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Converting a general partnership interest into a limited partnership interest tax-free.

Facts: Dick and Doug are equal general partners in Corvette City, which operates an airport-based sports car rental facility. Dick plans to become less active in the business and will turn over much of the management to Doug. The business has many risks of loss for which Dick no longer wishes to be liable. The partners ask their tax adviser how they can reorganize the partnership to limit Dick's exposure to liability. The partners do not want to incur any tax liability as a result of the reorganization. Issue: Will the conversion of Dick's general partner interest to a limited partner interest achieve his goal of limited liability? Can Dick convert his interest without incurring a tax liability on the transaction?

Analysis

Restructuring Corvette City from a general partnership to a limited partnership and exchanging Dick's general partner interest for a limited partner interest could accomplish the goal of limiting Dick's risk of loss to sums he invested in Corvette City.

The IRS has publicly ruled it possible, under certain circumstances, for a partner to exchange a general partner interest for a limited partner interest (or vice versa) without incurring tax liability from the transaction. Further, the Service has ruled these changes in ownership interests do not terminate the partnership.

Rev. Rul. 84-52 considered only situations in which a partnership is converted from a general to a limited partnership, and vice versa. However, several letter rulings have approved tax-free conversions of individual partners' interests. Also, these letter rulings address situations in which changes in the partners' interests in partnership capital and in profits and losses qualify for tax-free treatment, while Rev. Rul. 84-52 addressed only situations in which such interests remained the same. (While letter rulings do not have precedential value, they do indicate the IRS's position on an issue.)

Dick may recognize gain on the transaction if his share of recourse liabilities of the partnership will be reduced to zero when he becomes a limited partner. This reduction in liabilities is treated as a constructive cash distribution to Dick. If cash distributions (both actual and constructive, as the result of the reduction in Dick's share of recourse liabilities) exceed Dick's basis in his partnership interest, Dick recognizes taxable gain.

Conclusion

Dick can convert his general partner interest into a limited partner interest without incurring tax on the transaction, unless his share of partnership recourse liabilities exceeds the pre-transaction basis in his partnership interest.

Variation 1

Assume the facts are the same as above, except Doug is a limited partner. Rather than convert his general partner interest to a limited partner interest, Dick decides he and Doug should simply exchange their partnership interests.

After the exchange, Dick is a limited partner and Doug is a general partner--the result both parties wanted. Unfortunately, under Regs. Sec. 1.1031(a)-1(a), the exchange of partnership interests, even in the same partnership, is a taxable event. This would cause both Dick and Doug to recognize gain on the transaction. It is best to structure all conversions through the partnership rather than between partners.

Variation 2

Assume the same facts as in the initial example, except that the partners are considering converting the partnership into a limited liability company (LLC). LLCs that have elected to be classified as partnerships are governed by partnership tax rules. Thus, the rules for converting general partnerships into limited partnerships or vice versa are relevant.

Letter Rulings 9029019 and 9226035 have considered the conversion of a general partnership into an LLC, holding that no gain or loss is recognized (under Sec. 721) from the exchange. Further, the conversion does not terminate the old partnership under Sec. 708, because the business continues (in a form recognized as a partnership for tax purposes) and the conversion is not a sale or exchange. Finally, the partner's holding period in his partnership interest carries over to his LLC interest.

Letter Rulings 9119029 and 9210019 have also allowed the conversion of a limited partnership into a LLC. In these letter rulings, the form of the transaction was governed by Rev. Rul. 84-5:2. (Rev. Rul. 84-52 has been amplified by Rev. Rul. 95-37, which specifically addresses the conversion of a domestic partnership into a domestic LLC.) First, the partners transferred their partnership interests to the LLC. The LLC then liquidated the partnership and received the partnership's assets as a liquidating distribution.

The issue not addressed in the general or limited partnership rulings is whether there are any tax consequences under Sec. 752 from a deemed distribution of cash stemming from the relief of a partner's share of partnership debt. Presumably, for a limited partner, there would be no change in his liability for partnership debt on conversion to an LLC. An argument can also be made that there is no change in the liability of a general partner in either a general or limited partnership.

It is unlikely, from a state law standpoint, that the general partner would be released from personal liability by the firm's creditors for the business's recourse debts. Thus, until the LLC pays off the existing recourse debts, the former general partner is not relieved of any recourse liability by the conversion. Additionally, there should be no change in the general partner's (now member's) share of nonrecourse debt.

For Dick, the conversion of Corvette City from a general partnership to an LLC should be a tax-free transaction.

Editor: Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA

Editor's note: This case study has been adapted from "PPC Tax Planning Guide-Partnership," 14th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, Tex., 2000.
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Geographic Code:1USA
Date:Oct 1, 2000
Words:957
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