Key Takeaways

  • S corp to partnership conversion can offer greater flexibility in profit allocation, fewer compliance requirements, and unlimited ownership.
  • The conversion process involves dissolving the S corporation, which may have tax consequences depending on how assets and liabilities are handled.
  • IRS scrutiny and triggering of gain recognition events are critical tax considerations.
  • Temporary Treasury regulations provide a safe harbor method for certain conversions.
  • Professional legal and tax advice is essential for determining the most beneficial structure for your business.

If you want to convert S corp to partnership, it is imperative to understand the pros and cons of doing so. S corporations have the option to change their business operations and run as a partnership. Likewise, a partnership can choose to operate as an S corporation. These two types of entities share many similarities, but it's always a good idea to talk to a professional accountant within your state to ensure the changes you want to make are in your business's best interest.

In a partnership, all owners have a stake in the business. A partnership's legal agreement will decide how profits and losses are distributed based on the owners' percentage of ownership, and ultimately, how the assets are distributed if the business sells or fails. This agreement will also outline the following:

  • Who owns the business.
  • Operational practices.
  • How to handle disputes.

How Is a Partnership Taxed?

A partnership will be taxed according to a taxation method known as pass-through; this same method applies to an S corporation as well. This means the profits and losses pass through the company and are distributed to the partners. The partners/owners are responsible for reporting the profit and losses on their individual tax returns.

Tax Consequences of Converting from S Corp to Partnership

When undergoing an S corp to partnership conversion, one of the most significant considerations is the potential tax impact. This type of conversion is typically treated as a liquidation of the S corporation, followed by the contribution of assets to a partnership. As such, it may trigger taxable gain recognition on appreciated assets.

The IRS considers the S corporation to have sold its assets at fair market value, which can result in:

  • Corporate-level gain: Any appreciated property is subject to gain at the S corp level.
  • Shareholder-level consequences: Shareholders may have to recognize gain if the distributions exceed their stock basis.
  • Loss limitations: Losses may be limited if the partnership structure is used to offset other income.

However, certain safe harbor provisions—such as the Temporary Treasury Regulation §1.708-1(d)—offer pathways for conversions under specific conditions without immediate tax consequences. Businesses must comply with the timing, ownership continuity, and structure requirements of these provisions.

What Is a Partnership Agreement?

A partnership agreement is the most common method used when setting up the rules, obligations, and terms that the partnership will operate under. The agreement will define and describe in detail profit allocations, partnership roles, and responsibilities, among other functions.

While the agreement is not mandatory, if drafted properly, it is a legally binding agreement that will have legal standing in the event there are disagreements between owners.

Comparing Structural Flexibility Between Entities

Partnerships often provide greater structural flexibility than S corporations, especially when it comes to:

  • Allocation of profits and losses: Unlike S corps, which must allocate income based strictly on ownership percentage, partnerships can allocate items differently among partners, subject to IRS rules.
  • Classes of ownership: Partnerships can have multiple classes of partners (e.g., general and limited), while S corporations can only have one class of stock.
  • Distributions and contributions: Partnerships can manage capital contributions and distributions more fluidly, which may be useful for customized business arrangements.

This flexibility makes partnerships a preferred structure for businesses with complex ownership or funding arrangements.

How to Change a Partnership

The first step for an S corporation to take in order to change to a partnership involves the owners having to dissolve the company. In order to dissolve the company, the owners must file an articles of dissolution or a certificate of dissolution with their state government agency. The exact form that is required will vary from jurisdiction to jurisdiction.

Before the S corporation is dissolved, owners may need to get tax clearance. The next step after dissolution is to file the articles of organization with the state government. In addition, there are filing fees to be paid. Furthermore, to set up the new business, the entity will have to file a business name and register the business with the local government. These are all general startup rules and each state will vary in what is required.

Steps and Safe Harbor for S Corp to Partnership Conversion

Converting an S corporation to a partnership involves more than just paperwork. The steps generally include:

  1. Dissolving the S corporation by filing the appropriate dissolution forms with the state.
  2. Filing final S corp tax returns, including Form 1120S and issuing final Schedule K-1s.
  3. Liquidating corporate assets, which may trigger gain or loss recognition.
  4. Forming the partnership, with a new partnership agreement and state filings (e.g., articles of organization or registration).
  5. Transferring assets and liabilities from the S corp to the newly formed partnership.

IRS Safe Harbor: Under the Temporary Treasury Regulation §1.708-1(d), businesses may qualify for a safe harbor that allows for a tax-free conversion if:

  • The owners remain the same.
  • The ownership interests are proportionate.
  • The conversion occurs under a state law merger statute or liquidation and immediate contribution.

Compliance with this safe harbor should be confirmed by a tax advisor to minimize risk.

What Are the Advantages of an S Corporation?

There are a few advantages worth noting when it comes to running an S corporation as opposed to a partnership. In a corporation, if the company is sued or financially fails, the owner's assets are not touched to pay the debts. In a partnership, all the partners will be held liable.

S corporations also have the option to raise capital by offering a class of stock, while a partnership must rely on contributions, loans, or angel investors to raise capital. Furthermore, the ability of an S corporation to sell both voting and nonvoting shares helps mitigate any loss of control when and if new members join the S corporation.

Limitations of an S Corporation

While S corporations offer certain benefits, they also come with limitations that may prompt a switch to a partnership:

  • Ownership restrictions: S corps are limited to 100 shareholders and cannot have non-U.S. citizens or entities as shareholders.
  • Lack of allocation flexibility: Income and loss must be distributed based on ownership percentage, which may not reflect business arrangements or investment levels.
  • Compliance burden: S corporations must observe formalities such as board meetings, resolutions, and recordkeeping that may not be required in a partnership.

These constraints can hinder operational agility for some businesses.

What Are the Advantages of a Partnership?

There are advantages to operating as a partnership as well. S corporations are limited to 100 shareholders, while a partnership can have an unlimited amount of owners. In addition, a partnership is not mandated to hold annual meetings, record minutes, or keep financial records to the extent that an S corporation is required.

Depending on the state in which you live, partnerships are often exempt from paying some of the same types of taxes imposed on S corporations. The flexibility to allocate income and losses to its members is another advantage. S corporations must allocate on a per-share, per-day basis.

Risks and Complexities of a Partnership Structure

Although partnerships offer flexibility, there are some risks and complexities to be aware of:

  • Unlimited liability: In general partnerships, all partners are personally liable for business debts. This can be mitigated with limited partnerships (LPs) or limited liability partnerships (LLPs).
  • Complex tax reporting: Partnership tax filings (Form 1065 and K-1s) can become complicated, especially when special allocations or multiple partners are involved.
  • Self-employment tax: Partners generally pay self-employment tax on their share of earnings, unlike S corp shareholders who may receive dividends exempt from payroll taxes.
  • Dispute potential: Without strong governance structures, disagreements between partners can escalate. A detailed partnership agreement is essential.

Contact a Professional Business Attorney

One of the smartest moves you can make as a business owner is to contact a reputable attorney who is knowledgeable in business law. This is of the utmost importance when you are trying to convert S corporation to a partnership. The attorney can discuss the pros and cons of such a conversion and then guide you through the process.

Frequently Asked Questions

Can I convert my S corp to a partnership without paying taxes?Possibly, but only under certain IRS safe harbor provisions that must be carefully followed. Otherwise, gain on appreciated assets may be taxable.

What is the main reason to convert from an S corp to a partnership?Many businesses convert to gain flexibility in ownership structure, profit allocations, and compliance obligations.

Is there a tax form specifically for an S corp to partnership conversion?There is no single form. The conversion involves final S corp filings (Form 1120S), dissolution paperwork, and new partnership filings (Form 1065, etc.).

Will I need a new EIN if I convert to a partnership?Yes, in most cases, the new partnership will require a separate EIN from the S corporation.

How long does it take to complete the conversion process?The timeline varies by state and complexity of the business, but it generally takes a few weeks to a few months, including legal and tax steps.

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