Converting a general partnership interest into a limited partnership interest tax-free.

• Author: Ellentuck, Albert B.

Facts: Dick and Doug are equal general partners in Corvette City, which operates an airport-based sports car rental facility. Dick plans to become less active in the business and will turn over much of the management to Doug. The business has many risks of loss for which Dick no longer wishes to be liable. The partners ask their tax adviser how they can reorganize the partnership to limit Dick's exposure to liability. The partners do not want to incur any tax liability as a result of the reorganization. Issue: Will the conversion of Dick's general partner interest to a limited partner interest achieve his goal of limited liability? Can Dick convert his interest without incurring a tax liability on the transaction?

Analysis

Restructuring Corvette City from a general partnership to a limited partnership and exchanging Dick's general partner interest for a limited partner interest could accomplish the goal of limiting Dick's risk of loss to sums he invested in Corvette City.

The IRS has publicly ruled it possible, under certain circumstances, for a partner to exchange a general partner interest for a limited partner interest (or vice versa) without incurring tax liability from the transaction. Further, the Service has ruled these changes in ownership interests do not terminate the partnership.

Rev. Rul. 84-52 considered only situations in which a partnership is converted from a general to a limited partnership, and vice versa. However, several letter rulings have approved tax-free conversions of individual partners' interests. Also, these letter rulings address situations in which changes in the partners' interests in partnership capital and in profits and losses qualify for tax-free treatment, while Rev. Rul. 84-52 addressed only situations in which such interests remained the same. (While letter rulings do not have precedential value, they do indicate the IRS's position on an issue.)

Dick may recognize gain on the transaction if his share of recourse liabilities of the partnership will be reduced to zero when he becomes a limited partner. This reduction in liabilities is treated as a constructive cash distribution to Dick. If cash distributions (both actual and constructive, as the result of the reduction in Dick's share of recourse liabilities) exceed Dick's basis in his partnership interest, Dick recognizes taxable gain.

Conclusion

Dick can convert his general partner interest into a limited partner interest without incurring tax on the...