It is common for business owners to conclude that they must change the legal form of the entity through which a business has been conducted. When incorporating a business that has been a partnership, CPAs should pay close attention to the form of the conversion because the method used can affect the tax consequences of the transaction.
Rev. Rul. 84-111 provides three ways to incorporate a partnership: (1) the “assets-over” method, in which partnership assets are transferred to a newly formed corporation; (2) the “assets-up” method, in which partnership assets are distributed to the partners in liquidation of the partnership, followed by the contribution of the assets to a newly formed corporation; and (3) the “interests-over” method, in which partnership interests are transferred to a newly formed corporation in exchange for corporate stock. The specific method used affects basis, gains or losses, and holding periods.
Generally, Rev. Rul. 84-111 applies the rules of subchapter C on transfers to corporations; the rules of subchapter K on partnership distributions, transfers of partnership interests, and the treatment of unrealized receivables, inventory, and liabilities; and the rules of subchapter P on the holding period of property to each method of incorporation. The tax consequences will vary under each method because the basis in and the holding period of the assets held by a partnership, the partners’ basis in and holding period for their interests in the partnership, and the character of the assets held by the partnership, the partner, and the corporation will vary under each method.
For example, when the partners’ basis in their partnership interests is equal to the partnership’s basis in its assets, regardless of the method used to incorporate the partnership, the corporation’s basis in the assets after the incorporation will be the same as the basis of the assets when held by the partnership. However, when the basis in partnership interests does not equal the basis of partnership assets, differences will arise as a function of which method is used.
Caution: The tax consequences described in Rev. Rul. 84-111 are premised on the actual execution of all the steps inherent in the incorporation of a partnership, as a function of the method used.
SECTION 1244 STOCK CONSIDERATIONS
Taxpayers should compare the tax consequences to identify the method that yields the most favorable tax outcome, looking at basis, holding periods, and character of assets or interests transferred.
For example, since the original owner of section 1244 stock is the only taxpayer eligible to claim an ordinary loss from the sale or worthlessness of the small business stock, using the assets-over method of incorporating a partnership would void the section 1244 treatment. Under the assets-over method, the partnership serves as an intermediary owner in the process of transferring the stock to the former partners, and section 1244 treatment is lost when the stock is transferred by the partnership to the partners. Section 1244 treatment is preserved with both the assets-up and interests-over methods because the partners take ownership of the stock directly in the exchange.
For a detailed discussion of the issues in this area, see “Holding Period and Basis Considerations of Conversions to and from Partnerships,” by Jonathan Sousa, MBA, and Kathleen M. Weiden, CPA, Ph.D., in the March 2008 issue of The Tax Adviser .
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also find articles on the following topics in the March 2008 issue
of The Tax Adviser :
Roundup of state corporate tax developments.
Report on abusive tax shelters.
Commentary on the new protocol to the U.S.-Canada tax treaty.