Revenue Ruling 63-40: Tax on Corporate to Partnership Conversion
Rev. Rul. 63-40 clarifies that a corporate-to-partnership conversion is a taxable event, detailing a multi-step process affecting all parties involved.
Changing a business’s legal structure from a corporation to a partnership involves specific federal income tax consequences. While modern “check-the-box” regulations allow an entity to elect its tax classification, the process is not a tax-free reorganization.
Electing to change from a corporation to a partnership triggers a multi-step deemed transaction with distinct tax implications. This process determines the tax costs and basis adjustments that occur when shareholders of a corporation become partners in a new partnership that holds the same business assets.
The Deemed Liquidation and Contribution
Tax regulations establish that the conversion of a corporation into a partnership is treated for tax purposes as a complete liquidation of the corporation. This interpretation means the law views the transaction as a terminal event for the corporate entity, not a seamless continuation of the business in a new form.
This concept is referred to as a “deemed liquidation,” and it applies even if business operations continue without interruption. The corporation is considered to have distributed all of its assets and liabilities to its shareholders at their fair market value. Following this distribution, the shareholders are then treated as having contributed these same assets and liabilities into the newly formed partnership.
Corporate-Level Tax Consequences
The first tax event from the deemed liquidation occurs at the corporate level. Under Internal Revenue Code (IRC) Section 336, the corporation must recognize gain or loss as if it had sold all its assets to the shareholders at fair market value (FMV).
The corporation’s taxable gain or loss is calculated on an asset-by-asset basis. For each asset, the gain is the amount by which its FMV exceeds the corporation’s adjusted tax basis in that asset. Conversely, a loss occurs if the adjusted basis is higher than the FMV, and these amounts are aggregated to determine the net tax liability for the corporation.
For instance, if Corporation A converts to a partnership, its only asset is a building with an adjusted basis of $200,000 but a current FMV of $1,000,000. Upon conversion, Corporation A is treated as having sold the building for $1,000,000. It must recognize a taxable gain of $800,000 ($1,000,000 FMV – $200,000 basis), resulting in a corporate-level tax liability.
Shareholder-Level Tax Consequences
After the corporation accounts for its tax liability, a second layer of tax occurs at the shareholder level. The remaining assets, valued at their fair market value, are distributed to shareholders for their stock. According to IRC Section 331, shareholders must treat this distribution as full payment for their shares, requiring them to recognize a capital gain or loss.
A shareholder’s gain or loss is calculated by taking the FMV of the property they receive and subtracting their adjusted basis in the corporate stock. This calculation is performed for each shareholder individually. The character of the gain or loss is capital, assuming the stock was a capital asset for the shareholder.
Building on the previous example, assume Corporation A paid $168,000 in corporate taxes on its gain (at a 21% rate), leaving assets with a net value of $832,000. If a sole shareholder had an original stock basis of $100,000, they receive a liquidating distribution of $832,000. This shareholder recognizes a capital gain of $732,000 ($832,000 received – $100,000 stock basis) subject to individual capital gains tax.
Post-Conversion Partnership Tax Basis
The final step is the deemed contribution of the assets into the new partnership, which establishes the initial tax attributes for the partnership and its partners. Because shareholders recognized gain or loss on receiving corporate assets, their tax basis in those assets is adjusted to the fair market value at the time of distribution.
When they subsequently contribute these assets to the new partnership, the partnership inherits that new basis. This “stepped-up” basis allows the partnership to calculate future depreciation deductions based on the assets’ higher value.
Simultaneously, partners establish their initial basis in their new partnership interests. A partner’s basis in the partnership equals the adjusted basis of the contributed property. Since the assets were just adjusted to fair market value, the partners’ basis in their new partnership interest equals that FMV, adjusted for any liabilities. In the continuing example, the new partnership would have a basis of $1,000,000 in the building, and the partner would have an initial basis of $832,000 in their partnership interest.