Converting a partnership to a corporation.

• Author: Schuth, Michael R.

The IRS recently issued Rev. Rul. 2004-59, holding that the incorporation of a partnership under a state law formless conversion statute will be treated in the same manner as a partnership that makes a "check-the-box" election to be treated as a corporation for tax purposes. Thus, the following will be deemed to occur: (1) the partnership contributes its assets and liabilities to a new corporation in exchange for stock; and (2) the partnership immediately liquidates, distributing that stock to the partners.

Rev. Rul. 2004-59 provides that an earlier ruling, Rev. Rul. 84-111, does not apply to a formless conversion of a partnership. In the prior ruling, the IRS described three different methods of incorporating a partnership: (l) the assets-over method (as used in Rev. Rul. 2004-59); (2) the distribution of the partnership's assets to the partners in liquidation of the partnership, followed by the transfer of those assets by the partners to the corporation; and (3) the transfer by the partners of their partnership interests to the corporation. Rev. Rul. 84-111 held that the form of each of the three methods would he respected, then described the different tax consequences associated with each.

Although a formless conversion may be the simplest method of con vetting a partnership into a corporation, it may not be the most tax effective method. As illustrated below, one of the other methods described in Rev. Rul. 84-111 may result in greater tax savings.

Example 1: A and B are partners in AB partnership. AB's assets consist of machinery and equipment with a $100 fair market value (FMV), a $120 original cost and an $80 inside tax basis to the partnership. AB has no liabilities. A and B have a $100 collective outside basis in their partnership interests. They seek cash and bring in C, an outside venture capital fund, which wishes to invest only in a corporation. C will contribute $20 cash for new company (N) stock, coupled with A and B contributing the AB property to N for N stock with an $80 FMV and $20 cash.

The partners use their state's formless conversion law. AB will be deemed to transfer its assets to N for $80 of N stock, plus $20 cash. Under Sec. 351 (b), AB's $20 realized gain is recognized to the extent of the $20 cash received in the exchange. On the deemed distribution of the N stock to the AB partners, AB terminates under Sec. 708(b)(1)(A). Under Sec. 358(a)(1), in a transaction to which Sec. 351 applies, AB's basis in the N stock...