Using loans to offset negative capital accounts for Partnership to S-Corp conversion

[jsamans]

A three-member LLC that has been taxed as a partnership has negative equity apportioned across all three capital accounts. The members want to elect S-Corp taxation, which as you all know is a deemed liquidation whose proceeds are used to buy shares in a new S-Corp and distribute those shares to the members, so the S-Corp inherits all liabilities and assets. The members don't have the cash to bring their capital accounts back to zero, so they want to treat the amounts owed as loans from the LLC to each member in the amount needed to offset the negative capital account balances and bring these loans over with them to the new S-Corp structure.

The LLC's partnership operating agreement has provisions for loans made to the partners, with one already outstanding, and the new draft S-Corp agreement affirms that prior partner loans will become shareholder loans upon assumption, so as far as I'm aware, this is perfectly fine. Anyone have any cautionary tales or see a red flag I'm missing?

[DaveO]

I have seen this done at other firms before. However I have never seen any economic substance behind it. No notes, interest stated or payments made. Near as I can tell it's done solely to free up losses or Sec 179 deductions. Others may have a different take.

[jsamans]

I'm pretty sure they're serious about treating these loans as real loans. The loan system that the members set up under their partnership-styled operating agreement specify interest rates, repayment schedules, etc. and the one member who borrowed money has held to it. They've also written into their S-Corp-styled operating agreement an affirmation of those provisions and a requirement for minimum repayments made as payroll deductions.

The goal is address the requirement that negative capital accounts be brought current at liquidation, which they've been advised is necessary as a technical matter even though the business will otherwise pick up where it was the day before under S-Corp taxation with the same assets and liabilities. They don't have the cash to put in to do this, so by taking the loans, they're looking to make the conversion with equity at zero.

[Roland Slugg]

I'm just wondering what possible reason the partners see in converting to S Corp tax status. I do not. Did someone tell them, "Partnership baaaaaaaad! S Corp gooooooooood?"