Rev. Rul. 84-111: Tax Effects of Incorporating a Partnership

When a partnership decides to become a corporation, the transition involves tax considerations that are guided by Internal Revenue Service (IRS) Revenue Ruling 84-111. This ruling outlines three distinct methods for a partnership to incorporate, and it confirms that the IRS will respect the tax consequences of the specific method chosen by the taxpayers. This approach gives business owners flexibility in structuring the transaction to achieve their desired financial outcomes.

Rev. Rul. 84-111 acknowledges that the form of the transaction can alter the tax results, such as the tax basis of assets and stock, and the holding periods for those items. Understanding the ruling is a key step for partners planning a conversion, as the choice of method has lasting financial implications for both the new corporation and its shareholders.

The Three Scenarios for Incorporating a Partnership

Scenario 1

The first method is the “assets-over” transaction. The partnership contributes all of its assets, such as equipment, inventory, and accounts receivable, along with its liabilities, to a newly formed corporation. In return, the corporation issues all of its stock directly to the partnership. The partnership then liquidates by distributing the corporate stock to its partners in proportion to their partnership interests.

Scenario 2

The second method is the “assets-up” transaction. This scenario begins with the partnership liquidating and transferring all of its assets and liabilities directly to the partners in proportion to their respective interests. Following the distribution, the partners then collectively contribute the assets and liabilities they received into a newly formed corporation. In exchange, the corporation issues its stock directly to the partners.

Scenario 3

The third method is the “interests-over” transaction. The partners directly transfer their individual partnership interests to the new corporation. In exchange for these interests, the corporation issues its stock to the partners. As a result of the corporation acquiring all partnership interests, the partnership terminates, and the corporation becomes the direct owner of all the partnership’s assets and liabilities.

Treatment of Modern Conversions

Many states offer simplified methods for converting a partnership to a corporation, such as a statutory conversion. For federal tax purposes, the IRS generally treats these “formless” conversions as following the “assets-over” method (Scenario 1). The partnership is considered to have transferred its assets for stock and then distributed that stock to the partners, even if the steps did not literally occur.

Key Tax Differences and Strategic Choices

Asset Basis

A primary factor in selecting an incorporation method is the desired tax basis of the assets in the new corporation. This basis is important because it determines the amount of future depreciation deductions and the gain or loss recognized if an asset is sold. In an “assets-over” transaction (Scenario 1), the corporation’s basis in the assets is a carryover from the partnership’s basis, meaning the corporation steps into the shoes of the partnership. This is preferable if the partnership’s basis in its assets is high. In an “assets-up” transaction (Scenario 2), the asset basis is determined by the partners’ basis in their partnership interests. This can be advantageous if the partners’ collective basis is higher than the partnership’s asset basis, resulting in a “step-up” that creates larger depreciation deductions. For an “interests-over” transaction (Scenario 3), the corporation’s resulting asset basis is also determined by the partners’ basis in their partnership interests.

Shareholder Stock Basis

The method chosen also affects the shareholders’ basis in their new corporate stock. In both the “assets-over” (Scenario 1) and “interests-over” (Scenario 3) methods, the partners’ basis in the corporate stock they receive is a substituted basis. This means it is determined by their basis in their original partnership interests. In the “assets-up” transaction (Scenario 2), the partners’ stock basis is equal to the basis they had in the assets they contributed to the corporation after the partnership’s liquidation.

Liabilities in Excess of Basis

If a partnership’s liabilities exceed the tax basis of its assets, the conversion can trigger an immediate gain under Internal Revenue Code Section 357. This section treats the excess liability amount as a taxable gain. The “assets-over” (Scenario 1) and “interests-over” (Scenario 3) methods may help avoid or defer this gain. In these scenarios, the gain is determined at the partnership level or on a partner-by-partner basis, where aggregate or individual partner basis may be high enough to absorb the excess liabilities. The “assets-up” transaction (Scenario 2) is often the most problematic, as the assumption of liabilities by the corporation from the partners is more likely to trigger a gain.

Holding Periods

Holding periods determine whether a future sale of stock or assets results in a more favorably taxed long-term capital gain. In an “assets-over” transaction (Scenario 1), the corporation tacks the partnership’s holding period for the assets. This ensures the corporation can immediately qualify for long-term capital gains treatment if the partnership held the assets for a long time. In both “assets-over” and “interests-over” (Scenario 3) transactions, the shareholders’ holding period for their new stock includes the holding period of their original partnership interests. For an “assets-up” transaction (Scenario 2), the stock’s holding period is based on the holding period of the assets distributed from the partnership, which can be complex if multiple assets with different holding periods are involved.

Section 1244 Stock Qualification

Internal Revenue Code Section 1244 allows shareholders of a small business corporation to treat a loss on their stock as an ordinary loss instead of a capital loss. This treatment is capped annually at $50,000 for an individual or $100,000 for a married couple filing jointly. To qualify, the stock must be issued by the corporation directly to an individual or partnership in exchange for property. The “assets-up” method (Scenario 2) most clearly satisfies this requirement, as the stock is issued directly to the individual partners for the assets they contribute. In the “assets-over” method (Scenario 1), the stock is issued to the partnership first, which can disqualify it from Section 1244 treatment.