Revenue Ruling 84-19: Tax-Free Partnership Incorporation

Revenue Ruling 84-111 from the Internal Revenue Service provides guidance on methods for converting a partnership into a corporation. This ruling clarifies how such a transaction can be structured to avoid immediate taxation for the partners and the newly formed company. It addresses a common business evolution, offering a defined pathway for partnerships seeking the legal and financial structure of a corporation.

The “Assets-Over” Method of Incorporation

Revenue Ruling 84-111 outlines the tax consequences for three methods of incorporating a partnership, with the “assets-over” form being one of the most frequently used. This transaction unfolds in a three-step sequence. First, the partnership transfers all of its assets, such as cash, equipment, and accounts receivable, and any associated liabilities, to a new corporation. This transfer is made solely in exchange for all of the new corporation’s stock.

Following the initial exchange, the second step occurs when the partnership holds the corporate stock it just received. The final step is the complete liquidation of the partnership. In this liquidation, the partnership distributes all the corporate stock it holds to its partners in proportion to their respective interests in the partnership.

For example, imagine a two-person partnership that owns a small restaurant. To incorporate, the partnership would form a new corporation and transfer the restaurant building, kitchen equipment, and bank accounts to it. In return, the corporation issues 100% of its shares to the partnership. The partnership then distributes these shares to the two partners, leaving them as the direct shareholders of the new corporation.

Requirements for Tax-Free Treatment

For the transaction to qualify for tax-free treatment, the IRS views the entire “assets-over” process as a single event for analysis under Internal Revenue Code Section 351. The principle of Section 351 is to allow for the deferral of gain or loss when property is transferred to a corporation, provided the transferors are in control of the corporation immediately after the exchange.

The first requirement is that the partnership must transfer “property” to the corporation in exchange for stock. The assets of the partnership, like cash, inventory, and machinery, meet this definition. The assumption of liabilities by the corporation generally does not trigger gain unless the liabilities assumed exceed the basis of the assets transferred.

Another condition is the “control” requirement. Immediately after the exchange, the transferor partnership must be in control of the corporation. Control is defined as owning at least 80% of the total combined voting power of all classes of stock and at least 80% of the total number of shares of all other classes of stock. The subsequent distribution of the stock to the partners does not violate this requirement because the original partners, as a group, remain in ultimate control.

Tax Basis and Holding Period Consequences

When an incorporation qualifies under Section 351, the rules for basis and holding periods preserve the deferred gain or loss. The corporation’s tax basis in the assets it receives is not their fair market value. Instead, the corporation takes a “carryover basis,” meaning its basis in the assets is the same as the partnership’s basis in those assets just before the transfer, preserving any built-in gain or loss.

For the former partners, a similar rule applies to the stock they receive. A partner’s basis in the new corporate stock is generally the same as their basis was in their partnership interest, which is known as a “substituted basis.” This ensures the deferred gain or loss will be recognized if the shareholder eventually sells their stock.

The holding period, which determines if a future sale results in a long-term or short-term capital gain, also carries over. The corporation’s holding period for the assets it receives includes the period the partnership held them. Likewise, the partners’ holding period for the corporate stock includes the holding period of their original partnership interest, provided the assets transferred were capital assets or certain business property.