from partnership to corp: option 1 copyright 2005 dwight drake. all rights reserved. business...

From Partnership to Corp: Option 1

Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com

5-1

Corp

Stock

Tax Impacts:• No gain or loss recognized

• Partnership’s asset basis transfers to C corp

• Partnership terminated

• Owner’s stock basis equals basis in partnership interest (adjusted for debt transfers to corp)

• Owners not original issuees – 1244 impact and potential S election impact in year 1

Owners

Partnership

Assets & liabilities

Stock inliquidation



5-2

Corp

Stock

Tax Impacts:• No gain or loss to Partnership or Corp


• No gain or loss to owners unless money in excess of basis is distributed

• Owners’ basis in assets equal basis in partnership interests, which carries over to Corp and determines Owners’ basis in stock

• Owners original issuees of stock

Owners

Partnership

Assets & liabilities

Assets and liabilities in liquidation



5-3

Corp

Stock

Tax Impacts:• No gain or loss to Partnership or Owners


• No gain or loss to Corp unless money in excess of basis is distributed

• Owners’ basis in stock equals basis in partnership interests, which carries over to Corp and determines Corp’s basis in assets

• Owners original issuees of stock

Owners

Partnership

Partnership Interests

Assets and liabilities in liquidation

Check The Box

• No need to form corp or transfer assets and liabilities

• Entity remains the same – only tax status changes

• Reduces paperwork and third party hassles

• Tax consequences same as option 1- Partnership contribution followed by Partnership liquidation

• No corporate “trappings” benefits

• No S status capacity

• No tax-preferred employee benefits to owner/employees


5-4


Piece of Cake

• No entity change nor need to transfer assets and liabilities

• Entity remains the same – only tax status changes

• Revoke S election (takes majority) or cease to qualify as S

• Specify effective date to ease accounting and tax hassles. Default date is first day of next taxable year unless revocation before 15th day of 3rd month of current year

• Mid-year effective date creates short S year and short C year – allocation options

• No election back into S status for 5 yrs

• Bailout S earnings that have already been taxed to shareholders – 1371(e) one year bailout period


5-5

From S status C status

Problem 5-A: Colson Inc.


5-6

C Corp

Three Golfer Owners

Two LimitedPartnerships

One ToilerOwner

Two Golfer Owners

Common & PreferredCommon & Preferred

Big Loans

Common &Preferred

Common &Preferred

Challenge: Convert to Pass Thru Entity

Convert to LLC or Partnership?

• Prohibitively tax expensive

• Full recognition of all asset gains at corporate level

• Full recognition of capital gains at shareholder level

• S corp only viable option


5-7


Election Mechanics

• Election effective on first day of following year • 2 ½ month retroactive election not possible because

not eligible shareholder on 1st day of current year

• Must be eligible for S at time of election – no disqualified shareholders or 2nd class of stock

• S tax year calendar year unless sustain business purpose proof burden for fiscal year

• All shareholders must consent (Form 2553) – community and joint interest owners


5-8


S Eligibility Problems

• Limited partnerships not eligible S shareholders

• Preferred stock not permitted with S status

• Shareholder loans could trigger one class of stock requirement

• Any stock options held by toiler owner or other owners could violate one class of stock requirement


5-9



5-10

Getting rid of ineligible shareholders:

• Partnership shareholders: Redeem stock or have stock distributed to eligible partners

• Corporate Shareholder: Redeem stock; merge or reorganize to eliminate corporate shareholder; have corporate shareholder distribute or sell stock to eligible S shareholders

• Non-qualified trusts and estates: Redeem stock or distribute to qualified S shareholders

C to S Conversion: Getting Eligible


5-11

Getting rid of second class of stock issues:

• Preferred stock: Redeem or E Reorg (“Reclassification”)

• Risky debt: Reform to fit within safe harbor of 1361(c)(5)(B)

• Options and warrants “in the money”: Buy back or have them exercised.

• Options and warrants “not in money”: Make sure strike price is at least 90% of FMV. May present too tough of a valuation issue. Best course may be to buy back or trigger exercise.

C to S Conversion: Getting Eligible


5-12

Nothing Too Tough:

• Written unconditional promise to pay on demand or at time certain

• Interest rate and payments not contingent on profits, discretion, etc.

• Debt not convertible to stock

• Creditor eligible S shareholder or party in business of loaning money

Note: Safe Harbor protects only S election – has no impact on broader tax debt-equity issues

Debt Safe Harbor of 1361(c) (5) (B)


5-13

1. LIFO Inventory Trap – LIFO inventory reserve recaptured over four years

2. C Corp E & P Trap – Post-conversion distributions in excess of S corp accumulated adjustment account will trigger taxable dividends to shareholders to extend of C corp E & P

3. The Passive Income Trap of 1375

4. The BIG Tax Trap of 1374

Potential Conversion Tax Traps


5-14

• Royalties

• Dividends

• Interest

• Annuities

• Sales or exchanges of stocks or securities

Note: Looks more like portfolio income. But for 1375 purposes, called “passive income”

DO NOT CONFUSE WITH 469 PASSIVE INCOME

S Passive Income – Not Like the Other Passive


5-15

Passive Income S Penalties

Penalty One: S Corp has accumulated earnings and profits for three years and passive S receipts more than 25% total receipts.

S election terminated. 1362(d)(3)

Penalty Two: S Corp has accumulated earnings and profits and passive S receipts more than 25% total receipts. Entity level tax equal to 35% of “excess net passive income.” How to calculate:

- First, “net passive income” = passive income less passive expenses

- Second, ratio with numerator equal passive income over 25% of gross receipts and denominator equal to total passive income

- Third, multiple “net passive income” by ratio to arrive at “excess passive income”

- Limit – excess passive income can’t exceed corp’s taxable income


5-16

1. Be aware – keep an eye on receipts

2. Bail accumulated C Corp E & P at 15% rate with 1368(e)(3) election

3. Distribute or sell investments that trigger passive S to get below 25%

4. Increase active receipts relative to passive – do more business or stick additional operation or active business in S

Stay Clear of Passive S Penalties


5-17C to S: The “BIG” Tax Trap

• Huge exception to “no entity tax” rule

• Applies only when C corp has converted to S corp

• Purpose is to limit ability to convert and then sell and strip income with no double tax hit

• “BIG” stands for “Built-in-Gain”

• May also have built-in loss

• Major factor in converting from C to S corp.

• Although BIG tax can be rough, nothing compared to going from C Corp to partnership or LLC


5-18How “BIG” Trap Works

• Determine built-in gain or loss at time of conversion for all assets. This is gap between FMV and basis. Requires appraisals

• If asset sold during 10 years after conversion (“recognition period”), any gain or loss recognized up to “Built-in” amount taxed at corporate level

• Tax rate is highest corporate rate – 35%

• Income still taxed at shareholder level, but BIG tax treated as loss. 1366(f)(2)

• BIG income may not exceed corp income for year if taxed as C corp. Carry forward any excess


5-19How “BIG” Trap Works

• BIG income from any sale may not exceed total BIG income at conversion less BIG income previously recognized.

• Carry-over BIG income potential in non-recognition transactions (i.e. 1031, 1034), tax-free corporate reorgs.

• Installment sales during 10 year period that defers income beyond ten year window doesn’t help. Recognition period extended.

• Recognized BIG losses during 10 year window can offset recognized BIG income.


5-20

• Convert early, carefully document assets at conversion

• Pre-conversion – hang onto losers, but watch out for “loss stuffing”

• Collect zero basis receivables before conversion. May require factoring

• Accrue bonuses and similar expenses prior to conversion – counts in reducing total built-in amount at conversion

• Match BIGs and BILs during 10 year recognition period to extent possible

• Use non-recognition transaction (1031, 1033) to get through non-recognition period

• Work goodwill/going concern valuation

Strategies to Mitigate BIG Tax


5-21

• No termination of partnership for tax purposes under 708

• No sale, exchange or liquidation of owners’ interests

• No close of the entity’s tax year

• No tax year close with respect to any owner

• No need to obtain new federal tax ID number

From Partnership to LLC Status (Rev. Rule 95-37)

Problem 5-B: Larson Electronics, LLC


5-22

LLC

80% LLCInterests

Admit two new partners – each 10%

• Tax status of entity converts from sole proprietorship to partnership.

• Joel deemed to have sold 20% of each asset in taxable transaction. Recognizes gain.

• Joel and new partners deemed to have made tax-free 721 transfers to a new partnership

• New partners’ basis in partnership interest is amount paid Joel. Joel’s basis is basis in assets deemed transferred.

• LLC takes carryover basis and tacked holding period

Joel

New Partners

80% of Assets

20% of Assets

20% LLC Interests

20% of Assets

Cash & notes

Problem 5-B: Larson Electronics, LLC


5-23

LLC

Conversion to C Status

Joel and New Owners make 351 tax free transfer of LLC interests to new C corp for stock.

• Joel and New Owners stock basis equal to LLC basis. Tacked holding period.

• On liquidation of LLC, C corp’s basis in assets equals basis in LLC interests received from Joel and New Owners.

• No gain or loss to C corp. unless money in excess of basis received. No gain to LLC.

• Joel and New Owners original issuees of C corp stock

Joel

New C Corp

Assets inLiquidation

20% LLC Interests

NewOwners

Stock

80% LLC Interests

Stock

from partnership to corp: option 1 copyright 2005 dwight drake. all rights reserved. business...

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