Converting a Partnership to a Corporation
Restructuring a partnership into a corporation requires careful navigation of the transaction's tax effects and the new entity's ongoing compliance obligations.
Changing a business’s legal structure from a partnership to a corporation, a process known as conversion, involves a formal change in the entity’s legal and tax status. This is a fundamental shift in how the business is owned, managed, and taxed. The decision is often driven by the needs of a growing business, so partners must weigh the advantages of the corporate form against the less formal structure of their partnership.
Motivations for Conversion
A primary driver for converting to a corporation is limited liability protection. In a general partnership, partners are personally responsible for the business’s debts, meaning personal assets like homes and savings are at risk. A corporate structure creates a separate legal entity, shielding the owners’ personal assets from company liabilities.
The corporate structure is advantageous for raising capital. While partnerships are funded through partner contributions or loans, corporations can raise funds by issuing stock to investors, including venture capitalists and angel investors. These investors often prefer the straightforward equity ownership and governance of a corporation.
Adopting a corporate structure can enhance a business’s perceived credibility. Lenders, suppliers, and potential clients may view a corporation as a more stable and professional organization than a partnership. This can lead to better borrowing terms, more favorable trade credit, and an improved ability to attract larger customers.
Corporations offer flexible ways to incentivize employees. Unlike partnerships, corporations can offer stock options and other equity compensation. This allows the business to attract and retain talent by giving them a direct ownership stake in the company’s success.
Methods of Conversion
There are four methods to convert a partnership into a corporation, and the choice can be influenced by state law and the business’s circumstances.
- Statutory Conversion: This process allows the partnership to change its form by filing a certificate of conversion with the state. The partnership’s assets and liabilities automatically become those of the new corporation, and the partners’ interests are converted into corporate shares.
- Assets-Over Transfer: The partnership transfers all of its assets and liabilities to a newly formed corporation in exchange for all of the corporation’s stock. The partnership then liquidates and distributes the corporate stock to its partners in proportion to their interests.
- Assets-Up Transfer: The partnership liquidates and distributes its assets and liabilities directly to the individual partners. Immediately after, the partners contribute these assets to a new corporation in exchange for its stock.
- Interests-Over Transfer: The partners individually transfer their partnership interests to the new corporation in exchange for its stock. This transfer terminates the partnership, as the corporation becomes its sole owner, holding all former assets and liabilities.
Tax Implications of the Conversion
A primary goal when converting is to structure the transaction as a tax-free event. To qualify under the Internal Revenue Code, the former partners must transfer property to the corporation for stock and be in “control” of the corporation immediately after. “Control” is defined as owning at least 80% of the total voting power and at least 80% of all other classes of stock.
In a tax-free conversion, the partners’ tax basis in their former partnership interests becomes their basis in the new corporate stock, which is a substituted basis. The corporation assumes a carryover basis in the assets it receives, meaning the corporation’s basis in the assets is the same as the partnership’s was before the transfer.
A tax consideration arises from the assumption of liabilities. If the total liabilities assumed by the new corporation exceed the total tax basis of the assets transferred by the partnership, the excess amount is treated as a taxable gain to the partners. For example, if a partnership transfers assets with a total basis of $100,000 and liabilities of $120,000 to a corporation, the partners would recognize a taxable gain of $20,000, which must be allocated among them.
After the conversion, the owners must decide on the corporation’s tax classification. By default, a new entity is a C corporation for federal tax purposes. Shareholders can elect for it to be an S corporation by filing the appropriate form with the IRS, provided eligibility requirements are met.
Post-Conversion Corporate Requirements
After the conversion is complete, the business must operate in compliance with corporate formalities. The corporation must adopt bylaws, issue stock certificates to shareholders, and hold regular meetings of the board of directors and shareholders. Detailed minutes of these meetings must be recorded and maintained in the corporate record.
The corporation’s tax filing obligations also change. A C corporation files Form 1120 and pays tax at the corporate level, while an S corporation files Form 1120-S and passes income and losses through to its shareholders. As a new legal entity, the corporation must obtain a new Employer Identification Number (EIN) from the IRS.
The compensation for owners who work in the business also transforms. Former partners who took draws are now shareholder-employees and must be paid a reasonable salary for their services. This salary is subject to payroll taxes, including Social Security and Medicare (FICA), which must be withheld and remitted.