LLC Partnership to S-Corp

[shopkins]

Seeking guidance, please, as I have done very few S-Corp returns.  New client on extension is LLC and filed as Partnership for 2016. As of 1/1/17, prior accountant filed paperwork electing them to be taxed as S Corp. As of 1/1/17 their liabilities exceed their assets, resulting in negative RE. Same situation for end of 2017. Does this trigger tax for them in 2017 because of this negative RE?  Details: @ 12/31/16 they had assets (cash) of $62,045, liabilities (credit card & 2 bus loans) of $64,942, resulting in negative equity of $2,897. @ 12/31/17 they had assets of $33,631, and liabilities of $51,623, resulting in negative equity of $17,992. There are no shareholder loans. They have no A/R.  Also, is this negative $2,897 from 2016 the starting Capital Stock Amount for 2017 (for Schedule L) since they are now filing as an S-Corp? How can Capital Stock be negative??  Very confused and would appreciate any info. or guidance. Thanks!! 

[Abby Normal]

Hey Newbie! I saw this post on Facebook! Welcome! This doesn't directly address the negative capital. I'd be tempted to just leave it as negative retained earnings, since it's the same entity.

https://www.thefreelibrary.com/Holding+period+and+basis+considerations+of+partnership+conversions.-a0203028393

Partnership liabilities transferred as part of incorporation may also offer opportunities for planning. If, in addition to the assets transferred by the partnership, the corporation also assumes liabilities of the partnership, then under Sec. 357(a) the assumption will not taint an otherwise tax-free incorporation of a partnership, as long as the sum of the liabilities transferred does not exceed the adjusted basis of the assets transferred to the corporation. However, when the sum of the liabilities exceeds the adjusted basis of the assets transferred by the partnership to the corporation, Sec. 357(c)(1) requires the recognition of the excess as either ordinary income or capital gain.

An important exception to Sec. 357(c)(1) exists for certain obligations of a partnership. Under Sec. 357(c)(3)(A)(ii), partnership obligations for payments to a retiring partner or a deceased partner's successor in interest (Sec. 736(a) payments) are not included in liabilities for purposes of Sec. 357(c)(1) and therefore cannot give rise to income on incorporation. This treatment allows for flexibility in planning payments to partners contemplating retirement in the period immediately before incorporation. In addition, since under Rev. Rul. 83-155 (13) Sec. 736(a) payments can be deducted by the newly formed corporation when paid, the anticipated tax rates of the remaining partners, the retiring partner, and the new corporation should be considered when planning the timing of the incorporation.

Care should be taken in timing the incorporation of a partnership with an existing active business. Sec. 482 allows the IRS to allocate income between or among taxpayers if the allocation is necessary to prevent the distortion of income or the evasion of income taxes. The IRS successfully applied Sec. 482 to the incorporation of a partnership when it concluded that the partnership had earned the income ultimately realized by the corporation. In Foster, (14) income reported by four corporations on the sale of land developed by commonly controlled partnerships but transferred to the corporations after substantially all development was completed was reallocated to the commonly controlled partnerships. In the Service's eyes, the partnerships had done everything necessary to create the potential for income recognition and could not avoid that recognition by arranging for the property to be in the hands of another taxpayer at the moment the income was recognized. By carefully planning the timing of the cessation of business activities in the partnership and the commencement of business activities in the corporation, incorporating partnerships should be able to avoid this type of problem.

[shopkins]

Thank you so much! This is very helpful.  The other part of this is how to complete the Schedule L on their first 1120S. I assume beginning of year tax numbers flow from their 2016 1065. But do I need to include an amount for Capital Stock? Would this be the negative retained earnings figure? Can there really be negative Capital Stock?? Also, for Schedule M-2, will they start with a negative beginning balance in their AA account?  Really appreciate your help with this!

[Lee B]

You can have negative Retained Earning, but not  negative Capital Stock.

[jklcpa]

The mechanics of this are that the partnership transfers all assets to the S corp in exchange for the the stock of the S corp, then the partnership immediately liquidates and distributes the S corp shares out to the partners in liquidation of the partnership  Rev Rule 2004-59 addresses this, and can be found by scrolling down on this IRS page.

Quote

Rev. Rul. 2004-59

State law conversion from partnership to corporation. This ruling explains the federal tax consequences when an entity classified as a partnership for federal tax purposes converts into a state law corporation under a state statute that does not require an actual transfer of the unincorporated entity’s assets or interests.

ISSUE

If an unincorporated state law entity that is classified as a partnership for federal tax purposes (partnership) converts to a state law corporation under a state statute that does not require an actual transfer of the unincorporated entity’s assets or interests (state law formless conversion statute), how is the conversion treated for federal tax purposes?

FACTS

On January 1, 2003, A is organized in State as an unincorporated entity that is classified as a partnership for federal tax purposes. A elects to convert under a state law formless conversion statute into a state law corporation, effective January 1, 2004. As a result of the conversion, A is classified as a corporation for federal tax purposes.

LAW AND ANALYSIS

Section 7701(a)(2) of the Internal Revenue Code provides that the term partnership includes a syndicate, group, pool, joint venture, or other unincorporated organization, through or by means of which any business, financial operation, or venture is carried on, and which is not, within the meaning of this title, a trust or estate or a corporation.

Section 7701(a)(3) provides that the term corporation includes associations, joint-stock companies, and insurance companies.

Section 301.7701-2(b)(1) defines the term corporation to include a business entity organized under a federal or state statute, or under a statute of a federally recognized Indian tribe, if the statute describes or refers to the entity as incorporated or as a corporation, body corporate, or body politic.

Section 301.7701-3(a) provides that a business entity that is not classified as a corporation under § 301.7701-2(b)(1), (3), (4), (5), (6), (7) or (8) (an eligible entity), can elect its classification for federal tax purposes.

Section 301.7701-3(g)(1)(i) provides that, if an eligible entity classified as a partnership elects under § 301.7701-3(c)(1)(i) to be classified as an association, the following is deemed to occur: the partnership contributes all its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates, distributing the stock of the association to its partners.

Rev. Rul. 84-111, 1984-2 C.B. 88, describes the tax consequences when steps are taken as parts of a plan to transfer partnership operations to a corporation organized for valid business reasons. For each of three methods of incorporating a partnership, Rev. Rul. 84-111 describes the differences in the basis and holding periods of the various assets received by the corporation and the basis and holding periods of the stock received by the former partners provided the steps described are actually undertaken and the underlying assumptions and purposes for the conclusions in the revenue ruling are applicable. If the partnership converts into a corporation in accordance with a state law formless conversion statute, however, Rev. Rul. 84-111 does not apply.

For federal tax purposes, a partnership that converts to a corporation under a state law formless conversion statute will be treated in the same manner as one that makes an election to be treated as an association under § 301.7701-3(c)(1)(i). Therefore, when unincorporated entity A converts, under state law, to corporation A, the following steps are deemed to occur: unincorporated entity A contributes all of its assets and liabilities to corporation A in exchange for stock in corporation A, and immediately thereafter, unincorporated entity A liquidates, distributing the stock of corporation A to its partners.

HOLDING

If an unincorporated state law entity that is classified as a partnership for federal tax purposes converts into a state law corporation under a state law formless conversion statute, the following is deemed to occur: the partnership contributes all its assets and liabilities to the corporation in exchange for stock in such corporation, and immediately thereafter, the partnership liquidates distributing the stock of the corporation to its partners.

DRAFTING INFORMATION

The principal author of this revenue ruling is Christopher L. Trump of the Office of Associate Chief Counsel (Passthroughs and Special Industries). For further information regarding this revenue ruling, contact Christopher L. Trump at (202) 622-3080 (not a toll-free call).

 

[Abby Normal]

Here's a pertinent article that didn't come up the first time I searched:

Incorporating an Insolvent Partnership: Availability of the Insolvency Exclusion

https://www.thetaxadviser.com/issues/2013/apr/clinic-story-06.html

[Abby Normal]

1 hour ago, jklcpa said:

The mechanics of this are that the partnership transfers all assets to the S corp in exchange for the the stock

Apparently, there are 3 or 4 methods:

Rev. Rul. 84-111 provides guidance for Sec. 351 transfers of 100% of the interests of a partnership under subchapter K. It offers the following three methods for determining the treatment of the transfers, and holds that the form of the transfer controls the treatment:

1. Assets over: a transfer by a partnership (or an LLC) of assets to the corporation in exchange for consideration, followed by the liquidation of the partnership (or LLC) via the distribution of the consideration.

2. Interests over: a transfer of the partnership (or LLC) interests by the partners (or members) to the corporation in exchange for consideration.

3. Assets up and over: a distribution of all partnership (or LLC) assets to the partners (or members) in liquidation, followed by a contribution of the assets received to the corporation, in exchange for consideration.

Assets over: The specific tax treatment of each transfer differs. With the assets-over form, the transferee corporation takes a basis in the assets received under Sec. 362; the transferor partnership takes a basis in the transferee stock received equal to the basis in the assets transferred, reduced by liabilities, under Sec. 358. On liquidation of the transferor partnership, the partners take a basis in the transferee stock received equal to their bases in their partnership interests, under Sec. 732(b).

Interests over: In the interests-over form, the transferee corporation’s basis in the assets received on the partnership’s termination is determined under Sec. 732(c) and equals the transferors’ bases in their partnership interests transferred, while the transferor partners take a basis in the transferee stock equal to their bases in the partnership interests transferred.

Asstes up and over: In the assets-up-and-over form, the partners take a basis in the assets distributed to them under Sec. 732(b) equal to their respective bases in the partnership; the transferee corporation takes a basis in the assets received under Sec. 362(a) equal to the transferors’ bases in the assets transferred.

An important distinction occurs in the assets-over transfer; the partnership, not each partner, is the transferor. Thus, to the extent gain is recognized under Sec. 351(b) on the receipt of cash or other property, the partnership recognizes the gain; a partner receiving only stock consideration on liquidation could recognize gain on the partnership’s receipt of cash or other property.

Other methods: In addition to the three methods prescribed in Rev. Rul. 84-111, two additional methods could apply to the incorporation of a partnership. The first is a “formless” incorporation, in which the partnership incorporates via a check-the-box election under Regs. Sec. 301.7701-3(g)(1)(i) or a state law formless conversion. This is an assets-over transfer; see Rev. Rul. 2004-59.

https://www.thetaxadviser.com/issues/2007/apr/incorporatingapartnershiporllcdoesrevrul84-111needupdating.html