IRS Confirms - Formless Conversions Of Partnerships To Corporations Generally Are Tax Free – Usual Exceptions Continue To Apply
By now, many state legislators have codified the so-called "formless conversion statute" which authorizes partnerships and other unincorporated state law entities (e.g., limited liability companies) to convert into state law corporations without actually transferring their assets to the newly formed corporations. Prior to the issuance of Revenue Ruling 2004-59, on May 25, 2004, however, the federal income tax consequences of such state formless conversions were uncertain.
In Rev. Rul. 2004-59, the IRS held that when an unincorporated state law entity that is classified as a partnership for federal tax purposes converts into a state law corporation under a state formless conversion statute, the following is deemed to occur:
(i) the partnership contributes all of its assets and liabilities to the corporation in exchange for stock in such corporation; and
(ii) immediately thereafter, the partnership liquidates distributing the stock of the corporation to its partners.
Based on Rev. Rul. 2004-59, therefore, the formless conversion of a partnership to a state law corporation generally will be tax free for federal income tax purposes. In addition, the holding period for the stock deemed to be received by the liquidating partners generally will include the holding period of the partnership in both the capital assets and Section 1231 assets that are deemed to be transferred by the partnership to the corporation (to the extent that the stock is deemed to be received in exchange for such assets). To the extent the stock is not deemed to be received in exchange for either capital assets or Section 1231 assets, the holding period for such stock begins on the day following the date of the deemed exchange.
The above general "tax free" rule may not apply, however, and federal income tax liability might arise to all or some of the liquidating partners, in the event that, among other things -
(i) the liabilities of the partnership immediately before the conversion exceed the adjusted basis of its assets;
(ii) the partnership is deemed to transfer to the corporation certain "built-in gain" properties
within the meaning of Section 704(c); and/or
(iii) any of the stock is deemed to be distributed to the partner as "guaranteed payments."
Accordingly, taxpayers contemplating the formless conversion of their unincorporated state law entity to a state law corporation should consult with tax counsel prior to the conversion in the event they stumble upon any of the "imperfect" facts enumerated above.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
