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Watch Out for Potential Tax Bill When Converting Corporation


Your medical practice, currently running as a C or S corporation, may be considering the idea of converting to a limited liability company (LLC) or limited liability partnership (LLP). Under the right circumstances, that could be a good idea from a tax perspective. Here's why: Both LLCs and LLPs can be treated as partnerships for federal tax purposes. The tax rules for partnerships are far more flexible than the corporate rules.

In addition, a practice that is treated as a partnership qualifies for favorable pass-through taxation. Under the pass-through concept, the income, deductions and tax credits of the practice are passed through to the individual owners and taken into account on their personal returns (LLC owners are called members, rather than partners for tax purposes). There's no practice-level federal income tax to worry about. For this reason, pass-through taxation avoids the classic C corporation problem of potential double taxation of the profits of the practice (once at the corporate level and again at the shareholder level when taxable dividends are paid out to the owners).

Of course, pass-through taxation also applies to medical offices run as S corporations. However, other aspects of the S corporation tax rules are generally much less favorable than the rules for practices treated as partnerships (in other words, medical offices operating as LLCs or LLPs).

Converting to LLC or LLP status might make sense for your practice because of the long-term tax advantages that it would deliver. Here's the problem: When a C corporation converts to LLC or LLP status, it's considered to be liquidated for federal income tax purposes. In other words, the corporation is deemed to sell all its assets, become liable for the resulting corporate-level taxes on appreciated assets (if any), and then distribute all the assets remaining after paying the tax bills to the shareholders in complete liquidation.

To the extent the imaginary liquidation proceeds deemed to be received by a shareholder exceed his or her tax basis in the stock of the practice, taxable capital gain is triggered at the shareholder level. This is double taxation.

If your medical practice operates as an S corporation, there's generally no corporate-level federal income tax bill, but the corporate-level gain from the deemed asset sale must be passed through to the shareholders, where it can trigger personal income tax bills.

Key Point: This deemed liquidation treatment means an incorporated medical practice with appreciated assets may trigger significant taxable gains, and large current tax liabilities, from converting into an LLC or LLP. If so, the tax cost of converting may simply be prohibitive.

Watch Out for Goodwill And Other Appreciated Practice Intangibles

Now you understand the negative tax impact of converting an incorporated medical practice that owns appreciated assets. But before concluding that your practice is unaffected by this issue (because it doesn't have much in the way of appreciated assets), ask yourself if the practice owns any intangible assets — particularly goodwill — that have appreciated significantly. Intangibles often do not show up on the cash-basis corporate balance sheet, because they were developed without any historical costs being assigned to them for either financial accounting purposes or tax accounting purposes.

(In addition to intangibles, accounts receivable are another major appreciated asset that can cause tax problems. We will deal with this topic in a future article.)

If your practice does appear to have some valuable intangibles, you may be able to cite two court decisions in arguing that the professional shareholders (rather than the corporation) own the intangibles. If that argument works, corporate-level gain from the deemed sale of these intangibles can be avoided, which means you may be able to convert the practice into an LLC or LLP without any major tax hitches. The intangibles can then be contributed tax-free to the new LLC or LLP, or they can continue to be owned individually by the professionals outside the business entity.

As you can see, converting an existing medical practice into an LLC or LLP can be problematic from a tax standpoint. The key factor is whether the corporation is considered to own significantly appreciated assets. If not, conversion should not have major negative tax consequences. If so, converting could trigger a big current tax bill, which could make converting an unattractive proposition. However, the two court decisions mentioned above may help avoid tax bills if one of the major assets of the practice is goodwill. In any case, all tax issues associated with converting the practice into an LLC or LLP should be carefully assessed before the transaction is completed. Contact your tax advisor if you have questions or want more information on this important subject.

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