Key Takeaways

  • Converting a partnership or LLC into an S corporation can provide tax advantages but also comes with strict rules on shareholder limits, stock classes, and gain recognition.
  • A partnership to S corp conversion basis determines how assets, liabilities, and partner capital accounts transfer into the new S corporation.
  • In many cases, partnership-to-S corporation conversions can be structured tax-free under Internal Revenue Code §351, provided the requirements are met.
  • Pitfalls include loss of flexibility, restrictions on ownership, and built-in gain or passive income taxes if assets are appreciated or earnings are retained.
  • Careful planning, appraisals, and legal review are critical to ensure compliance and avoid unintended tax liabilities.

S-corp conversion is the process of electing S corporation tax treatment for a standard C corporation or limited liability company (LLC). Before making this election, it's important to understand the tax implications and other issues that may affect your business.

Tax Implications of S-Corp Conversion

While S-corp conversion can result in substantial tax savings for qualifying business owners, it's important to consider potential costs also. For example, a C-corp that converts to an S-corp is subject to built-in gains tax of 35 percent on appreciated property that is sold within five years of the first day of the first year in which S-corp conversion is affected. When an S-corp sells an appreciated asset, it must determine the unrealized appreciation present at the time of S-corp election by comparing the fair market value at the election date to the tax basis.

This calculation must be done separately for each appreciated asset. The net amount of unrealized gains and losses is considered the built-in gain of the S-corp. A prorated portion of the taxed amount must be reported on each shareholder's Schedule K-1. Assets sold after the fifth year after S-corp election are not subject to the built-in gains tax. Many new S corporations choose to operate at a loss for the first five years to avoid this tax.

C corporations that convert to S corporations are also taxed if passive income exceeds 25 percent of gross receipts and the corporation has carried over profits and earnings from its days as a C corporation. Passive income includes:

  • Interest
  • Dividends
  • Royalties
  • Rent
  • Stock sale gains

Many new S-corps avoid this tax by distributing profits and earnings as taxable shareholder income rather than accumulating them. Corporations that owe this tax for three years in a row are no longer eligible for S-corp status.

C corporations with unused net operating losses cannot use these losses to offset S-corp income or pass them through to shareholders. These losses must be credited to an earlier C-corp year or forfeited; however, they can be reinstated if the S-corp ever converts back to a C-corp.

Newly converted S-corps are also charged income tax on profits that were not taxed before the election. This commonly affects accounts receivable that were not collected and/or real estate that has appreciated.

If a C-corp uses LIFO inventories, it is taxed on these derived benefits when converting to an S-corp. This tax can be paid in equal payments over four years.

If you're considering an S corporation conversion, an attorney can help you determine which of these taxes will affect you and whether it is financially advantageous to make the S election.

Partnership to S Corp Conversion Basis

When a business converts from a partnership (or an LLC taxed as a partnership) to an S corporation, the conversion basis is one of the most important considerations. The basis represents each owner’s tax investment in the entity and affects how income, losses, and future distributions are taxed.

  • Partner Capital Accounts Become Stock Basis: In most cases, the partner’s capital account balance transfers to become their stock basis in the S corporation. This means the amount invested, plus prior income allocations, minus distributions, sets the starting point for determining gain or loss.
  • Liabilities Matter: If the partnership had liabilities, those amounts can complicate the calculation. A partner relieved of debt during conversion may have taxable gain recognition.
  • IRC §351 Nonrecognition Rule: The Internal Revenue Code often allows a tax-free conversion if property is transferred to the corporation solely in exchange for stock and immediately after the exchange, the transferors control the corporation. This lets many partnership-to-S corporation conversions proceed without immediate tax cost.
  • Built-In Gain Assets: Appreciated assets brought into the new S corporation may be subject to a built-in gains tax if sold within the five-year recognition period.

In short, the partnership to S corp conversion basis determines whether the transaction is treated as tax-free or if owners face taxable income upon conversion.

Requirements of S-Corp Status

Converting a C corporation to S-corp status makes it a pass-through entity in which income is not taxed at the corporate level. Instead, profits and losses pass through to the shareholders, who are taxed at the individual rate. This allows the business to avoid the double taxation that affects C corporations.

However, the corporation must meet certain requirements to be eligible for S election. This status is available only to domestic corporations that are not financial institutions, insurance companies, possessions corporations, or current or former DISCs. An S-corp must have fewer than 100 shareholders, all of whom must be U.S. citizens or residents, certain trusts and estates, and certain tax-exempt organizations.

S corporations must offer only one class of stock, though different voting rights can be offered within this class. This can be a limitation for C corps that have shareholders who want a preferred return on their investment, as well as for those who offer equity-based payments and other financing arrangements.

Common Pitfalls of Conversion

While S corporation status provides pass-through taxation benefits, businesses converting from a partnership should be aware of common challenges:

  • Loss of Flexibility: Partnerships allow special allocations of profits and losses, while S corporations require strict pro rata distribution based on stock ownership.
  • Ownership Restrictions: Partnerships can have entities as partners, but S corporations cannot. Only eligible individuals, estates, and certain trusts may be shareholders.
  • Single Class of Stock: Partnerships often provide preferential rights or special allocations; these disappear upon S election because only one class of stock is allowed.
  • Employment Taxes: One motivation for conversion is reducing self-employment tax. However, S corporation owners must pay themselves a reasonable salary subject to payroll tax, and IRS scrutiny is common.
  • State-Level Complications: Some states impose franchise taxes or additional filing requirements on S corporations, which may offset federal savings.

These limitations mean that while tax savings can be attractive, not every partnership is a good candidate for conversion.

Advice for Making the Conversion

Preparation can help you minimize your corporation's tax burden. To derive maximum benefit from S-corp election, C corporations should:

  • Gift stock before making the election.
  • Have an appraisal, which shifts the burden of proof for understatement penalties to the IRS.
  • Choose valuation experts carefully.
  • Understand that judges can challenge every valuation estimate.

Structuring a Tax-Free Conversion

To avoid triggering unexpected taxes, partnerships can often use strategies to qualify under IRC §351 for tax-free treatment when converting to an S corporation:

  • Ensure that partners receive only stock in exchange for their contributed property.
  • Transfer substantially all assets and liabilities to the new corporation.
  • Maintain continuity of ownership so that the same individuals who owned the partnership stock own the new S corporation shares.
  • Avoid disguised sales or debt relief that could result in taxable gain.

When done correctly, the conversion preserves the basis of contributed assets, with no gain or loss recognized at the time of transfer.

However, missteps—such as transferring assets subject to liabilities in excess of basis—can result in unexpected taxable income. For this reason, most businesses seek legal and accounting guidance before attempting the election.

Frequently Asked Questions

  1. What does “partnership to S corp conversion basis” mean?
    It refers to how a partner’s capital account and tax basis in the partnership become their stock basis in the new S corporation after conversion.
  2. Is converting a partnership to an S corp always tax-free?
    Not always. Conversions can qualify as tax-free under IRC §351 if requirements are met, but debt relief, built-in gains, or improper structuring may trigger taxes.
  3. Can a partnership carry forward losses after converting to an S corp?
    No. Partnership losses cannot carry over to the S corporation. They must be used in the partnership’s final tax year or are lost.
  4. Why would a partnership convert to an S corp?
    The main reason is to reduce self-employment taxes by treating some income as distributions instead of salary, though this comes with restrictions and IRS scrutiny.
  5. What risks exist if I convert my partnership to an S corp?
    Risks include loss of flexible allocations, potential built-in gain taxes, limits on shareholders, and stricter IRS oversight of reasonable compensation.

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