What is the process to convert from one entity status to another?
The answer depends upon the technique used to convert and the type of entity from which the business is converting. With the exception of changing from S to C corporation status (and vice versa), converting from one business entity to another requires the organizer to undertake the steps previously discussed in Chapters 5 -through 9 to form a new business entity. The techniques for converting generally include liquidating the existing entity or merging the existing entity into the new entity.
What are the options in converting from a partnership or LLC (partnership) to a corporate entity status?
As stated above, conversion from a partnership to a corporate status can be done by liquidating (dissolving) the current business entity or by transferring ownership of the current entity over to the corporation. Here is a breakdown of the options:
• Liquidation Option – Liquidation requires the partnership to wind down operations, distribute its assets, and dissolve the entity. Distributing assets can be done in two ways. First, after paying off all liabilities, the partnership can distribute the remaining assets to the partners. The partners are then free to undertake the process necessary to organize the new entity. This may include contributing the assets received from the liquidation of the partnership (cash and property) to the new corporate entity. Second, the partnership may liquidate by contributing partnership assets to the new corporate entity. The partnership receives corporate stock for the contribution. The partnership is then dissolved and the corporate stock assets are distributed to the partners.
• Note: The second method is not available if the new corporation elects S status. Remember, all owners of an S corporation must be real people. The partnership cannot own an interest in the S corporation without jeopardizing its S status.
• Merger Option – The new corporation acquires the ownership interest of the partners in exchange for an ownership interest in the new corporation. The result is that the new corporation owns the partnership and all of its assets. The corporation can then wind up the affairs of the partnership in the manner most advantageous to the corporation. This could include transferring contracts, property, and other assets. The partnership becomes one with the new corporation.
Do partners recognize any gain or loss in the conversion from a partnership to a corporate entity?
The partners will recognize any gain or loss following the liquidation of partnership property. That is, if the proceeds from the liquidation of partnership assets exceed the partner’s basis in the partnership, then there will be a taxable gain. Likewise, if the proceeds from the liquidation are less than the partner’s basis in the partnership, the partner will recognize a loss in the conversion. If the partnership merges with the new corporation, the partners will have contributed property to the corporation in exchange for stock. As discussed in Chapter 13, IRC Section 351 may apply to defer the recognition of any gain or loss on property when contributing any assets and liabilities to the new corporation.
• Example: Terrence and Mike are partners. Each contributes property with a value of $10,000 in exchange for his partnership interest. When the partnership liquidates its assets, it receives $22,000. Terrence and Mike will have a taxable gain on the liquidation of $1,000 each. If the partnership interest is contributed directly to the corporation, the transaction may qualify under IRC Section 351 to defer the recognition of gain by the partners.
• Note: The liquidation of assets by the partnership may lead to a gain or loss for the partners contributing that asset.
Does the partnership recognize any gain or loss in the conversion from a partnership to a corporate entity?
If the partnership liquidates its assets, it will recognize any gains or losses on those assets if sold to outside individuals. The partnership will not recognize any gains or losses if it simply distributes the assets or liabilities to its partners. Remember, the tax basis of the partners contributing any property to a partnership is tracked for tax purposes. As previously discussed, gain on property sold, transferred, or distributed by the partnership may give rise to a gain for the contributing partner. Pursuant to IRC Section 358, if the partnership transfers the assets and liabilities to the new corporation, then it may not recognize any gain or loss. In such a transaction, a partnership’s basis in the stock received equals the basis in the assets and there is no taxable gain or loss to the partnership. The partnership may face gains or losses when the internal assets are liquidated.
• Example: Anne and Carl are partners of Anne’s Place. Anne’s Place contributes all of it’s assets to Big, Inc., in exchange for shares of Big, Inc. Anne’s Place may defer recognition of gain or loss on the transaction. Anne and Carl, however, may incur gains or losses upon distribution of the partnership assets.
What will be the partner’s basis in the new corporation?
Each partner’s basis in the assets distributed to the partner by the partnership will equal the partner’s basis in the partnership. So, if those assets are then contributed to a corporate entity, the partner’s basis in the new entity is unchanged. If the assets are liquidated by the partnership and transferred to the new corporation in exchange for stock of the new corporation, the partnership’s basis in the stock is equal to the value transferred to the corporation for the stock. If the assets and liabilities of the partnership are simply transferred to the corporation (rather than sold and the proceeds transferred), the partnership’s basis in the corporate stock will equal the partnership’s basis in the assets and liabilities transferred. When the partnership dissolves and distributes the stock, the partner’s basis will equal the partner’s basis in the partnership, plus any gain or loss recognized on the distribution. If the corporation assumes any liabilities that reduce the liability of the partner, the partner’s basis in stock received is reduced accordingly. If the partnership and corporation merge, the partners’ basis in the stock will equal their basis in the partnership interest contributed to the corporation.
What is the new corporation’s basis in assets contributed by the partners or partnership?
If the partners or partnership transfers assets to the corporation, the corporation’s basis in those assets equals the partners’ or partnership’s basis. If the partnership transfers assets to the corporation in exchange for stock, and the partners’ basis in the partnership is higher than the partnership’s basis in the internal assets, the corporation takes the lower partnership basis. The partner’s basis in the stock equals the partners’ basis in the property. If, however, the partnership is merged into the corporation, the corporation takes the partners’ outside basis as the basis of the partnership assets when the partnership is liquidated.
What does it take to convert from S to C corporation status?
The decision to become an S corporation is nothing more than a tax election. Therefore, if the entity meets the requirements to be an S corporation, the act of converting to a C corporation is very simple. To begin the conversion process, more than 50% of the corporate shareholders must vote to make a Subchapter S election. The S corporation board must then vote to approve the decision to convert to a C corporation. The corporation must then execute the appropriate IRS form.
• Note: An S corporation can lose its S election status by failing to adhere to S corporation requirements. If so, the C corporation cannot return to S status within a 5-year period without permission from the IRS.
What are the tax consequences of converting from S to C corporation status?
As previously discussed, C corporation income is subject to a double tax structure. Any retained earnings of the S corporation that are distributed to shareholders within one year of conversion to a C corporation will be tax free and will reduce the shareholder’s basis in the C corporation to the extent of the S corporation’s accumulated earnings account.
• Note: This one-year period allows shareholders a period to withdraw funds accrued as an S corporation.
What does it take to convert from C corporation status to a partnership or LLC?
Converting from a C corporation status to a partnership-taxed entity requires that the corporation be liquidated. This generally gives rise to extensive tax consequences due to the built-in-gains of corporate assets.
• Note: Upon liquidation, the corporation will pay tax at ordinary income rates on the value of the assets above the adjusted basis. Further, shareholders will pay capital gains tax on any distributions above the shareholder’s basis in the stock.
What does it take to convert from C to S corporation status?
To convert from C to S corporation status requires that the corporation meet the numerous requirements to be an S corporation. To qualify for S corporation status, the business must be a corporation organized in the United States. All shareholders must be U.S. Citizens or resident aliens. It cannot have more than 100 shareholders. All members of a family are considered to be one investor for purposes of this rule. All shareholders must be individuals, trusts, or certain other exempt organizations. The company may only authorize one class of stock (common stock). The company must follow an accepted tax year. Finally, all shareholders must consent to the S-Election. The corporation must meet all of these requirements on the first day of the year in which the tax election is effective. 100% of the shareholders must vote to convert to S status. The board must then authorize the filing.
• Note: All shareholders who owned an interest in the C corporation during the tax year of election must also agree to the conversion. This includes individuals who no longer own shares in the corporation.
When is the S election effective?
There are multiple options for when the S election becomes effective. The application may request that the election become effective on a specific date. This splits the annual tax year for the corporation into two tax years. The portion of the year prior to the S election is taxed as a C corporation. The tax year after the election is taxed as an S corporation. If the corporation fails to request a specific effective date, then the default rules for the taxable year apply. If the corporation makes the election prior to the 15th day of the third month of the year, then the election is effective for the year of election. If the election is made after this date, the election will become effective during the following tax year.
What are the tax consequences when converting from C to S corporation status?
Any profits that remain in the corporation after the effective date of the S election will be treated as a dividend to shareholders if these funds are distributed. Any future earnings after the effective date of the S election will pass through to the shareholders. Any assets of the C corporation that are sold after the S-Election will be subject to a corporate gains tax and will be treated as a dividend to the shareholders.
• Note: Remember, the C corporation must meet all of the requirements of an S corporation at the time of election.