Holding period and basis considerations of partnership conversions.

• Author: Sousa, Jonathan
• Position: Partners & Partnerships

EXECUTIVE SUMMARY

* A conversion of an entity treated as a partnership to an entity treated as a sole proprietorship could come about when one partner purchases all the remaining outstanding ownership interests in a partnership or when all the partners of a partnership sell their interests to a single third party.

* A conversion of an entity treated as a sole proprietorship to a partnership Could come about when a third party purchases a membership interest in a solely owned entity from the existing owner or when a third party contributes cash or property to a solely owned entity in exchange for an interest in the entity.

* Three transaction forms, which each result in different tax consequences, are available for incorporating a partnership.

* A partner typically exits a closely held partnership either by selling his or her partnership interest to the remaining partner or through a liquidation of the partner's interest by the partnership.

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This article discusses the tax consequences when a single-owner entity is converted to a partnership and when an entity treated as a partnership is converted to a sole proprietorship or a corporation. It also considers the differences for tax purposes of treating the exit of a partner from a partnership as a sale of a partnership interest or as a liquidation of a partnership interest.

It is common for owners of a business to conclude, at some point in the life of the business, that they must change the legal form of the entity through which the business has been conducted. While the legal process and attendant paperwork for implementing a change of entity form may draw most of the attention of business owners and their legal advisers, owners and advisers must also consider the tax consequences of the change.

For changes in entity form subsequent to formation, the tax consequences of the change depend on the entity's federal income tax law status before and after the change. The exhibit on p. 156 presents the most common state law entities and the corresponding federal income tax law entities associated with the particular state law entities.

For example, the incorporation of a two-person limited liability company (LLC) could be viewed as a tax event (partnership into corporation) or a nontax event (corporation into corporation), depending on which federal income tax law entity status the entity chose at formation.

This article summarizes the tax consequences of entity changes involving the conversion to or from any entity treated as a partnership for federal income tax purposes (e.g., general partnerships, limited partnerships, LLCs with two or more members, and limited liability partnerships) .Thus, the terms "partner" and "partnership" as used in this article include all state law entities treated as partnerships for federal income tax law purposes. The conversions discussed here include partnership to sole proprietorship, sole proprietorship to partnership, and partnership to corporation, with a focus on basis and holding period considerations, as well as gain or loss recognition, at conversion. The same issues are also discussed in the context of partnership sales and liquidations. In addition, tax planning considerations for these transactions are outlined.

Partnership to Sole Proprietorship

The conversion of an entity treated as a partnership for tax purposes to an entity treated as a sole proprietorship for tax purposes could come about when one partner of a partnership purchases all the remaining outstanding ownership interests in the partnership or when all the partners of a partnership sell their respective interests to a single third-party purchaser.

Example 1: AB is a two-member LLC treated as a partnership for tax purposes. AB has only long-term capital assets and no liabilities. The basis of AB's assets is $10,000 and the fair market value (FMV) is $20,000. The two partners each own 50% of AB, and they each have a basis of $5,000 in their partnership interests. B purchases A's 50% interest in AB for $10,000 and continues to operate AB as a single-member LLC.

Under general partnership tax rules, A's sale of her partnership interest in AB to B could be viewed as (1) A's sale and B's purchase of a partnership interest, (2) a partnership termination (because there is only one owner after the sale), (3) a partnership distribution of the business's operating assets to B, and (4) B's contribution of the business operating assets to a sole proprietorship. (1) Under those general rules, (1) A would recognize a $5,000 gain on the sale of her partnership interest, (2) B would take a $10,000 basis (the amount he paid A) in the new interest, (3) B would recognize no gain or loss on the liquidating distribution of property from the partnership, (4) B would take a $5,000 basis in 50% of the property received in the liquidating distribution (his basis in his original interest immediately before the distribution) and a $10,000 basis in 50% of the property received (his basis in the new interest acquired from A), and (5) B's holding period of all the property received in the distribution would include the time the property was held by the partnership.

Rev. Rul. 99-62 provides for a slightly different outcome in the disposition of an interest in an entity treated as a partnership for tax purposes. The haling provides for asymmetric treatment of sellers and buyers: Sellers are treated as having sold their partnership interests, while buyers are treated as having purchased the seller's share of partnership assets. While in almost all respects the tax consequences to the seller and buyer under Rev. Rul 99-6 are the same as when the general rules are applied, the revenue haling does yield a difference in the holding period of assets for the buyer of the partnership interest.

With respect to the purchase by one partner of the other partner's partnership interest, under Rev. Rul. 99-6, the following is the correct outcome: When B purchases all of A's interest in the partnership for $10,000, the partnership is deemed terminated for federal tax purposes under Sec. 708 (b)(1)(A), even though for state law purposes B continues to operate the LLC (a state law single-member LLC). From A's perspective, she is treated as having sold her partnership interest to B and recognizes a gain of $5,000 on the sale of her interest ($10,000 received from B - $5,000 basis in her interest). Because the partnership has no unrealized receivables or inventory items, the gain is treated as a capital gain. From B's perspective, the partnership is deemed to have made a liquidating distribution of all its assets to A and B; following the distribution, B is treated as having acquired from A all the assets deemed to have been received by A in the liquidating distribution. Thus, B ends up with 100% of the partnership property, 50% of which came to B via a deemed partnership liquidating distribution and 50% via a deemed acquisition of A's share of partnership property.

In the deemed liquidating distribution, B would recognize no gain or loss on the distribution ($5,000 basis of assets distributed to B--$5,000 basis of B's partnership interest = $0 gain or loss). B's basis in the partnership property deemed distributed would be the $5,000 basis of B's partnership interest immediately before the distribution, reduced by the amount of money, if any, received in the distribution ($0), or $5,000. B's holding period of the property received in the deemed liquidating distribution would include the time the property was held by the partnership, which was long term. With respect to B's deemed acquisition of A's share of partnership assets, Rev. Rul. 99-6 indicates that under the general rules, B's basis in the partnership property acquired from A would be the amount paid to A ($10,000), but B's holding period in the property received via the deemed acquisition of A's share of partnership assets would begin the day after B is deemed to have acquired them from A. In other...