Do you or your clients have an S corporation that you would like to convert to a limited partnership for tax purposes, but for the taxable gain thereon? Surprisingly, the Ways and Means tax proposals introduced on September 13 would permit a tax-free reorganization from an S corporation to a domestic partnership, with one catch. The “get out of S corp. free” card would only be valid for corporations that were an S corporation on May 13, 1996 and at all times thereafter (an “Eligible S Corporation”). Also, the S corporation must elect to exercise its “get out of S corp. free” card during a two-year period commencing on December 31, 2021. The change to a partnership must be accomplished through a complete liquidation of the S corporation, coupled with a transfer of substantially all of the assets and liabilities to a domestic partnership within such two-year window (a “Qualified Liquidation”). Treasury would be authorized to prescribe necessary regulations to implement these provisions.
The Qualified Liquidation is treated as if it were a liquidation under §332(b) and the domestic partnership were a corporation which is an 80-percent distributee under §337(a). Thus, the Qualified Liquidation generally would not result in any taxable gain to the liquidating S corporation or its shareholders.
Currently, a state law conversion of an S corporation into a partnership is treated as a taxable liquidation of the S corporation. Gain is recognized by the S corporation as if it disposed of all of its assets and liabilities in a taxable transaction under §336, which gain flows through to the shareholders. Such conversion is generally treated as a complete liquidation of the S corporation. Presumably a conversion of an Eligible S Corporation into a domestic partnership under state law would constitute a Qualified Liquidation for these purposes. Hopefully further guidance would be forthcoming to confirm that presumption.
While many S corporations have been formed to take advantage of favorable rules on self-employment and Medicare tax, partnerships offer greater flexibility in many respects. An S corporation is limited to 100 shareholders, whereas there is no limitation on the number of partners in a partnership. Unlike a partnership, which may provide for special allocations, subject to the §704 Regulations, income and deductions of an S corporation must be allocated in accordance with the shareholders’ respective percentage interests on a per share per day basis. While a partners’ basis in the partnership may be increased by their share of partnership debt under §752, S corporation shareholders are much more limited on what debt can be included in their basis. Also, the single class of stock restriction on S corporations continues to be trap for the unwary, despite the potential for inadvertent termination relief which, if available, comes with an expensive user fee. (Click here to read my previous blog on, "Have You Checked the Validity of That S Election Recently? (Relief Alternatives Available for No S Election, Invalid Elections or Inadvertent Terminations)." No such single class of equity restrictions applies to partnerships.
Although much of the Ways and Means proposals would, if enacted, significantly undercut the planning tools available to tax advisors, particularly estate planners, this provision is a welcome bright spot. Of course, the limitation to S corporations existing on May 13, 1996 significantly limits its scope. However, those with qualifying S corporations should keep an eye on the progress of this provision through the legislative process.
For any questions regarding this provision of the Ways and Means Committee’s tax proposals or the reorganization of S corporations in general, please contact Tom Hineman at firstname.lastname@example.org, or (214) 744-3700.