Tax-deferred disposition of a former partnership business via a type b stock swap.

• Author: Ellentuck, Albert B.

Facts: Joe and Frank Pessimist are 50% partners in a highly profitable small business. Although they presently have a competitive advantage in terms of quality and "trade secrets" over their major publicly traded competitors, they believe their position to be relatively short-term. One of these has approached them, expressing an interest in purchasing their business. For cashflow and current-ratio purposes, the potential buyer has indicated that the corporation would be willing to pay a high price if the Pessimists would accept the company's publicly traded stock instead of cash or debt instruments. Both partners expect their income to drop in future years. They would like to accept the stock offer but are reluctant to enter into any arrangement that generates a current tax burden. Also, they expect the value of the stock of the acquiring corporation to rise significantly in the years ahead, and would prefer to dispose of that stock gradually in future years. Issue: How might an S corporation be used to assist Joe and Frank in the sale of their business?

Analysis

One major advantage of an S corporation when compared to a partnership is its ability to use the tax-free reorganization provisions of subchapter C. These provisions apply to S corporations, unless otherwise expressly provided by the Code or inconsistent with subchapter S. If Joe and Frank swap their partnership interests for publicly traded stock, they will have a fully taxable sale at the current time. (The transaction would not qualify as a tax-free incorporation under Sec. 351, because Joe and Frank together would not be in control of the publicly traded corporation immediately after the exchange.) The tax costs of this sale would likely require a disposition of some of the shares to generate cash to cover the tax liabilities.

Joe and Frank's tax adviser recommends that they work toward a tax-deferred, stock-for-stock swap by first accomplishing a Sec. 351 tax-free incorporation of their partnership. In considering this recommendation to incorporate, the adviser examines the partnership's pre-incorporation tax-basis balance sheet to test for the existence of either excess liabilities or liabilities unrelated to the business. To the extent that liabilities transferred to the corporation exceed the bases of the assets transferred, gain recognition will occur. This potential pitfall is quite common in converting partnerships to a corporate structure. Also, to the extent any...