Tax Consequences of Converting a Partnership to an S Corp

Changing a business from a partnership to an S corporation is a decision often driven by tax considerations. This shift alters how the entity and its owners are taxed, with the goal of reducing employment tax burdens. While both are pass-through entities, an S corporation allows owners who work in the business to be classified as employees. This means FICA taxes apply only to salaries paid to shareholder-employees, not to subsequent profit distributions.

Methods of Conversion and Their Tax Implications

The Internal Revenue Service (IRS) recognizes three methods for converting a partnership into a corporation. These transactions are tax-free, provided the partners of the former partnership control the corporation immediately after the exchange. The chosen method dictates the tax basis of assets and stock.

The assets-over approach is the default method. It involves the partnership transferring its assets and liabilities to a new corporation for stock. The partnership then liquidates by distributing the corporate stock to its partners. The new corporation’s basis in the assets is the same as the partnership’s basis, and the partners’ basis in the stock equals their original partnership interest basis.

Another method is the assets-up transfer. The partnership first liquidates, distributing its assets and liabilities to the partners, who then contribute them to the new corporation for stock. This approach can trigger gain recognition for partners if cash distributed exceeds a partner’s basis. The partner’s basis in the distributed assets determines the corporation’s basis in those assets upon contribution.

The third method is the interests-over transfer. The partners contribute their partnership interests to the new corporation for its stock. This terminates the partnership, leaving the corporation as the sole owner of its assets and liabilities. The corporation’s basis in the assets is carried over from the partnership, and the shareholder’s stock basis equals the basis they had in their partnership interest.

Key S Corporation Tax Considerations Post-Conversion

After conversion, the initial stock basis for each shareholder is determined by the method of conversion. A shareholder’s stock basis limits the amount of tax-free distributions they can receive and the corporate losses they can deduct. Liabilities assumed by the new corporation from the partnership decrease a shareholder’s stock basis. If assumed liabilities exceed the basis of the assets transferred, it can trigger taxable income.

Shareholders must also consider the treatment of losses that were suspended at the partnership level, such as passive activity or at-risk losses. These suspended losses do not carry over to the S corporation. Instead, they may become available to the shareholder to offset future income, and any remaining losses are freed up when the shareholder disposes of their entire interest in the activity.

Operational Tax Differences Between a Partnership and an S Corporation

The day-to-day tax operations of an S corporation differ from a partnership, particularly concerning owner compensation. S corporations must pay reasonable compensation to shareholders who provide services to the business. These payments are salaries subject to FICA taxes for Social Security and Medicare, as well as unemployment taxes. The IRS requires the salary to be reasonable for the services performed to prevent shareholders from avoiding payroll taxes by taking all income as distributions.

This contrasts with the partnership model, where partners are not employees and take distributions or guaranteed payments. A partner’s entire share of the partnership’s net earnings from self-employment is subject to self-employment tax. For an S corporation shareholder, only their salary is subject to payroll taxes, which can result in tax savings on profit distributions.

In an S corporation, distributions to shareholders are tax-free if they do not exceed the shareholder’s stock basis; distributions in excess of basis are taxed as capital gains. In a partnership, distributions are tax-free to the extent of the partner’s basis in their partnership interest.

The tax treatment of certain fringe benefits is less advantageous for S corporation shareholders who own more than 2% of the company’s stock. For these shareholder-employees, the cost of corporate-paid health and accident insurance premiums is included in their gross wages for income tax purposes. However, these premium amounts are not subject to Social Security, Medicare, or federal unemployment taxes, and the shareholder may be able to deduct the cost on their personal tax return.

Filing and Reporting Requirements

The conversion from a partnership to an S corporation requires specific tax filings to close the old entity and establish the new one. A final tax return, Form 1065, U.S. Return of Partnership Income, must be filed for the partnership’s final tax year, with the “final return” box checked.

The new corporation must elect to be treated as an S corporation by filing Form 2553, Election by a Small Business Corporation. To be effective for the current tax year, the form must be filed no more than two months and 15 days after the beginning of that tax year. If filed late, S corporation status will not begin until the following tax year.

Annually, the S corporation must file Form 1120-S, U.S. Income Tax Return for an S Corporation. This return reports the corporation’s income, deductions, and profits. The S corporation also provides each shareholder with a Schedule K-1, detailing their share of the company’s financial results for their personal tax returns.