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Incorporating a partnership.

Finding the Right Piece to the Puzzle

There are a number of tax and non-tax reasons for incorporating a partnership. Non-tax reasons for incorporating include:

* the limited liability characteristic of the corporate form of business;

* the law relating to corporations is better understood by investors than partnership law; and

* capital can be easier to raise in the corporate form than the partnership form of business.

Tax reasons for incorporating a partnership include:

* the possibility of lower tax rates;

* the existence of a dividend-received deduction;

* the availability of certain tax-free fringe benefits, etc.

The decision to incorporate should not be made until all of the tax and nontax reasons have been weighed. In many cases the business should be continued in the partnership form. However, in those cases where the decision is made to incorporate, the partners should be aware of the three different methods of incorporating a partnership.

Here we will construct a model that will assist in the selection of the most favorable method of incorporation.

Methods of Incorporating a Partnership

Rev. Rul. 84-111 provides for the following three methods of incorporating a partnership.

Method 1: A partnership transfers all of its assets to a newly-formed corporation in exchange for all of the outstanding corporate stock and the assumption by the corporation of the partnership liabilities. The partnership is then terminated by distributing all the corporate stock to the partners.

Method 2: The partnership distributes all of its assets and liabilities to its partners in a transaction that terminates the partnership. The partners then transfer all of the assets received to a newly-formed corporation in exchange for all the outstanding corporate stock and the assumption by the corporation of the partnership's liabilities assumed by the partners.

Method 3: The partners transfer their partnership interests to a newly-formed corporation in exchange for all of the corporation's outstanding stock. The exchange terminates the partnership and all of its assets and liabilities become assets and liabilities of the corporation.

Even though all three methods of incorporation achieve the same result, the Internal Revenue Service in Rev. Rul. 84-111(1) has adopted the position that the tax consequences of each of the three methods of incorporation will be followed. Prior to the issuance of Rev. Rul. 84-111, the IRS took the position in Rev. Rul. 70-239(2) that since all three methods of incorporation had the same result, the tax consequences should be the same regardless of the method used.

Tax Consequences of the Methods of Incorporation

The tax consequences of incorporating a partnership can vary significantly depending upon the method of incorporation.

Tax Consequences of Method 1

Under Sec. 351 the partnership will not recognize either gain or loss on the transfer of assets to the corporation. However, if the amount of the liabilities assumed by the corporation exceed the basis of the transferred assets, the partnership recognizes gain with respect to the excess liabilities under Sec. 357(c). Further, the assumption of the liabilities by the corporation is treated as a payment of money to the partners under Sec. 752 which reduces each partner's basis for his partnership interest under Sec. 733. If the deemed payment is greater than the partner's basis for his partnership interest, gain is recognized under Sec. 731.

The partnership's basis in the stock received is determined in accordance with Sec. 358(a) which provides that the stock basis is the same as the basis of the assets transferred reduced by the liabilities assumed by the corporation. Under Sec. 362(a) the corporation's basis in the property is equal to the partnership's basis in the property plus any gain recognized by the partnership.

On the distribution of the stock by the partnership the partnership is terminated, and each partner's basis in the stock is equal to the adjusted basis of his partnership interest in accordance with Sec. 732(b).

Under Sec. 1223(1), the holding period of the stock received by the partnership includes the partnership's holding period in the capital assets and Sec. 1231 assets transferred. To the extent that the stock was received in exchange for neither capital assets nor Sec. 1231 assets, the holding period begins on the day following the exchange. The corporation's holding period in the assets transferred to it includes the partnership's holding period. The partner's holding period in the stock received includes the partnership's holding period.

Tax Consequences of Method 2

On the transfer of the partnership's assets to the partners, the partnership is terminated under Sec. 708(b). The basis of the assets in the hands of a partner equals the adjusted basis of the partner's interest in the partnership reduced by any money distributed. Under Sec. 752, the decrease in the partnership's liabilities resulting from the transfer to the partners is offset by the partners' corresponding assumption of the liabilities so that the net effect on the basis of each partner's interest in the partnership is zero.

Under Sec. 351, neither gain nor loss is recognized when the former partners transfer their assets to the corporation in exchange for the corporate stock and the assumption of any liabilities. If the liabilities exceed the basis of the transferred assets, gain would be recognized to the extent of the excess.

The corporation's basis in the assets received from the former partners equals the basis in the hands of the former partners under Sec. 732(c). The corporation's basis is increased by any gain recognized by the partners on the transfer.

The basis of the stock in the hands of the former partners is the same basis as the former partners had in the assets received in liquidations of the partnership reduced by the liabilities assumed by the corporation.

Under Sec. 735(b), the holding period for the assets distributed to the partners by the partnership includes the partnership's holding period. In accordance with Sec. 1223(1), the partners' holding period for the stock received in exchange for the assets includes the holding period of the capital assets and Sec. 1231 assets. The corporation's holding period, under Sec. 1223(2), includes the partner's holding periods.

Tax Consequences of Method 3

Section 351 provides for the nonrecognition of gain or loss on the transfer by the partners of their partnership interests to the corporation in exchange for corporate stock. The basis of the corporate stock under Sec. 358(a) equals the basis of their partnership interests transferred to the corporation reduced by the partnership liabilities assumed by the corporation. Since this release from the liabilities is treated as a payment of money, the partners may recognize a gain to the extent that the liabilities exceed the basis of the partnership interests.

The transfer of the partnership interests terminates the partnership under Sec. 708(b). The corporation's basis in the property equals the basis of the partnership interests that were transferred by the partners. The corporation's holding period includes the partnership's holding period in the property.

Under Sec. 1223(1), the holding period of the stock received by the former partners includes each respective partner's holding period for the partnership interest transferred.

Selection of Optimum Incorporation Method

Each of the three methods of incorporation has its own unique set of tax consequences. Each method can affect the following:

1. Amount of gain to be recognized by the partners.

2. Basis of the property held by the corporation.

3. Basis of the stock received by the former partners.

4. Character of gain recognized.

5. Holding period of the property transferred to the corporation.

6. Holding period of the stock received by the former partners.

7. Eligibility of the stock received by the former partners for Sec. 1244 which permits ordinary loss treatment on the later sale of the stock up to an annual maximum of $50,000.

8. Eligibility for S corporation status.

Partners who are incorporating their partnership want to select the method that results in the most favorable set of tax consequences. This paper provides a model that can assist partners in selecting the most favorable method of incorporation. The model shows how the selection of a method of incorporation can affect:

1. The amount of gain to be recognized by the partners,

2. The basis of the property held by the corporation, and

3. The basis of the stock received by the former partners.

These three items are normally of paramount importance to the partners who are incorporating their partnership and can be quantified. However, the effect of the method of incorporation on the remaining tax consequences is not incorporated into the model.

Other consequences of the method of incorporation can also be important but cannot be quantified. For example, the value of preserving the eligibility for S corporation status depends on the future profitability of the business as well as many other factors. In fact, there is some uncertainty as to the effect of the method of incorporation on the corporation's eligibility for S corporation status. An S corporation cannot have a partnership as a shareholder. Under Method 1 the partnership does hold stock in the newly-formed corporation. However, a recent private letter ruling permits the corporation to make a subchapter S election where Method 1 had been used.(3)

There is also some uncertainty as to the effect of the method of incorporation on the eligibility of the stock received by the former partners for the preferential treatment of losses on the sale of their stock under Sec. 1244. To qualify under Sec. 1244 the shareholders must be the original holders of the stock. Under Method 1, the partnership is the original shareholder. If Method 1 has been used, the former partners might be able to argue that the brief period of time that the stock was held by the partnership should be disregarded.

After the partners have identified the most favorable method in terms of gain recognition, property basis, and stock basis, they can consider the effect of that method on the remaining consequences. In some cases the choice may be very simple. For example, if the partners have an interest in preserving the benefits under Sec. 1244, and all three methods produce the same amount of gain to be recognized, property basis, and stock basis then the partners could select the method that accomplishes this objective. However, the choice may not be that easy. In order to preserve the benefits of Sec. 1244, the partners may have to select a method that results in the recognition of additional gain or a less favorable basis for the property or stock.

The Model

In constructing the model the following assumptions were used:

1. The corporation to which the partnership property will be transferred is a newly-formed corporation.

2. The former partners will receive from the corporation, directly or indirectly, only common stock in the newly-formed corporation.

3. The property owned by the partnership has a value greater than its basis.

4. The property held by the partnership does not include cash.

5. Any gain recognized on the incorporation would be treated as long-term capital gain.

6. All partners have the same relative basis for their partnership interests.

Given the assumptions that have been made, a partner's recognized gain, a partner's stock basis, and the basis of the property to the corporation depend on three factors. The three factors are as follows:

1. Partner's basis for his partnership interest which is sometimes referred to as the outside basis.

2. Partnership's basis for its property which is sometimes referred to as the inside basis.

3. Amount of partnership liabilities.

If the numbers representing the dollar amount of the outside basis, the inside basis, and partnership liabilities are all equal, the tax consequences with respect to recognized gain, basis of property held by the corporation, and basis of stock held by the former partners are identical.

If the numbers representing the dollar amount of the three factors are all different, then there are six possible combinations that appear on the upper half of Table 1. If any two of the three factors are equal, there are an additional six combinations that appear on the lower half of Table 1.

It is not unusual for the dollar amount of the outside basis, the inside basis, and the partnership liabilities to be different. The outside basis can vary from the inside basis when partners have acquired their interests through purchase or inheritance and the partnership did not make the Sec. 754 election that would have had the effect of equalizing the outside and inside basis. Further, the amount of partnership liabilities can be greater or smaller than either the outside or inside basis.

The preferred method of incorporation varies depending upon which one of the twelve combinations is being considered. A series of examples were used in order to identify the preferred method of incorporation for each of the twelve different combinations. In the examples, dollar amounts were assigned to the outside basis, the inside basis, and partnership liabilities. A figure of $7,000 was assigned to the largest number in the combination, a figure of $6,000 was assigned to the middle number in the combination, and a figure of $5,000 to the smallest number in the combination. Using these figures, the dollar amount of recognized gain, basis of stock, and basis of property was calculated using each of the three different methods of incorporation for each of the twelve different combinations. The results of these calculations are contained in Table 2.

When the results of Table 2 are examined the first observation that can be made is that there is no difference in the results for Methods 2 and 3. A careful analysis of the figures in Table 2 also reveals that some of the combinations have similar results. For example, for combination Numbers 6, 8, 9 and 10, the amount of gain, basis of stock, and basis of property do not vary with the method of incorporation. Combinations which possessed similar results were combined into clusters. Table 3 shows the five different clusters into which the 12 combinations can be grouped, and the preferred method of incorporation for the combinations in each cluster.

Cluster A

This cluster includes those four combinations (Number 6, 8, 9 and 10) where identical tax consequences are obtained regardless of the method of incorporation. It includes Combination Number 8 where the outside basis and inside basis are equal but greater than the liability. It also includes three combinations that result in a recognized $2,000 gain. In Method 1, gain is recognized to the extent of the excess of the liability over the smaller of the inside basis or outside basis. In Method 2 and 3, gain is recognized to the extent of the excess of the liabilities over the outside basis. Therefore, when the liability is greater than both the inside and outside basis, but the outside basis is smaller than the inside basis, the same amount of gain will be recognized regardless of the method of incorporation.
Table 1
Possible Combinations of Outside Basis, Inside Basis, and
Liabilities in the Incorporation of a Partnership
A. If all three figures are different:
Combination Outside Inside
Number Basis Basis Liability
1 Largest Middle Smallest
2 Largest Smallest Middle
3 Middle Largest Smallest
4 Middle Smallest Largest
5 Smallest Largest Middle
6 Smallest Middle Largest
B. If two of the three figures are the same:
7 Largest Smallest(*) Smallest(*)
8 Largest(*) Largest(*) Smallest
9 Smallest Largest(*) Largest(*)
10 Smallest(*) Smallest(*) Largest
11 Largest(*) Smallest Largest(*)
12 Smallest(*) Largest Smallest(*)
* Is equal to one other number in the combination.


Cluster B

This cluster includes two combinations (Number 1 and 7) where the basis of the property in the hands of the corporation is higher under Methods 2 and 3 than it is under Method 1. Under Method 1, the corporation's basis of the property is equal to the inside basis. Under Methods 2 and 3 the corporation's basis in the property is equal to the outside basis. Methods 2 and 3 result in the corporation having a larger basis since the outside basis is greater than the inside basis. Methods 2 and 3 are the preferred methods since they produce a larger property basis without causing any difference in the amount of gain recognition or stock basis.

Cluster C

This cluster includes three combinations (Number 3, 5 and 12) where the basis of the property in the hands of the corporation is higher under Method 1 than it is under Methods 2 and 3. In contrast to the results in Cluster B, Method 1 now produces a larger corporate basis in the property since the inside basis is now greater than the outside basis. Method 1 is the preferred method since it produces a larger property basis without causing the amount of gain to be recognized or stock basis to be different.

Cluster D

There are two combinations (Number 4 and 11) in this cluster. In both cases there is more gain recognized under Method 1 than under Methods 2 and 3. The additional gain does have the effect of increasing the basis of the stock by the amount of gain recognized. As explained earlier, gain will be recognized to the extent of the excess of the liability over the smaller of the inside basis or outside basis, whereas in Methods 2 and 3 gain is recognized to the extent of the excess of the liability over the outside basis. The additional gain is recognized in these two combinations since the inside basis is less than the outside basis, but both are less than the liabilities. Methods 2 and 3 are the preferred methods since they do not cause immediate gain recognition. However, when the stock is sold at a later date, Methods 2 and 3 will produce a larger gain.
Table 2
Effect of Incorporation Method on Amount of Gain, Basis of
Stock, and Basis of Property for Each Combination (amounts
reported assume that the largest number in the combination is
$7,000, the middle number, $6,000, and the smallest number,
$5,000)
 Method 1 Method 2/3
Combination 1:
Gain $ -0- $ -0-
Basis of stock 2,000 2,000
Basis of property 6,000 7,000
Combination 2:
Gain $1,000 $ -0-
Basis of stock 2,000 1,000
Basis of property 6,000 7,000
Combination 3:
Gain $ -0- $ -0-
Basis of stock 1,000 1,000
Basis of property 7,000 6,000
Combination 4:
Gain $2,000 $1,000
Basis of stock 1,000 -0-
Basis of property 7,000 7,000
Combination 5:
Gain $1,000 $1,000
Basis of stock -0- -0-
Basis of property 7,000 6,000
Combination 6:
Gain $2,000 $2,000
Basis of stock -0- -0-
Basis of property 6,000 6,000
Combination 7:
Gain $ -0- $ -0-
Basis of stock 2,000 2,000
Basis of property 5,000 7,000
Combination 8:
Gain $ -0- $ -0-
Basis of stock 2,000 2,000
Basis of property 7,000 7,000
Combination 9:
Gain $2,000 $2,000
Basis of stock -0- -0-
Basis of property 7,000 7,000
Combination 10:
Gain $2,000 $2,000
Basis of stock -0- -0-
Basis of property 7,000 7,000
Combination 11:
Gain $2,000 $ -0-
Basis of stock 2,000 -0-
Basis of property 7,000 7,000
Combination 12:
Gain $ -0- $ -0-
Basis of stock -0- -0-
Basis of property 7,000 5,000


Cluster E

There is only one combination (Number 2) in this cluster. Method 1 causes the recognition of gain since the liability is greater than the inside basis. Methods 2 and 3 do not cause the recognition of gain since the liability is not greater than the outside basis. The basis of the property is less under Method 1 since the inside basis increased by the gain recognized becomes the basis of the property and this amount is less than the outside basis. The basis of the stock is greater under Method 1 because of the gain recognized. Methods 2 and 3 are the preferred methods since they do not cause the immediate recognition of gain.

Limitations of Model

Corporation Transfers Only Its Common Stock

Section 351 provides that the transferor of property to a controlled corporation does not recognize either gain or loss upon the receipt of stock in the corporation. Section 351 applies to all three methods of incorporation. In general, the assumption of liabilities in connection with a transfer of property to a controlled corporation does not trigger the recognition of gain. However, the assumption of liabilities by the corporation can be treated as a distribution of property other than stock, and cause the recognition of gain to the extent that the liabilities assumed exceed the basis of the transferred property. In some of the combinations, gain was recognized due to this provision. However, in constructing the model it was assumed that the corporation transferred no property other than its own stock. If the corporation had transferred cash or property other than its own stock, the amount of gain recognized would have been increased in some cases in all three methods of incorporating the partnership.

Partnership Property Excludes Cash

In constructing the model it was assumed that the property held by the partnership did not include any cash. Section 731(a) requires the recognition of gain when a cash distribution to a partner exceeds his outside basis. Under Sec. 752, the assumption of partnership debt by the corporation is treated as a distribution of cash. If the corporation had distributed cash to its partners, the amount of gain recognized would have been greater in some cases where Methods 2 and 3 were used.

Relative Basis Assumption

It was assumed that all partners had the same relative basis for their partnership interests. This assumption makes it easy to select a method of incorporation. If the partners do not have the same relative basis, the partners might prefer different methods of incorporation. Further, when cash or other property is transferred to the former partners by the corporation gain can be recognized under Sec. 351(b). This section causes the recognition of gain only to the extent of the realized gain. If the partners do not have the same relative basis the total amount of recognized gain can vary depending on the method of incorporation.

Long-term Capital Gain Assumption

In constructing the model, is was assumed that any gain recognized would be classified as long-term capital gain. There are several provisions that could have produced ordinary income on the incorporation of a partnership. For example, if the property transferred to the corporation had been appreciated inventory, the gain recognized under Sec. 357(c) would have been taxed as ordinary income under Method 1.

Also, Sec. 1239 can cause the recognition of ordinary income on a sale or exchange of property between a corporation and a more than 50% shareholder if the property is depreciable. Although this provision would likely apply to a Method 1 or Method 2 incorporation, there is some uncertainty as to whether it would also apply to a Method 3 incorporation.

The recognition of ordinary income instead of capital gain would not likely affect the preferred method of incorporation. The provisions that cause the recognition of ordinary income do not result in the recognition of additional gain. They only cause recognized gain to be treated as ordinary income instead of capital gain. Currently there is only a small difference between the tax rates on ordinary income and capital gains. Ordinary income can be taxed at a 31% rate while capital gains cannot be taxed at a rate greater than 28%.

TABULAR DATA OMITTED

Conclusion

A partnership can be incorporated using any one of three different methods. Although all three methods achieve the same final result, the tax consequences vary depending upon the method selected. The most favorable method of incorporating a partnership depends on a mix of different factors. This paper provides partners with a model that can assist them in selecting the most advantageous method.

Footnotes

1 Rev. Rul. 84-111, 1984-2 CB 88.

2 Rev. Rul. 70-239, 1970-1 CB 74.

3 Priv. Ltr. Rul. 8948015 (Aug. 31, 1989).

W. Peter Salzarulo, PhD, CPA, is the Ernst & Young Professor of Accountancy at Miami University in Oxford, Ohio. He has published in numerous professional journals. He hold a PhD in accounting from the University of Colorado. His research for this article was funded by a Price Waterhouse summer research grant.
COPYRIGHT 1992 National Society of Public Accountants
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Salzarulo, W. Peter
Publication:The National Public Accountant
Date:Sep 1, 1992
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