Tax-Free Conversion of a Partnership into an S CorporationTax Planning
Let’s say you currently run your small business as a partnership or as an LLC that’s treated as a partnership for federal tax purposes.
(In this analysis, we will refer to both of these ways of doing business as partnerships, because the partnership federal income tax rules apply to both.)
Let’s say you’re considering converting your partnership into an S corporation. The reason might be to reduce exposure for you and the other owners to Social Security and Medicare taxes, which come in the form of the self employment tax for partners.
Specifically, each partner’s share of net partnership income is usually fully exposed to the self-employment tax. For 2022, the self-employment tax rate is a painful 15.3 percent on the first $147,000 of net self-employment income. On net self-employment income above $147,000, the self-employment tax rate drops to 2.9 percent.
For a shareholder-employee of an S corporation, the Social Security and Medicare taxes come in the form of the FICA tax. But for shareholder-employees, the FICA tax hits only amounts paid as salaries. Distributions of the remaining corporate cash flow are FICA-tax-free.
Whatever the reason for wanting to convert your partnership into an S corporation, here’s an explanation and a summary of the key federal income tax implications.
Execute a Section 351 Incorporation
You can transfer the business assets, liabilities, and operations of your partnership into a C corporation by incorporating the partnership. This can potentially be a totally federal-income-tax-free transaction under Section
351 of our beloved Internal Revenue Code. Or it can be mostly tax-free.
Then you can turn the C corporation into an S corporation. More on that later. Let’s first talk about how Section 351 incorporations work.
Section 351 treatment for the incorporation of a partnership is allowed when all the following requirements are met.
- One or more persons (which can include the partnership itself or its partners) transfer property (assets, which can include cash) to the corporation.
- The transfer is solely in exchange for stock of the corporation.
- The person or persons (the partnership itself or its partners) are in control of the corporation immediately following the transfer. Control means owning at least 80 percent of the stock.
- The transaction has a business purpose. The IRS created this additional requirement, but meeting it should not be a problem. For instance, incorporating to take advantage of the liability protection offered by the corporate form of doing business would be an acceptable purpose. So would providing for the orderly transfer of ownership of a business from one generation to the next.
The tax results when Section 351 applies are not elective. When you meet the Section 351 requirements, the tax results are what they are. One result is that there cannot be any taxable loss in a Section 351 incorporation.
Key point. As explained immediately below, what would otherwise be a totally tax-free Section 351 transaction can be partially taxable when boot (cash and/or property) is received in addition to stock in the new corporation.
When Boot (Including Relief from Liabilities) Is Received
When the partnership itself or its partners receive boot from the corporation in a Section 351 transaction, taxable gain can result. The taxable gain equals the lesser of
- the gain realized on the transfer due to the existence of transferred property with fair market value in excess of tax basis, or
- the amount of boot received (cash plus the fair market value of any other property).
But a tax loss cannot be recognized in a Section 351 transaction even when boot is received.
If the new corporation assumes liabilities, any excess of assumed liabilities over the tax basis of transferred property counts as boot. But ignore the transfer of cash-basis accounts payable in this determination.
If you and the other partners are the ones transferring property to the new corporation (more on that later), each partner is considered separately in determining whether there has been a transfer of liabilities in excess of basis.
Basis of Stock Received
When the incorporation is a totally tax-free Section 351 deal because no boot is received, the tax basis of the stock received equals the basis of the property transferred to the corporation (so-called substituted basis).
When boot is received, the basis of the stock equals the basis of the property transferred, plus any taxable gain recognized in the deal, minus the amount of any boot received in the deal (relief from liabilities, plus any cash, plus the fair market value of any property).
Corporation’s Tax Basis in Transferred Property
The general rule is that the tax basis of property received by the new corporation in a Section 351 transaction is so called carryover basis. That means the basis of the property in the hands of the partnership or partners that transferred the property.
But the corporation’s basis is generally increased by the amount of any taxable gain that’s recognized by the partnership or partners in the incorporation deal.
Corporation’s Initial Tax Year
In a Section 351 transaction, the new corporation’s initial federal income tax year begins on the day after the partnership is effectively converted into a corporation, i.e., when the Section 351 requirement of 80 percent control is met.
If the new corporation will use the calendar year for federal income tax purposes, the initial tax year will be a short year that ends on the following December 31.
Recommendation. It’s usually advisable to set the conversion date as December 31 so the new corporation’s initial tax year is the calendar year that begins the next day, on January 1.
Make the S Election and Get the Timing Right
Your new corporation can elect S corporation status by filing IRS Form 2553 (Election by a Small Business Corporation). You will want the S election to be effective for the corporation’s initial tax year. To get that result, file Form 2553 by no later than two months and 15 days after the beginning of that initial tax year.
So if, as recommended, you arrange for the initial tax year to be the calendar year that begins on January 1, file
Form 2553 by no later than March 15. That way, the S election will be effective starting with the new corporation’s initial calendar tax year.
If you somehow miss the deadline to have the S election take effect for the new corporation’s initial tax year, you can file Form 2553 at any time during that initial tax year. Then, the S election will take effect on the first day of the following tax year.
But if you want the election to take effect in the S corporation's initial calendar tax year, look for relief.
Relief for Missed S Election Deadlines
If you fail to file Form 2553 by the deadline to have the S election take effect on the intended date, the IRS offers a relief procedure. You can find a plain English version in the instructions for Form 2553.
If you qualify for relief, the S election is allowed to take effect on the date that you originally intended—the first day of the new corporation’s initial tax year. As described in those instructions, you must show reasonable cause for missing the Form 2553 filing deadline (a pretty easy task).
Ways to Structure a Section 351 Incorporation
You can meet the Section 351 requirements in three ways. The way you choose determines the federal income tax consequences.
First way. The partnership transfers its assets and liabilities to the new corporation in exchange for stock, which is then distributed to the partners to liquidate their partnership interests.
This way is preferable when the aggregate basis of the partnership’s assets is higher than the aggregate basis of the partners’ partnership interests, because the corporation takes over the partnership’s basis in the assets.
Second way. The partnership distributes its assets and liabilities to the partners in liquidation of the partnership.
In turn, the former partners transfer the distributed assets and liabilities to the new corporation in exchange for stock.
This way may be preferable when the partners’ aggregate basis in their partnership interests is higher than the partnership’s basis in the assets. In effect, the basis of the assets received in liquidation of the partnership will be stepped up to equal the aggregate basis of the partners’ interests in the partnership. The new corporation will then take over that higher stepped-up basis.
Third way. The partners transfer their partnership interests to the new corporation in exchange for stock in the corporation. This automatically liquidates the partnership since there are no longer two or more partners. All of the partnership’s assets and liabilities become assets and liabilities of the new corporation.
This way may also be preferable when the partners’ aggregate basis in their partnership interests is higher than the partnership’s basis in the assets.
When the partnership liquidates, the basis of its assets will be stepped up to equal the aggregate basis of the partners’ interests in the partnership. The new corporation then takes over that higher stepped-up basis.
With Proper Timing, Your Partnership Can Simply Convert into a Corporation and Simultaneously Elect S Status
An eligible entity (such as a multi-member LLC) that’s classified as a partnership for federal tax purposes under the so-called check-the-box regulations can elect to be treated for tax purposes as an S corporation without going through an actual Section 351 incorporation transaction.
Under this option, the partnership is treated as contributing all of its assets and liabilities to the corporation in exchange for stock. The partnership is then treated as having liquidated by distributing the stock to its partners immediately before the close of the day before the election to be treated as a corporation becomes effective.
So, if the election to convert from partnership to corporation status takes effect on the first day of the tax year, the entity will be a partnership until the end of the previous tax year and then become a corporation on the first day of the next tax year.
If the new corporation then makes a timely S corporation election on IRS Form 2553 (Election by a Small Business Corporation) for its first tax year, the corporation will be an S corporation for that entire year.
Example. Your partnership elects to become a corporation effective January 1, 2023. The new corporation can be treated as an S corporation for the tax year beginning on January 1, 2023, by filing IRS Form 2553 by March 15, 2023, to elect S corporation status for that year.
S Corporation Limitations and Tax Filing Requirements
Only domestic entities are eligible to elect S corporation status.
An S corporation cannot have more than 100 shareholders, and all shareholders must be individuals and/or eligible trusts and estates.
Unlike partnerships, S corporations cannot make special allocations of federal income tax items. All tax items must be allocated strictly in proportion to stock ownership percentages.
For loss deduction purposes, partners receive additional tax basis from their shares of partnership liabilities. In contrast, S corporation shareholders cannot deduct losses in excess of the basis in their shares plus the amount of any direct loans to the S corporation.
Like partnerships, S corporations must file an annual federal income tax return (on Form 1120-S) and issue a Schedule K-1 to each shareholder to report that shareholder’s percentage of S corporation tax items. Those tax items are then reported on each shareholder’s federal income tax return (Form 1040 for individual shareholders).
A partnership can convert to an S corporation in a variety of ways. The good news is that most ways allow the partnership to make the conversion without inflicting income tax on the partners.
To avoid unnecessary complications, the partnership should target its conversion to a C corporation and then to an S corporation for the first day of the corporation’s tax year (generally January 1).
Note that with an LLC that’s treated as a partnership, the LLC can bypass the incorporation route, elect corporate status, and use IRS Form 2553 to elect S corporation status