Partnership Incorporation Provides Planning Opportunities

Business owners may find they wish to modify the legal formation of a business entity at some point. If a business is set up as a partnership, it's important to review the conversion form, as the method selected for converting a partnership to a corporation can impact the taxation of the business.

Under Rev. Rul. 84-111, there are three ways to change a partnership to a corporation:

  • Assets-Over Method: Transferring assets owned by the partnership to a corporation that has recently been formed.
  • Assets-up Method: Liquidating the partnerships and distributing all assets to partners, followed by the forming of a corporation to which the partners can transfer the assets.
  • Interests-Over Method: Transferring all interests in the partnership to a corporation that has recently been formed in exchange for stock in the corporation. With this method, holding periods, losses, gains, and basis can be affected.

In general, Rev. Rul. 84-111 applies to:

  • Partnerships that follow the rules in subchapter C when becoming corporations
  • Partnerships that follow the rules of subchapter K for distributions
  • How unrealized receivables, liabilities, and inventory are treated and partnership interests are transferred
  • Subchapter P rules based on how property is held for each incorporation method.

Depending on the method chosen for transferring a partnership to a corporation, the consequences of taxation will vary. These consequences depend on several factors:

  • Holding period and basis in the partners' interests in the partnership
  • Holding period and basis in the partnership's assets
  • Character of the partnership's assets

For example, if the basis for the partners' interest in the partnership equals the partners' interest in the partnership's assets, the basis interest in the assets will be the same upon converting the business to a corporation. However, if the interests aren't equal, the differences will come up as a factor in deciding which method to use for becoming a corporation.

Section 1244 Stock Considerations

When making the decision on how to convert a partnership to become a corporation, those involved in the business taxes should look at potential consequences and select the method that offers the best outcome for taxation. Aspects to consider include character of assets, basis, interests transferred, and holding periods.

For example, if one of the partners owned section 1244 stock, they would be the only taxpayer eligible to claim the worthlessness of the stock or an ordinary loss from selling it. However, using the assets-over method would voice the treatment of section 1244 stock because the partnerships become the owner of the stock transfer process. In this method, the stock is transferred back to the partnership by all involved partners. Using the interests-over and assets-up methods would preserve the treatment of the section 1244 stock since the partners become owners of the stock as part of the exchange.

Partnership in Business

If a business has more than one owner and is not organized as a limited liability company or incorporated, it is called a partnership. All partners in the business share the personal liability, as well as in the losses and profits of the organization. Partners in a partnership can be trusts, corporations, individuals, or other partnerships.

When at least two individuals wish to start a business and be part of its daily operations, they will often form a partnership. As soon as any type of business activity begins with another, a partnership is formed. No state requires a partnership to file legal paperwork, although many partners choose to draft written partnership agreements that outline the plan for business management and any other issues that may arise.

The agreement should also include the plan for distributing losses and profits to all partners. With a partnership agreement in place, it's much easier to spell out the responsibilities and expectations of each partner.

Advantages of a Partnership

One of the advantages of forming a partnership is taxation. Instead of being double taxed, the partners report all business losses and profits on their personal tax returns. Partners also bring their own unique strengths, which can be applied to different areas of running the business, such as managing the financials or employees.

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