The assets-over method converts an LLC into a corporation in three ordered steps: the LLC transfers all of its assets and liabilities to a newly formed corporation in exchange for 100% of the corporation’s stock, holds that stock briefly, and then liquidates by distributing the stock to its members in proportion to their membership interests. The IRS recognizes this sequence in Revenue Ruling 84-111, and when it satisfies Section 351 of the Internal Revenue Code, no gain or loss is recognized by the LLC or its members. The catch is that the IRS taxes the transaction based on its form, not the parties’ intent, so the steps have to happen in the right order and the numbers have to line up.
The Three Steps, in Order
First, the LLC transfers everything it owns to the new corporation. Tangible assets, intangible assets, contracts, and outstanding debts all move across. In exchange, the corporation issues all of its stock to the LLC. The LLC is now the sole shareholder of the corporation, and the corporation has assumed the LLC’s liabilities.
Second, the LLC exists briefly as a holding vehicle. It owns nothing but the corporate stock. This phase is short but legally significant: it establishes the LLC as the transferor for tax purposes, which drives how basis is calculated at every level.
Third, the LLC liquidates. It distributes the corporate stock to its members in proportion to their membership interests and ceases to exist. The former members now hold shares directly in the corporation. For federal tax purposes, the whole sequence collapses into a single integrated transaction.
This is also the deemed form that applies automatically when an LLC files a check-the-box election on Form 8832 to be classified as a corporation for federal tax purposes.1eCFR. 26 CFR 301.7701-3 – Classification of Certain Business Entities
What Keeps It Tax-Free Under Section 351
Section 351 provides that no gain or loss is recognized when property is transferred to a corporation solely in exchange for stock, provided the transferors control the corporation immediately after the exchange.2Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor
Control has a specific meaning here: the transferors must own at least 80% of the total combined voting power of all voting stock and at least 80% of the total shares of every other class of stock.3Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations In a straightforward assets-over conversion the LLC receives 100% of the stock, so control is easily satisfied. The test can fail if stock is issued to outside parties, such as new investors or service providers, as part of the same transaction.
Two other conditions matter. If the LLC receives anything besides stock, such as cash or other property, that “boot” triggers gain up to the value of the non-stock consideration.2Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor And stock issued in exchange for services doesn’t qualify for nonrecognition. If any member’s shares are partly compensation for services, that portion is taxable. Clean conversions issue stock solely for property.
The Liability Trap Most Conversions Miss
This is where conversions that look tax-free on paper can produce a surprise bill. Under Section 357(c), if the total liabilities the corporation assumes exceed the total adjusted basis of the property transferred, the excess is recognized as gain.4Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability
Take an LLC transferring assets with an adjusted basis of $400,000 but carrying $600,000 in liabilities, such as a mortgage on appreciated real estate. The corporation assumes the full $600,000. The $200,000 excess is recognized as gain even though no one received any cash. The character of that gain (capital, ordinary, or a mix) depends on the underlying assets.
There is a narrow exception: liabilities whose payment would give rise to a tax deduction, such as accounts payable for a cash-method business, are excluded from the Section 357(c) calculation.4Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability The exception doesn’t apply if the liability created or increased the basis of any property, so it helps service businesses with accrued expenses but not an LLC whose debts are mortgages or purchase-money loans.
Before converting, compare total liabilities against the total adjusted basis of everything being transferred. If liabilities are higher, the conversion still works, but it isn’t fully tax-free. Paying down debt before the conversion, or contributing additional property with enough basis to close the gap, will eliminate or reduce the problem.
Basis and Holding Period Carryover
Section 351 defers gain rather than eliminating it, and the substitute basis rules keep that built-in gain in the system.
The corporation takes the same basis in each transferred asset that the LLC had, increased by any gain the LLC recognized on the transfer.5Office of the Law Revision Counsel. 26 USC 362 – Basis to Corporations If the LLC contributed equipment with an adjusted basis of $200,000 and a fair market value of $500,000, the corporation inherits the $200,000 basis. The $300,000 of built-in gain gets taxed later, when the corporation sells the equipment or depreciates it out.
The LLC’s basis in the stock it receives equals its basis in the assets transferred, reduced by liabilities the corporation assumes and increased by any gain recognized.6Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees When the LLC liquidates, each member takes a basis in their shares equal to their basis in their LLC membership interest under the partnership distribution rules of Section 732(b).
Holding periods tack. Under Section 1223, when the basis of property received is determined by reference to the basis of the property given up, the old holding period carries over.7Office of the Law Revision Counsel. 26 USC 1223 – Holding Period of Property A member who held their LLC interest for three years is treated as having held their corporate stock for three years, which matters for long-term capital gains rates on a later sale.
Why Assets-Over Rather Than the Other Two Forms
Revenue Ruling 84-111 recognizes three ways to incorporate an LLC. The interests-over method has each member transfer LLC interests directly to the corporation for stock; the corporation ends up owning 100% of the LLC and the LLC terminates. Basis works differently there: the corporation determines its basis in the assets under the partnership distribution rules rather than the Section 362 transferred-basis rules, which can produce different results when members have varying inside and outside bases.
The assets-up method has the LLC first distribute all its assets to the members in liquidation, and then each member contributes their share to the corporation. Every member is a direct transferor, which is useful if some want to contribute and others don’t, but every asset must be retitled twice and each member handles their own piece.
Assets-over keeps the LLC as a single transferor and avoids the double retitling. It also aligns with most state statutory conversion procedures and with the deemed transaction the check-the-box regulations already assume.
Section 1244 Stock: A Benefit Worth Capturing
Conversion is a good moment to make sure the stock qualifies under Section 1244, which allows shareholders to treat losses on the stock as ordinary rather than capital. Ordinary losses offset all types of income; capital losses only offset capital gains plus $3,000 of ordinary income per year. If the corporation later fails, the difference is substantial.
To qualify, the stock must be issued by a domestic small business corporation, meaning aggregate capital received for all stock (including prior issuances) does not exceed $1,000,000, and it must be issued for money or property rather than for other stock or securities.8Office of the Law Revision Counsel. 26 U.S. Code 1244 – Losses on Small Business Stock Assets-over conversions issue stock for the LLC’s property, so that box is checked.
The corporation must also derive more than 50% of gross receipts from active business operations rather than passive sources like rents, royalties, dividends, and interest. The ordinary loss deduction is capped at $50,000 per taxpayer, or $100,000 for a joint return; anything above the cap reverts to capital loss treatment.8Office of the Law Revision Counsel. 26 U.S. Code 1244 – Losses on Small Business Stock No election is required, but documenting that the requirements were met at the time of issuance is essential if you ever need to claim the deduction.
Securities Law Applies, Even Among Existing Owners
Issuing corporate stock is a securities transaction, even when the recipients are the same people who owned the LLC. Federal law requires registration unless an exemption applies.
Section 4(a)(2) of the Securities Act exempts “transactions by an issuer not involving any public offering.”9Office of the Law Revision Counsel. 15 U.S. Code 77d – Exempted Transactions A conversion that issues stock only to existing members is the opposite of a public offering.
For added certainty, many conversions rely on Rule 506(b) of Regulation D, which sets concrete conditions that qualify as a non-public offering: no more than 35 non-accredited purchasers, no general solicitation, and any non-accredited investor must have enough financial sophistication to evaluate the investment.10eCFR. 17 CFR 230.506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering When members receive stock in proportion to their existing interests, these are almost always met. Rule 506(b) also carries a “bad actor” disqualification, so a quick background check on directors and significant shareholders is prudent.
State blue sky laws apply too. Most states exempt transactions with existing owners, but the specific requirements vary and a notice filing with the state regulator is often required.
Governance: Operating Agreement to Bylaws
An LLC’s operating agreement is a flexible contract among members that can allocate profits unevenly, grant management authority to specific people, and impose almost any voting structure the members agree to. Corporate bylaws assume a three-tier hierarchy of shareholders, directors, and officers with default rules set by state corporate law.
The Plan of Conversion should translate the operating agreement’s key provisions into corporate form. Uneven profit-sharing may require multiple classes of stock. Management rights held by specific members have to be channeled into officer positions or board seats. Noncompete clauses, buyout provisions, and distribution preferences don’t carry over automatically; they must be rebuilt in the corporate documents.
Shareholder agreements are the usual home for protections that bylaws can’t accommodate: rights of first refusal on share transfers, drag-along rights, tag-along rights, and board nomination rights for specific shareholders. Board voting requirements and quorum rules must appear in the certificate of incorporation or bylaws to be enforceable, not just the shareholder agreement.
Filings and Post-Conversion Cleanup
Before filing anything with the state, the LLC drafts a Plan of Conversion covering the asset transfer, the ratio for converting membership interests into shares, treatment of debts, and the governance structure. Most state conversion statutes require member approval, often by majority or supermajority depending on the state and the operating agreement.
Two primary documents go to the Secretary of State: Articles of Incorporation for the new corporation and a Certificate of Conversion showing the corporation as successor to the LLC. The Articles specify the corporate name (with a required suffix such as “Inc.” or “Corporation”), the number and par value of authorized shares, the registered agent’s name and address, and the stated purpose. All of this must match the Plan of Conversion and the LLC’s existing records.
On the EIN, outcomes depend on structure. If the LLC made a check-the-box election on Form 8832 to be taxed as a corporation, which is a deemed assets-over transaction under the Treasury regulations, the entity keeps its EIN. If the LLC actually terminated and a new corporation was formed as a separate entity, the IRS requires a new EIN.11Internal Revenue Service. When to Get a New EIN State statutory conversions, where the entity continues in a new form without technically terminating, generally fall in the keep-your-EIN camp, but confirming with the IRS before filing is worth the call.
After the filings clear, bank accounts must be retitled and signatory cards updated. Insurance policies need the corporation named as insured. Local business licenses and permits require updating. Contracts should be reviewed; most survive a statutory conversion by operation of law, but some contain change-of-entity clauses that require counterparty consent. And the corporation has to start observing corporate formalities the LLC may have ignored: annual shareholder meetings, board minutes, annual or biennial reports, and separation of corporate and personal records. Skipping those formalities puts at risk the liability protection that motivated the conversion in the first place.