By CA Surekha
Conversion from Private Limited Company to Limited Liability Partnership (LLP): Legal, Strategic & Tax Framework — Eligibility, Conditions, Caution Points and Lock-In Compliance
Conversion of a Private Limited Company (or unlisted Public Company) into an LLP is governed by Section 56 & 57 of the LLP Act, 2008 and Section 47(xiiib) of the Income-tax Act, 1961.
While the LLP route offers managerial flexibility and simplified compliance, its tax neutrality is strictly conditional.
Failure to satisfy any of the prescribed conditions—either at the time of conversion or during the subsequent monitoring period—renders the transaction a “transfer” under Section 45, exposing it to capital-gains taxation, interest, and penalty under Section 270A.
Strategic Rationale
| Objective | Benefit | Caution |
|---|---|---|
| Simplification of ownership & compliance | LLP eliminates DDT, annual general meeting and complex ROC filings | Must preserve continuity; any dilution attracts tax |
| Withdrawal flexibility | Partner’s drawings are not treated as dividends | Lock-in on reserves restricts withdrawals for 3 years |
| Cost & administrative efficiency | Lesser audit/compliance burden | LLP not eligible for certain corporate deductions and SEBI listing access |
| Exit planning | Tax-neutral reorganization if compliant | Breach → retrospective taxation under 47A(4) |
Statutory Preconditions under Section 47(xiiib)
| Sl. No. | Condition | Analytical Insight |
|---|---|---|
| (a) | All assets & liabilities of the company become those of the LLP | Must transfer at book value; no revaluation permitted. |
| (b) | All shareholders become partners in same proportion | Even one omission breaks continuity. |
| (c) | No consideration other than partnership interest | Cash/loan/bonus issue ⇒ disqualifying event. |
| (d) | Profit-sharing ratio continuity (≥ 50 %) for 5 years | Lock-in of ownership and control; breach → retrospective tax. |
| (e) | No distribution of accumulated profits for 3 years | Prevents dividend-like withdrawals post-conversion. |
| (f) | Total assets ≤ ₹5 crore (book value) | Statutory upper ceiling for tax neutrality. |
| (g) | No turnover > ₹60 lakh in any of the preceding 3 years | For small/closely held businesses; exceeding nullifies exemption. |
| (h) | All other conditions as prescribed (e.g., Section 72A, Rule 12C) | Ensures genuine reorganization intent. |
The ₹5 Crore Asset Threshold — The Absolute Limit
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Purpose: Restricts tax-neutral conversion to small entities.
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Computation: Aggregate book value of total assets (not fair value).
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Breach Impact: If assets exceed ₹5 crore even by ₹1, the conversion loses exemption ab initio.
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Practical caution:
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Recheck valuation date immediately before filing Form 18 (LLP Act).
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Avoid last-minute revaluation or capitalisation of reserves.
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Liabilities are not netted off for this test.
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| Scenario | Result | Strategic Step |
|---|---|---|
| Book value ₹4.9 cr → Compliant | Tax-neutral conversion | Maintain evidence via CA certificate |
| Book value ₹5.01 cr → Non-compliant | Capital-gains triggered | Split business or hive-off assets before conversion |
| Post-conversion asset rise | Irrelevant (only at conversion date) | Safe if below limit at date of filing |
Shareholders → Partners : Continuity and Ownership Rule
After conversion, shareholders become owners (partners) in the same ratio as their shareholding.
They are collectively deemed the continuing owners of the business; ownership proportion determines capital contribution and profit-sharing entitlement.
| Aspect | Requirement |
|---|---|
| Continuity test | Every shareholder must become a partner; share-to-profit ratio mapping must be identical. |
| Transfer of ownership | No other person can be admitted at conversion. |
| Documentary proof | Partner capital accounts, LLP Agreement, and valuation statement must reflect identical ratios. |
Duration-Based Lock-In Conditions
(a) Five-Year Ownership Continuity (≥ 50 %)
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Condition: Shareholders who become partners must jointly hold ≥ 50 % profit-sharing ratio for five years.
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Rationale: Prevents short-term dilution or disguised transfers.
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Breach: Retrospective capital-gains taxation under 47A(4).
| Do’s | Don’ts |
|---|---|
| Incorporate five-year clause in LLP Agreement. | Don’t admit/retire partners if ex-shareholders’ share < 50 %. |
| Maintain annual ratio register & board confirmation. | Don’t alter capital contributions without recalculating ratio. |
(b) Three-Year Reserve Distribution Lock
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Condition: No distribution of accumulated company profits/reserves for three years post-conversion.
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Scope: Includes general & revaluation reserves, P&L surplus.
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Indirect payments: Adjustment in capital/current accounts, advances or set-offs = violation.
| Do’s | Don’ts |
|---|---|
| Create separate “Company Reserve A/c” in LLP books. | Don’t withdraw or adjust from that reserve for 3 years. |
| Obtain auditor’s annual certification. | Don’t fund partner drawings from legacy profits. |
Consequences of Breach (either condition):
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Exemption withdrawn retrospectively.
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LLP deemed to have transferred capital assets on conversion date.
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Tax liability + interest u/s 234B/C + penalty u/s 270A.
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Depreciation recast; MAT/AMT recomputation.
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Possible reopening under Section 147.
Inter-Condition Matrix & Cascading Risk
| Parameter | Lock-in | Typical Pitfall | Result |
|---|---|---|---|
| Ownership ratio | 5 years | Admission of new investor | Exemption revoked |
| Reserve lock | 3 years | Partner withdrawal | Retrospective CG |
| Asset limit | Conversion-date | Revaluation entry | Ineligible conversion |
| Turnover cap | Preceding 3 FYs | Group-company turnover wrongly consolidated | Exemption denied |
| Continuity breach | Any time | Partner exit | Conversion taxable |
Practical Compliance Strategy
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Pre-conversion audit: Verify asset ceiling, turnover, shareholding pattern.
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LLP Agreement drafting:
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Include five-year & three-year clauses.
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Map shareholding ratios explicitly.
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Accounting treatment: Transfer assets/liabilities at book value; maintain distinct reserve accounts.
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ROC & Income-tax filing: Form 18 (LLP Act) + intimation to AO with computation note.
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Post-conversion monitoring: Annual confirmation by CA/auditor; ratio reconciliation.
Do’s and Don’ts — Compliance Compass
| ✅ Do’s | ❌ Don’ts |
|---|---|
| Keep documentary trail: valuation, partner ledger, CA certificate. | Don’t make indirect payments from legacy reserves. |
| Check ₹5 cr threshold at book value. | Don’t rely on fair value adjustments. |
| Preserve ≥ 50 % ex-shareholder ratio for 5 years. | Don’t dilute via capital introduction or revaluation. |
| Keep statutory registers and minutes for AO scrutiny. | Don’t merge/sell during lock-in without legal opinion. |
Withdrawal or Extraction of Money — Least-Tax Route (Post-Lock Period)
After expiry of the 3- & 5-year locks:
| Option | Tax Impact | Planning Tip |
|---|---|---|
| Partner drawings from current profits | Exempt in partner’s hands; taxed in LLP | Maintain profit-withdrawal register |
| Remuneration/interest to partners | Deductible to LLP ( Sec 40(b) ) / taxable to partner | Fix via deed within limits |
| Capital reduction after 5 years | Not taxed if out of post-conversion capital | Avoid linking to old reserves |
| Loan repayment to partners | Permissible if funded from post-tax profits | Document purpose clearly |
Forward-Looking Risks & Professional Cautions
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Retrospective Exposure: AO can reopen past years up to 6 years from breach.
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Indirect Transfers: Any restructuring in holding/subsidiary chain may be construed as dilution.
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Accounting vigilance: Maintain separate ledgers for “Old Reserves,” “New Profits,” and “Capital Accounts.”
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Audit disclosure: Non-compliance to be reported in Form 3CD clause 21(b).
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Exit readiness: Investors must plan entry/exit post 5 years to avoid exemption loss.
Conclusion
The conversion of a company into an LLP is advantageous only when executed within the narrow corridor carved by Section 47(xiiib).
While the procedural mechanics under the LLP Act are straightforward, the tax neutrality hinges on meticulous compliance—especially the ₹5 crore asset ceiling, ownership & profit-sharing continuity for five years, and reserve distribution embargo for three years.
A breach—however technical—can nullify all intended benefits.
Hence, the professional mandate is clear:
Plan precisely, document comprehensively, monitor continuously.
