The Tax Implications of Converting Your New Jersey Partnership or LLC to a Corporation
The reasons why a business owner might choose to convert his or her partnership or LLC into a corporation are numerous. Corporations offer many potential advantages. Regardless of the business reasons that motivate you, it is very important to understand the tax consequences of converting your business.
Rev. Rul. 84-111 lays out three ways to take an entity that is taxable as a partnership and convert it to a corporation. One method is what’s called “assets over.” Using this technique, the partnership transfers its assets to the corporation. In exchange, the partnership receives stock from the corporation. Additionally, the corporation takes on all of the partnership’s liabilities. At the end of this process, the partnership liquidates, dispersing the corporation’s stock among the partners based upon their partnership proportions. Many tax professionals consider the “assets over” approach as generally the least complicated of the three. Another method is called “assets up.” In this method, the partnership distributes its assets to the partners (again, based on their partnership proportions.) The partners then take those assets and transfer them over to the corporation in exchange for stock and other consideration. The corporation also takes on the partners’ liabilities, which they had assumed when the partnership liquidated.
The third approach is the partnership interest transfer method. With this approach, the partners each transfer their interests in the partnership directly into the corporation. This series of transfers will trigger the termination of the partnership, and all of the assets and liabilities of the partnership will belong to the corporation.
In most cases, any of these three approaches will yield a tax-free incorporation.
Twenty years after Rev. Rul. 84-111, Rev. Rul. 2004-59 declared that, when an entity that is not incorporated under state law and is classified as a partnership for federal tax purposes decides to incorporate under state law by following that state’s conversion statute, the IRS will deem the conversion to have taken place using the “assets over” approach.
The approach your business selects can affect basis, gains, losses, and holding periods. That’s because the basis in, and the holding period of, the partnership’s assets, as well as the partners’ basis in, and holding period of, their interests in the partnership, and the character of the partnership’s assets, will be different under each method. If the partners’ collective basis in the partnership’s assets is equal to their basis in their partnership interests, the corporation’s basis in those assets will be the same as the partnership’s basis in the assets pre-conversion. If not, differences will emerge depending on which method you use to convert.
Converting your partnership to a corporation involves extensive knowledge of state business entity law and the tax code. For reliable and knowledgeable advice about the tax implications of your business entity conversion, contact the tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.