Simplified Return Filing and Tax Payments for Partnership and Limited Liability Company Conversions

• Publication year: 2016
• Author: By Layton L. Pace

Simplified Return Filing and Tax Payments for Partnership and Limited Liability Company Conversions1

By Layton L. Pace²

EXECUTIVE SUMMARY

For each taxable year, California requires general and limited partnerships and limited liability companies ("LLC"s) classified as partnerships to file Franchise Tax Board ("FTB") Forms 565 and 568, respectively. The Instructions to each of those forms states to file two California returns if a conversion of a partnership into an LLC (or vice versa) happens on a date other than the last day of the year. This tax treatment conflicts with the Internal Revenue Service ("IRS") Form 1065 requirements that follow Revenue Ruling 95-37 and only require one return for the year.

The Franchise Tax Board's position set forth in the Instructions creates confusion, cost and inefficiency for limited partnerships, LLCs, partners, members and the State because the position implies that the taxable year of the converting entity ends. As such, the conversion would require: (i) the entity to close its books and prepare two full complete short-year tax returns; (ii) the entity to issue K-1s to the owners for each short year; and (iii) the State to process and audit two fully completed tax returns. Moreover, the State's interest in requiring two tax returns appears to be limited generally to collecting the $800 annual minimum tax from the converting entity.

This paper recommends that, if the conversion does not occur on the last day of the taxable year, either (i) the converted entity files a supplemental schedule with its tax return that suffices as a tax return for the converting entity; or (ii) the converting entity files a greatly abbreviated tax return for the year of the conversion. The supplemental schedule or abbreviated tax return would contain (i) the name, address and other basic identifying information about the converting entity, (ii) sufficient information to verify and assess the taxes of the converting entity for the year of the conversion, and (iii) estimated and any other tax payment information.

This paper also recommends that the FTB clarify that the tax return filing due date and due date of the taxes (other than for taxes otherwise due without a conversion) of a converting entity for the year of the conversion be the same as for the converted entity.

DISCUSSION

I. BACKGROUND AND UNDERLYING LAW A. Classification of Partnerships

The Internal Revenue Code of 1986, as amended ("IRC"), generally imposes income taxes on taxpayers based on their status and tax classification. Tax classifications, among others, include individuals, estates, trusts, partnerships and corporations. The IRC generally has a separate Subchapter that contains specific income tax rules that apply to the particular classification. For instance, the IRC contains income tax rules for partnerships in Subchapter K. California generally conforms to the IRC and Subchapter K.³,⁴

In 1997, the IRS revamped the rules that determine when a business entity is classified as a partnership, a corporation or disregarded entity for Federal tax purposes by issuing Regulations known as "check-the-box." The "check-the-box" rules generally allow a business entity to select its classification either through default rules or by making an election.⁵ California has generally conformed to the "check-the-box" rules.⁶,⁷

This paper pertains to general partnerships, limited partnerships and LLCs that are classified as partnerships for income tax purposes. As such, Subchapter K applies to them. Consequently, the members of LLCs discussed in this paper are partners of partnerships for income tax purposes.

This paper does not address issues related to conversions in which one of the entities is classified as other than a partnership subject to Subchapter K. For instance, this paper does not deal with the conversion of a limited partnership into an LLC that makes an election to be an association taxed as a corporation.

B. Pass-Through Treatment of Partnership Items

The IRC and Subchapter K contain many rules that govern the taxation of partnerships and its owners, the partners. Under those rules, a partnership must file its own income tax return.⁸

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In California, general partnerships and limited partnerships file FTB Form 565. More specifically, a partnership must file a return on or before the 15^th day of the fourth month following the close of its taxable year. The return must show the items of income and deduction allowed by Part 10 (Personal Income Tax provisions). The return also must include the names, addresses and TINs of the partners and their distributive shares of partnership items. A partner must sign the return.⁹

In California, an LLC must file a return on or before the 15th day of the fourth month following the close of its taxable year. As with a partnership return, the return also must include the names, addresses and TINs of the members and their distributive shares of LLC items. A member must sign the return.¹⁰

The FTB may impose penalties on partnerships and LLCs that do not timely or properly file the returns described above.¹¹ Similarly, the FTB may impose penalties on partnerships and LLCs that fail to pay timely "Entity Taxes".¹² Those penalties do not apply if the failure is due to reasonable cause and not due to willful neglect (Section 19172 does not require a showing of no willful neglect).

Notwithstanding that partnerships and LLCs must file returns, the partners, rather than the partnership or LLC itself, must report the items of income, deduction, gain, loss and credit realized by a partnership.¹³ Each partner reports these items by including them in the partner's tax return along with any other items of income, gain, deduction, loss and credit the partner may have in determining the partner's income tax liability.¹⁴ IRS Form 1065, FTB Form 565 and FTB Form 568 contain Schedule K-1, which must be completed and issued to each partner to report each partner's share of items passing through from the partnership.

Subchapter K rules govern when a partnership and its taxable year terminates or ends and in what years partners must report partnership items. Generally, a partnership terminates when it ceases business activity and has no assets or when it technically terminates when the partners sell or exchange 50 percent or more of the outstanding partnership interests within a 12-month period.¹⁵ Generally, a partner must include partnership items in its tax return in the year in which the partnership year ends with respect to a partner.¹⁶

C. California's Entity Level Taxation

California expressly provides that the conformity with the partnership tax rules of Subchapter K does not prevent the taxation of a limited partnership or LLC as provided above.¹⁷

For each taxable year...