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Tax Consequence of Converting to a Corporation

This lecture addresses the tax effects on basis and gain recognition when converting from a partnership-taxed entity to a 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 liquida4on of partnership property. That is, if the proceeds from the liquida4on of partnership assets exceed the partner’s basis in the partnership, then there will be a taxable gain. Likewise, if the proceeds from the liquida4on

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 corpora4on, the partners will have contributed property to the corpora4on in exchange for stock.  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 corpora4on.

  • 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 liquida4on of $1,000 each. If the partnership interest is contributed directly to the corpora4on, the transac4on may qualify under IRC Sec4on 351 to defer the recogni4on of gain by the partners.
  • Note: The liquida4on of assets by the partnership may lead to a gain or loss for the partners contribu4ng that asset.

    Does the partnership recognize any gain or loss in the conversion from a partnership to a corporate en.ty?

    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 liabili4es to its partners. Remember, the tax basis of the partners contribu4ng 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 contribu4ng partner. Pursuant to IRC Sec4on 358, if the partnership transfers the assets and liabili4es to the new corpora4on, then it may not recognize any gain or loss. In such a transac4on, 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 recogni4on of gain or loss on the transac4on. Anne and Carl, however, may incur gains or losses upon distribu4on of the partnership assets.

What will be the partner’s basis in the new corpora.on?

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 en4ty, the partner’s basis in the new en4ty is unchanged. If the assets are liquidated by the partnership and transferred to the new corpora4on in exchange for stock of the new corpora4on, the partnership’s basis in the stock is equal to the value transferred to the corpora4on for the stock. If the assets and liabili4es of the partnership are simply transferred to the corpora4on (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 liabili4es 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 distribu4on. If the corpora4on assumes any liabili4es that reduce the liability of the partner, the partner’s basis in stock received is reduced accordingly. If the partnership and corpora4on merge, the partners’ basis in the stock will equal their basis in the partnership interest contributed to the corpora4on.

What is the new corpora.on’s basis in assets contributed by the partners or partnership?

If the partners or partnership transfers assets to the corpora4on, the corpora4on’s basis in those assets equals the partners’ or partnership’s basis. If the partnership transfers assets to the corpora4on in exchange for stock, and the partners’ basis in the partnership is higher than the partnership’s basis in the internal assets, the corpora4on 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 corpora4on, the corpora4on takes the partners’ outside basis as the basis of the partnership assets when the partnership is liquidated.

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