Following on from last week’s blog regarding the “Conversion of a Multi Member LLC to a Corporation”, it is probably an opportune time to move away from LLC conversion and look at a different type of entity conversion. In the culinary field some people might refer to it as a “deconstructive conversion”.
In layman’s terms, let’s assume you already have a Corporation, but would now like to convert it into a Partnership. What would the US Federal Income Tax Implications of such a conversion entail?
This conversion should be carefully examined by business owners, both in terms of the change in legal form and in tax status.
In this week’s blog, we will focus mainly on the US Federal Income Tax implications of converting a Corporation to a Partnership and identify the potential pitfalls that local and global tax advisors should be cognizant of when a client wants to convert their Corporation to a Partnership.
Does the above “warning” seem repetitive and starting to work on your nerves due to it being mentioned in every week’s blog?
Good! That is the intention. It is not purely added in as part of a “cut and paste” exercise, but rather to continue emphasizing the importance of entity conversions.
For purposes of this blog, it is important to briefly recap on how a Partnership and a Corporation will be taxed by the IRS.
Partnership – While a partnership is treated as an entity separate from its owners for some tax purposes, it is not treated as a separate tax-paying entity. The partnership’s items of income, gain, loss, deduction, and credit are passed through to its owners and included on their income tax returns for the year that includes or ends with the end of the partnership’s taxable year.
Corporation – Entities classified as corporations that do not elect to be taxed as “S corporations” are considered “C corporations.” The term “C corporation” refers to Subchapter C of the Internal Revenue Code, which governs the taxation of a C corporation. Under Subchapter C of the Code, a corporation is treated as a separate taxable entity and the income generated by the corporate business is taxed twice.
It is clear from the above, that the main difference here is that flow through applies to partnerships and not corporations. For a quick recap on this, please refer to our previous blog – Entity Classification Series: Corporate Taxation vs Passthrough – What is the Difference?
FEDERAL INCOME TAX TREATMENT OF CLASSIFICATION CHANGES
The check-the-box regulations permit entities to elect to change their U.S. tax classification. However, a change in tax classification, no matter how achieved, has tax consequences. This is applicable to U.S and International business owners.
Essentially there are three ways to accomplish a classification change.
- An elective classification change by filing IRS Form 8832,
- An automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners; and
- An actual conversion, wherein an entity merges into, or liquidates and forms, an entity that has the desired classification.
If a corporation elects to be classified as a partnership, the corporation will be deemed to have distributed all its assets and liabilities to its shareholders in liquidation, and the shareholders are deemed to contribute all the distributed assets and liabilities immediately thereafter to a newly formed partnership. The entity will therefore be deemed to have liquidated under either §331 or §332 and the deemed liquidation is treated for tax purposes as if it were an actual liquidation.
An entity that is not regarded as an eligible entity, will first need to convert into an eligible entity before making the check-the-box election.
Lastly an actual conversion can be implemented.
If a corporation merges into a partnership, the IRS will alter the transaction as a transfer of assets by the corporation to the partnership in exchange for partnership interests. This will then be followed by the distribution of the partnership interests by the corporation to its shareholders in complete liquidation. The transfer of assets to the partnership will generally be tax-free under §721 and the liquidation is tax-free under §332 if it meets the requirements of that section; otherwise, it is taxable under §331.
THE BUTTERFLY EFFECT
During the 139th meeting of the American Association for the Advancement of Science, Edward Lorenz posed a question: “Does the flap of a butterfly’s wings in Brazil set off a tornado in Texas?”
This question ultimately led to what we now refer to as the “Butterfly Effect”
In simple terms, the “Butterfly Effect” is a situation in which an action or change that does not seem important has a very large effect, especially in other places.
Let’s give it a shot and apply this theory to the blog.
Let’s assume your current situation necessitates you to change your entity from a Corporation to a Partnership. You action this without considering all the potential tax implications, what do you think the effect would be?