The costs of converting a partnership to an LLC.

• Author: Cochran, Carol Mayo
• Position: Limited liability company

One of the first decisions to be made when forming a new business involves the legal structure of the entity. The options include a sole proprietorship, partnership, limited partnership, or S or C corporation. In addition, 48 jurisdictions (including the District of Columbia and excluding Hawaii, Massachusetts and Vermont) now recognize limited liability companies (LLCs) as legal entities. An LLC is an unincorporated association organized under a state law that enjoys the tax advantages provided a partnership and much of the liability protection afforded a corporation. These characteristics make the LLC form of operation an attractive option for many small businesses, high-risk business ventures and professional firms.

Many articles have detailed the general characteristics of an LLC,(1) and the tax benefits of using an LLC within certain industries,(2) from the perspective of a start-up company electing a particular ownership structure. However, little is known about the cost of converting an existing entity to an LLC; this article provides a practical analysis of issues to consider in electing to convert an existing partnership to an LLC, including gain or loss nonrecognition, basis calculations and treatment of unrealized receivables and inventory ("hot assets"). Tax ramifications for investment partnerships, disguised sale issues and partnership allocation methods are also addressed.

Overview

The growth of LLC legislation in the United States has been remarkable. In 1977, Wyoming passed the first LLC statute,(3) followed by Florida in 1982.(4) LLCs are a unique structural option, providing limited personal liability to members at a single level of tax. The popularity of this form of entity led to a need for IRS approval to obtain the benefits. Rev. Rul. 88-76,(5) which provided that an LLC formed under Wyoming law would be treated as a partnership for Federal income tax purposes, accelerated the creation of LLC legislation in other states.

Although the LLC laws vary from having very rigid requirements (e.g., Wyoming) to being extremely flexible (e.g., Florida), the basic purpose of all state LLC statutes is the same: to afford to LLC members passthrough tax treatment and limited liability.

In ruling on LLC qualification issues, the Service's approach has been to examine the state law in question. Generally, however, the IRS has followed Regs. Sec. 301.7701-2, which provides that an unincorporated business receives partnership tax treatment only if it lacks two of the four major corporate characteristics.(6) LLCs may lack limited liability if members waive it to meet a net worth requirement.(7) Additionally, state law may prohibit professionals from escaping personal liability for malpractice. As a practical matter, members of professional firms organized as LLCs may not have limited liability. However, Rev. Ruls. 93-91(8) and 93-93,(9) addressing, respectively, Utah and Arizona LLCs, point out that the professional exposure of individual LLC members for malpractice does not eliminate the corporate characteristic of limited liability, because although there is limited liability for claims against the LLC, members also have personal liability in connection with a member's performance of services on behalf of the LLC. Nevertheless, most LLC members have limited liability; therefore, LLCs must fail two of the remaining three tests to achieve passthrough treatment.

Often, the LLC statute or the entity's articles of organization will determine which of the corporate characteristics are eliminated. The Wyoming LLC Act,(10) for example, requires that continuity of life and free transferability of interests be eliminated, while allowing (if the company so desires) for centralized management. The Utah LLC Act(11) allows each company the flexibility to decide which corporate characteristics it wishes to eliminate, permitting members to tailor the entity to their business needs. Given the importance of the partnership designation of an LLC for tax purposes, companies are frequently advised to request a letter ruling if an LLC agreement deviates from previously tested structures. As the Service continues to rule on the specific ownership characteristics of an LLC, a higher degree of certainty regarding tax treatment can be expected. The focus of tax planning then shifts to the cost of reorganizing existing entities into LLCs.

Conversion Costs of Partnership Transfers

As more states implement LLC legislation, it is critical that companies address the tax costs of converting an existing entity to an LLC. Many practitioners believe that partnerships can convert into LLCs easily and without tax ramifications, and so focus attention instead on the effort and cost of reorganizing S or C corporations into LLCs. Most letter rulings analyze whether an entity is classified as a partnership for tax purposes,(12) and only occasionally focus on the conversion issue. Recently, however, several rulings have addressed both issues.(13) In most cases, the tax implications of the conversion are of secondary importance to the partnership classification issue, or are overlooked altogether.

General Rule: Gain or Loss Nonrecognition

In 1984, the Service ruled on the Federal income tax consequences of converting an interest in a general partnership to an interest in a limited partnership, when each partner's interest in the partnership's profits, losses and capital were to remain constant and the general partnership's trade or business was to continue after the conversion. Rev. Rul. 84-52(14) concluded that no gain or loss would be recognized by either the partners or the partnership on the conversion. The ruling noted that gain recognition was possible if each partner's share of partnership liabilities shifted as a result of the conversion; however, as long as each partner's share of partnership liabilities remained the same, the Sec. 752(b) deemed distribution rules did not apply. Rev. Rul. 95-37(15) applied this holding to the conversion of an interest in a domestic partnership to an interest in a domestic LLC, concluding that conversion to an LLC would have the same tax consequences as the conversion of a general partnership interest to a limited partnership interest.

Sec. 721(a) provides that neither gain nor loss is recognized by the partnership or the partner on the partner's contribution of property in exchange for a partnership interest. Primarily, this rule applies to unrecognized gain created by differences between the tax basis of contributed property and the value of the partnership interest received in exchange for such property. Sec. 351(a) provides a similar rule for contributions to corporations, except that the shareholder must receive a controlling interest for the contribution to be tax free.(16)

Additionally, under Sec. 357(c), gain is generally recognized if liabilities transferred to a corporation exceed the aggregate basis of contributed assets. Under Sec. 752(b), partners do not generally recognize gain on the contribution of encumbered property from a partnership to an LLC, unless they are relieved of partnership liabilities in excess of the basis in their partnership interests.

Partnership Continuation

Under Sec. 708(a), if the business of the partnership continues after conversion to an LLC, the partnership has not terminated, and the LLC is considered a continuation of the partnership. In Letter Ruling 9226035,(17) all of a general partnership's partners contributed their interests in the partnership to an LLC in exchange for all of the interests in the LLC. They received the same pro rata shares of the LLC as they had held in the partnership. Immediately after the contribution, the partnership dissolved and distributed all of its assets to the LLC. Because the general partnership never became a subsidiary of the LLC, the tiered partnership rules did not apply.(18) The IRS concluded that the conversion of the general partnership to an LLC was not taxable to either the partners or the partnership, except as required by Sec. 752(b).

In Letter Ruling 9010027,(19) a limited partnership converted to an LLC. Because each partner's total percentage interest in the entity remained the same after the conversion, the transaction was tax free, except as required by Sec. 752(b), a determination that relied, in part, on Rev. Rul. 84-52 (previously discussed). In both the revenue and the letter ruling, it had been represented that the converting partner's interests in capital, profits and losses remained the same; this representation was critical, because different liability-sharing rules applied under "old" Regs. Sec. 1.752-1(e).(20)

Rev. Rul. 95-37 combined the holdings of Letter Rulings 9226035 and 9010027, concluding that the conversion of an interest in a domestic partnership into an interest in a domestic LLC treated as a partnership for Federal income tax purposes does not cause a termination under Sec. 708.

Partnership interests can, however, expand or contract and still receive tax-free treatment in certain circumstances. Under Regs. Sec. 1.708-1(b)(1)(i), if a transaction has...