Tax Consequences of Converting to a Corporation
Many startups initially organize as limited liability companies (LLCs). However, as time passes and new investment opportunities arise, incorporation often becomes necessary. Business owners should be aware that short-year tax returns will be due if they decide to incorporate their businesses in the middle of the year.
A short-year filing requirement is triggered when any of the following occur:
(1) there is a change in accounting period,
(2) an entity forms in the middle of a tax year, or
(3) an entity dissolves, terminates, or goes out of business before the end of its tax year.
Considering the above, there will likely be a short-year filing requirement when an LLC converts to a corporation on any day other than the first day of its fiscal year. The process of conversion typically involves dissolving the LLC and registering a new corporation with a new Employer Identification Number (EIN), thereby creating a new entity for tax purposes. In these situations, assuming a calendar-year tax period, the corporation must file a short-year corporation tax return covering the period from the date of incorporation through the end of the year. For example, if the incorporation occurs February 15th, then the short-year tax period starts February 15th and ends December 31st. Additionally, the LLC would be required to file a final partnership tax return for the short year beginning January 1st and ending on February 14th. The final return would be due 2 ½ months after the end of the short year, which would be the end of April in this case. Consequently, income and loss items for the year, as well as tax deductions and credits, will need to be allocated to the appropriate part of the year and included in the appropriate income tax return. The business therefore must have a strong accounting system in place that accurately accounts for all transactions on the dates they occurred.
Tax planning strategies should be considered when converting a business to a corporation, including optimal timing of incorporation and allocation and recognition of deductions and income. At Snyder Cohn, we’re eager to help you navigate your specific circumstances and to ensure compliance with both federal and state tax laws.
