded entity is a business that is not separated from the owner for tax purposes. In other words, a business that is taxed through the individual’s personal tax return. A good example of a disregarded entity would be a single-member LLC.
When a corporation decides to convert into a disregarded entity, it often utilizes what is called “statutory conversion”. In this case, the corporation’s assets and liabilities automatically transfer to the newly created LLC “by operation of law rather than through separate, formal agreements regarding exchanges of stock and transfers of assets and liabilities”.
Is it a Liquidation?
Generally, a conversion of a corporation into an LLC would be treated for tax purposes as if the corporation liquidated. In the case of a liquidation, the shareholders receive the distributed assets with a fair-market-value basis. According to the Internal Revenue Code, “A liquidating corporation generally recognizes gain or loss on the liquidating distribution as if it had sold its assets for their fair market value at the time of the distribution” I.R.C. § 336(a). Additionally, contingent on the entity’s creditors’ consent, the shareholders could assume the entity’s liabilities and then contribute the distributed property and liabilities to the new entity. It can often be treated for federal income tax purposes as a contribution of one interest in a partnership in exchange for another interest in the same partnership.
What Are The Tax Costs?
I.R.C. § 336 requires gains and losses to be reported according to a fair market value sale of all property. Moreover, I.R.C. § 331 taxes the shareholders on the sale of all of their shares to the company. However, I.R.C. § 368(a)(1)(F) in some scenarios allows the transaction to go through as a “tax free reorganization” if the disregarded entity would be taxed as an S corporation. Another cost of the conversion in some cases would be the loss of the corporation’s accumulated business tax credits that it was unable to use in prior years.
What is a Q-Sub Inversion?
A “Q-Sub” stands for a “Qualified Subchapter S Subsidiary”. Simply put, it is an S corporation that is owned by another S corporation.
A corporate inversion or a “cross-border corporate expatriation transaction” is a process of a domestic company relocating its operations overseas to reduce its income tax burden. It could also be a U.S. company merging with a smaller foreign company. In certain cases, taxes can be reduced by 12-17%. For some corporations that could mean millions in savings. Inversions are legal in the United States.
Tax Liability in a Q-Sub Inversion
Typically, an inverted corporation ceases to be subject to U.S. worldwide taxation. According to 26 U.S.C.A. § 1361, “A corporation which is a qualified subchapter S subsidiary shall not be treated as a separate corporation, and
(ii) all assets, liabilities, and items of income, deduction, and credit of a qualified subchapter S subsidiary shall be treated as assets, liabilities, and such items (as the case may be) of the S corporation.”
In 2018, the U.S. Department of the Treasury and the Internal Revenue Service issued the most recent regulations that attempt to curb inversions by limiting the tax advantages that inversions grant. For example, the 2017 Act tightened up the inversion trap by imposing certain penalties. In cases where the inversion fraction is 60% or higher one of the following might occur:
- Transition tax on foreign earnings at 35% rate without the foreign tax credits (previously 15.5%);
- An increased base erosion and anti-abuse tax (a new minimum internal tax on cross-border transactions;
- Taxing shareholders on distributions at ordinary income rates.
In October 2019, the Trump administration removed certain rules requiring corporations to document some internal loans.