Incorporation of an Entity Taxable as a Partnership to a Corporation or Association Taxable as a Corporation
At times it may be desirable to convert an entity taxable as a partnership, such as a limited liability company having more than 1 member or a limited partnership, into a corporation for federal income tax purposes. There may be several reasons why this planning option should be considered including the possible IPO of the business entity although in such case the conversion of tax status should be dependent upon the successful offering.
As set forth in Rev. Rul. 84-111, supra, there are three methods by which an entity taxable as a partnership may convert to a corporation.
The first method is the “assets over” or “partnership asset transfer” approach. In such instance the tax partnership transfers its assets to the newly organized corporation in exchange for the stock and the assumption by the corporation of partnership liabilities, and the partnership then liquidates by distributing the corporate stock received in the incorporation transaction to the partners in accordance with their partnership proportions.
The second method is the “assets up” or “partner asset transfer” approach, where the tax partnership’s assets are first distributed in-kind to the partners who then transfer the assets to the corporation in exchange for the corporations's stock and the corporation assumes the liabilities of the partners which were just assumed by the partners from the distributing or liquidating partnership.
The third method is the “partnership interest transfer” approach, where the interests of the partners in the tax partnership are transferred to the corporation in exchange for the corporation's stock. This exchange will terminate the partnership (since only one “partner” will then hold interests in the former partnership). The partnership's assets and liabilities will become the assets and liabilities of the corporation.
The check-the-box regulations contain a rule whereby the partnership may elect to change from a tax partnership to an association taxable as a corporation. Treas. Reg. § 301.7701-3(g)(1)(i) sets forth the effects of the CTB election which takes the “assets over” or “partnership asset transfer” approach: (i) the partnership contributes all of its assets and liabilities to the association in exchange for stock in the association; and (ii) immediately thereafter, the partnership liquidates by distributing the stock of the association to its partners.
In Rev. Rul. 2004-59, 2004-1 CB 1050 the Service ruled that if an unincorporated state law entity that is classified as a partnership for federal tax purposes converts into a state law corporation under a state law conversion statute, the following (“assets over”)is deemed to occur: (i) the partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation; and immediately thereafter, (ii) the partnership liquidates, distributing the stock of the corporation to its partners. In other words, the conversion is treated in the same manner as an election (without a state law conversion to corporate status) under Treas. Reg. § 301.7701-3(c)(1)(i) .
Impact of “Assets Over” Conversion. The exchange under §351, as mentioned, is between the partnership and the corporation. The partnership then terminates through a liquidating distribution of the newly received stock. The basis of the assets received by the transferee corporation will be the partnership's basis per §362. The basis of the stock received by the partnership will be the basis of the partnership’s assets transferred to the corporation, reduced by liabilities assumed by the corporation or to which the transferred properties were subject. § 358 . This amount may vary significantly with the partners’ basis in their partnership interests which becomes the corporation’s basis in the acquired assets under the “Assets Up” method. The basis of the transferee corporation's stock received by the partners in liquidation of the partnership is the adjusted or outside basis of the partners' interests in the partnership less the amount of the corporation's assumption of the partnership's liabilities in the incorporation transaction.
The holding period for the stock received in the exchange and distributed to the partners in liquidation receives “tacking” of the holding period of the partnership but only as to capital or §1231 assets. Ordinary income assets of the partnership are not entitled to tacking and the holding period for the stock begins on the day following the date of the exchange. §§ 1223(1), 1223(2). The “assets over” approach is considered by many tax advisors as the least complex method for incorporating a partnership.
“Assets Up” Approach. Under this alternative, the partnership first liquidates by distributing its assets, subject to liabilities, to the partners. The second step is the transfer of assets received from the partnership to the transferee corporation in exchange for stock in accordance with §351(a). The basis of the distributed received in liquidation to the partners is the adjusted basis of each partner's interest in the partnership, less any money distributed or property treated as money. Each partner’s basis in the stock received in the exchange (or deemed exchange) will be equal to the basis of the assets received in the liquidating distribution, less liabilities assumed by the transferee. §358. The corporation’s basis in the transferred assets is equal the partners adjusted basis in the assets “contributed” up to the corporation. § 362 . Note again, that the outside basis in the partners’ interest in the partnership will become the corporation’s basis in its assets which may produce a different result then the “Assets Over” approach.
The partners' holding period in the assets received in liquidation includes the partnership’s holding period. The holding period in the stock received in the exchange includes the holding period for the capital assets and § 1231 assets. Ordinary ncome assets receive no tacking of holding period. §1223(1) . The holding period for the corporation in assets received in the exchange includes the (former) partners' holding periods in the assets transferred to the corporation. § 1223(2) .
Transfer of Partnership Interests Approach. As the third alternative, the partners transfer their partnership interests to a transferee corporation in exchange for shares of the corporation under §351. The partnership terminates since upon receipt by the corporation there will be only one “partner”. The partners basis in the stock received in the exchange will be the basis for their partnership interests, reduced by any liabilities assumed. §358. The corporation’s basis for the partnership assets will be each partner's basis in the partnership interest transferred. § 362 . Tacking of holding period is permitted for the stock received holding period to the extent that the assets in the partnership are neither §751 or ordinary income assets. The corporation's holding period in the assets received in the exchange includes the holding period of the partnership in the assets transferred. § 1223(2) .
If the corporation-transferee is an S corporation, the Assets Up method may place jeopardy on the corporation’s S status as it will have, at least momentarily, a partnership as a shareholder. This is discussed briefly in Rev. Rul. 84-111, supra.