Rev Rul 84-111: Three Methods to Incorporate a Partnership

When a partnership considers converting to a corporate structure, the process is governed by specific guidance from the Internal Revenue Service (IRS). Revenue Ruling 84-111 provides the official framework for the tax implications, outlining three distinct methods for a partnership to incorporate. The ruling confirms that the IRS will respect the tax consequences of the specific method chosen, giving partners the ability to structure the transaction to align with their financial goals.

By acknowledging that the form of the transaction can alter tax results—affecting the basis of assets and stock, as well as their holding periods—the ruling introduced strategic planning into the incorporation process. Understanding this ruling is a foundational step for any partner contemplating a conversion, as the selected method has lasting financial consequences for both the new corporation and its shareholders.

The Three Recognized Methods of Incorporation

The first method is the “Assets-Over” transaction. In this scenario, the partnership transfers all of its assets and liabilities to a newly formed corporation. In exchange, the corporation issues all of its stock directly to the partnership. The final step is the liquidation of the partnership, where it distributes the corporate stock to its partners.

A second path for incorporation is the “Assets-Up” transaction. This process begins with the partnership liquidating by distributing all of its assets and liabilities directly to the individual partners. Immediately following this distribution, the partners collectively transfer them to a newly formed corporation in exchange for all of its stock.

The third method is the “Interests-Over” transaction. Here, the partners act first by transferring their individual partnership interests directly to the new corporation in return for its stock. This exchange results in the corporation owning all interests in the partnership, which causes the partnership to terminate. As a result, the corporation becomes the direct owner of all assets and liabilities previously held by the partnership.

Tax Consequences of Each Method

The tax outcomes of incorporating a partnership vary significantly depending on the chosen method, particularly concerning the tax basis and holding periods. The transfer of property to a controlled corporation can be tax-free if it meets the requirements of Internal Revenue Code Section 351. This section allows for a nonrecognition exchange if property is transferred to a corporation for stock and the transferors control the corporation immediately after. All three methods are structured to qualify under this provision.

In an “Assets-Over” transaction, the corporation’s basis in the assets it receives is determined by the partnership’s basis in those assets, a carryover basis under Section 362. The shareholder’s basis in the new corporate stock is determined by their original basis in their partnership interest, as outlined in Section 358. The corporation’s holding period for the assets includes the partnership’s holding period per Section 1223, and the shareholder’s stock holding period includes their partnership interest holding period.

The “Assets-Up” method produces different basis results. When the partnership liquidates, the partners’ basis in the distributed assets is determined by their basis in their partnership interest under Section 732. The corporation’s basis in the assets is then equal to the basis the partners had in those assets. The shareholder’s basis in their stock is equal to the basis they had in the assets they contributed, and the stock’s holding period includes their holding period for those assets.

Under the “Interests-Over” method, the corporation’s basis in the assets it acquires is equal to the sum of the partners’ bases in their partnership interests. The new shareholders’ basis in their corporate stock is equal to the basis they had in their transferred partnership interests. The corporation’s holding period for the assets is determined by the partnership’s holding period, and the shareholders’ stock holding period includes the holding period of their partnership interests.

Key Factors in Choosing a Method

Several factors influence which incorporation method is best for a particular partnership.

• Partnership Liabilities. If a partnership’s liabilities exceed the total tax basis of its assets, the transfer can trigger immediate gain recognition under Internal Revenue Code Section 357. This section treats the excess liability amount as a taxable gain to the transferor. The “Assets-Up” method is problematic because the gain is calculated on a partner-by-partner basis. The “Assets-Over” method aggregates asset basis at the partnership level, which may be sufficient to absorb the total liabilities and avoid gain recognition.
• Section 754 Election. A Section 754 election allows a partnership to adjust the basis of its assets, such as after the sale of a partnership interest, to reflect the price paid by a new partner. This can result in a “step-up” in basis for that partner’s share of the assets. The “Assets-Up” and “Interests-Over” methods are more effective at carrying this specific partner-level basis adjustment over to the new corporate structure.
• S Corporation Status. An S corporation is not permitted to have a partnership as a shareholder. In an “Assets-Over” transaction, the partnership momentarily holds the new corporation’s stock before distributing it to the partners. This temporary ownership by an ineligible shareholder could technically terminate an S election. The “Assets-Up” and “Interests-Over” methods avoid this issue because the stock is issued directly to the individual partners.
• Practical and Logistical Considerations. State and local laws can impose transfer taxes on the exchange of real estate and other assets. The “Assets-Up” method involves two transfers—from the partnership to the partners, and then from the partners to the corporation—which could trigger these taxes twice. This method can also be administratively burdensome if the partnership holds numerous assets that require individual retitling, making the single-transfer “Assets-Over” or “Interests-Over” methods more streamlined and cost-effective from a non-tax perspective.