Converting a Partnership to a Corporation

The IRS recently issued Rev. Rul. 2004-59, holding that the incorporation of a partnership under a state law formless conversion statute will be treated in the same manner as a partnership that makes a check-the-box election to be treated as a corporation for tax purposes. Thus, the following will be deemed to occur: (1) the partnership contributes its assets and liabilities to a new corporation in exchange for stock; and (2) the partnership immediately liquidates, distributing that stock to the partners.

Rev. Rul. 2004-59 provides that an earlier ruling, Rev. Rul. 84-111, does not apply to a formless conversion of a partnership. In the prior ruling, the IRS described three different methods of incorporating a partnership: (1) the assets-over method (as used in Rev. Rul. 2004-59); (2) the distribution of the partnerships assets to the partners in liquidation of the partnership, followed by the transfer of those assets by the partners to the corporation; and (3) the transfer by the partners of their partnership interests to the corporation. Rev. Rul. 84-111 held that the form of each of the three methods would be respected, then described the different tax consequences associated with each.

Although a formless conversion may be the simplest method of converting a partnership into a corporation, it may not be the most tax effective method. As illustrated below, one of the other methods described in Rev. Rul. 84-111 may result in greater tax savings.

Example 1: A and B are partners in AB partnership. ABs assets consist of machinery and equipment with a $100 fair market value (FMV), a $120 original cost and an $80 inside tax basis to the partnership. AB has no liabilities. A and B have a $100 collective outside basis in their partnership interests. They seek cash and bring in C, an outside venture capital fund, which wishes to invest only in a corporation. C will contribute $20 cash for new company (N) stock, coupled with A and B contributing the AB property to N for N stock with an $80 FMV and $20 cash.

The partners use their states formless conversion law. AB will be deemed to transfer its assets to N for $80 of N stock, plus $20 cash. Under Sec. 351(b), ABs $20 realized gain is recognized to the extent of the $20 cash received in the exchange. On the deemed distribution of the N stock to the AB partners, AB terminates under Sec. 708(b)(1)(A). Under Sec. 358(a)(1), in a transaction to which Sec. 351 applies, ABs basis in the N stock is the same as that of the property exchanged ($80), decreased by the cash received ($20) and increased by the gain recognized ($20). Under Sec. 732(b), the basis in the partners hands of the property distributed in the AB liquidation is As and Bs collective outside basis ($100), increased by the $20 gain, and reduced by the $20 received. As a result, a gain of $20 is reported when AB converts to a corporation in an assets-over transaction using a state formless conversion law, and the partners take a $100 collective tax basis in the N stock.

Example 2: The facts are the same as in Example 1, except AB does not make a formless conversion, but instead takes the steps described in the third situation in Rev. Rul. 84-111 to convert to a corporation (i.e., A and B transfer their partnership interests to N in exchange for $80 of N stock and $20 cash). The partners realize no gain or loss on transferring their partnership interests to N in exchange for its stock and cash, inasmuch as their aggregate outside basis is $100 and the combined FMV of stock and cash received is $100. Under Sec. 358(a), the partners basis in the N stock received in the exchange for their partnership interests equals the basis of those interests ($100), reduced by the cash received ($20). As a result, they recognize no gain on receiving $20 cash when AB converts to a corporation by a transfer of A and Bs interests. In addition, their resulting basis in the N stock is $80.

Compared to the formless conversion alternative, the partners do not recognize an immediate $20 gain. However, they will be subject to a $20 greater gain or lesser loss on a future sale of their stock, inasmuch as their basis in the N stock is $80, not $100, as it would be after a formless conversion.

Conclusion

Choosing between a formless conversion and another method described in Rev. Rul. 84-111 may have state implications, too. A taxpayer with facts similar to those above, in which the partnership recognizes gain on the receipt of boot in an assets-over formless conversion under Rev. Rul. 2004-59, would recognize business income in the amount of the gain apportionable to the states within which it does business. By treating the conversion as a transfer of the partners interests in exchange for stock, not only might immediate gain be avoided as illustrated in Example 2, but any recognized gain might also be sourced only to each partners state of commercial domicile. In such a case, a transfer of interests would be beneficial when the state income tax rate in a partners state of residency is less than the average rate in states in which the partnership does business.

From Michael R. Schuth, CPA, MST, Oak Brook, IL