Protecting Business Interests: How to Protect Subchapter S-Corporations?

Protecting Business Interests: How to Protect Subchapter S-Corporations?

Your most valuable asset is very likely your ownership interest in your business; it is the primary source of your future income.  Protecting your ownership interest in your business from future personal creditors is a paramount consideration in an asset protection plan.  A business which operates as a sole proprietorship offers no asset protection whatsoever.  Membership interests in an LLC, and shares of stock in a C-Corporation, can be conveyed to a Family Limited Partnership (FLP) for additional asset protection.

If you own shares in a Subchapter S-Corporation, however, these shares cannot be protected.  The Internal Revenue Code (IRC) only allows for shares of an S-Corp to be owned by individuals.  IRC §1361(b).  Thus, entities such as FLPs may not own shares in an S-Corp.  FLPs can own shares of a C-Corp or an LLC.

There are two ways to handle S-Corp shares within the context of asset protection.  One way is to transfer the S-Corp shares to an FLP and allow the S-Corp to default to a C-Corp. Alternatively, you could re-organize the S-Corp into an LLC, and then protect the LLC membership interests within an FLP.

An S-Corp should not default to a C-Corp if either of the following two concerns are present:

  1. If the S-Corp owns appreciated assets (such as appreciated real estate), the IRS will treat the default as a sale of those assets (from the S-Corp to the C-Corp), subject to capital gains tax.
  2.  C-Corps have an inherent “double taxation” issue:  First, the C-Corporation pays corporate tax on its profits.  Second, when the C-Corporation distributes the remaining profits as dividends to its shareholders, the shareholders pay income tax on the dividends received.  The double tax issue would not exist if the C-Corporation can issue bonuses to its shareholders/employees, which would be deductions to the C-Corp and thus “zero out” its profits.  However, if these bonuses are excessive, there is a danger that the IRS would deem the bonuses to be disguised dividends.

If these two situations cause concern, the S-Corp should re-organize as an LLC, rather than default to a C-Corp, and the membership interests in the new LLC may then be protected within an FLP.

An S-Corp may be re-organized, on a tax-free basis, into an LLC.  This re-organization is a change in form of ownership.  IRC § 368(a)(F).  The business operations of the S-Corp, now an LLC, remain unchanged.  Both LLCs and S-Corps are “pass through” tax entities, i.e., the entities themselves pay no tax; rather, the gains or losses “pass through” to the members of the LLC or shareholders of the S-Corp.  (Thus, the “double taxation” issue of C-Corporations, discussed above, is avoided by both S-Corps and LLCs.)   The “flow through” status of the S-Corp, now re-organized as an LLC, remains unchanged.   In addition, there is no deemed sale of assets and resulting capital gains tax consequences, as there may be if an S-Corp defaults to a C-Corporation.  IRC § 354(a).
Qualified tax counsel can prepare the documentation necessary for an S-to-LLC reorganization, complying with the proper tax laws and regulations.  This must be done carefully, lest the IRS consider the reorganization to be a “conversion” of S-Corp to LLC, which would result in negative tax consequences.  The following steps must properly occur:

a.  An actual “reorganization” must take place;
b.  There must be a valid business purpose;
c.  There can be no change in the nature of the taxpayer’s capital position;
d.  There must be a continuity of interest and control;
e.  There must be continuity of business enterprise;
f.  There must be a plan of reorganization.

If the S-Corp becomes an LLC in accordance with the steps specified above, the transaction will qualify as a “reorganization” under the Internal Revenue Code, and will be tax-free.

After a proper S-Corp to LLC reorganization, the LLC membership interests may be conveyed to an FLP.  Once within an FLP, the LLC interests will be protected from future creditors.

 

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