Can You Convert a Partnership into an S Corp Tax-Free?

Let’s say you currently run your small company as a partnership or as an LLC that’s treated as a partnership for federal tax purposes. (In this analysis, we will describe both of these methods of working as partnerships since the partnership federal income tax guidelines apply to both.) Then, let’s say you’re considering transforming your Partnership into an S Corp. The reason may be to reduce direct exposure for you and the other owners to Social Security and Medicare taxes, which can be found in the form of self-employment tax for partners.

Particularly, each partner’s share of net partnership earnings is typically completely exposed to the self-employment tax. For 2022, the self-employment tax rate is an unpleasant 15.3 percent on the first $147,000 of net self-employment income. On net self-employment earnings above $147,000, the self-employment tax rate drops to 2.9 percent.

For a shareholder-employee of an S corporation, the Social Security and Medicare taxes are available in the form of the FICA tax. However, for shareholder-employees, the FICA tax strikes only amounts paid as incomes. Distributions of the remaining business cash flow are FICA-tax-free.

Whatever the reason for wishing to convert your partnership into an S corporation, here’s a description and a summary of the key federal income tax implications.

Execute a Section 351 Incorporation

Great news: You can transfer the liabilities, business assets, and operations of your partnership to a C corporation by incorporating the partnership. This can potentially be an absolutely federal-income-tax-free deal under Section 351 of our cherished Internal Revenue Code. Or it can be mainly tax-free.

You can then turn the C corporation into an S corporation.

Section 351 treatment for the incorporation of a partnership is allowed when all the listed below requirements are satisfied.

One or more persons (which can consist of the partnership itself or its partners) transfer property (assets, which can consist of cash) to the corporation.
The transfer is entirely in exchange for the stock of the corporation.
The individual or individuals (the partnership itself or its partners) are in control of the corporation right away following the transfer. Control indicates owning at least 80 percent of the stock.
The transaction has a business function. The IRS developed this additional requirement but satisfying it needs not to be an issue. For example, incorporating to benefit from the liability security provided by the corporate form of doing business would be an acceptable purpose. So would providing for the organized transfer of ownership of an organization from one generation to the next.

Bottom line. What would otherwise be a totally tax-free Section 351 deal can be partially taxable when boot (money and/or property) is gotten in addition to stock in the brand-new corporation.

With Proper Timing, Your Partnership Can Simply Convert into a Corporation and Simultaneously Elect S Status

An eligible entity (such as a multi-member LLC) that’s classified as a partnership for federal tax purposes under the so-called check-the-box regulations can elect to be treated for tax purposes as an S corporation without going through an actual Section 351 incorporation transaction.

Under this option, the partnership is treated as contributing all of its assets and liabilities to the corporation in exchange for stock. The partnership is then treated as having liquidated by distributing the stock to its partners immediately before the close of the day before the election to be treated as a corporation becomes effective.

So, if the election to convert from a Partnership into an S Corp status takes effect on the first day of the tax year, the entity will be a partnership until the end of the previous tax year and then become a corporation on the first day of the next tax year.

If the new corporation then makes a timely S corporation election on IRS Form 2553 (Election by a Small Business Corporation) for its first tax year, the corporation will be an S corporation for that entire year.

Example. Your partnership elects to become a corporation effective January 1, 2023. The new corporation can be treated as an S corporation for the tax year beginning on January 1, 2023, by filing IRS Form 2553 by March 15, 2023, to elect S corporation status for that year.

S Corporation Limitations and Tax Filing Requirements

Only domestic entities are eligible to elect S corporation status.

An S corporation cannot have more than 100 shareholders, and all shareholders must be individuals and/or eligible trusts and estates.

For loss deduction purposes, partners receive additional tax basis from their shares of partnership liabilities. In contrast, S corporation shareholders cannot deduct losses in excess of the basis in their shares plus the amount of any direct loans to the S corporation.

Like partnerships, S corporations must file an annual federal income tax return (on Form 1120-S) and issue a Schedule K-1 to each shareholder to report that shareholder’s percentage of S corporation tax items. Those tax items are then reported on each shareholder’s federal income tax return (Form 1040 for individual shareholders).

Takeaways

A partnership can convert to an S corporation in a variety of ways. The good news is that most ways allow the partnership to make the conversion without inflicting income tax on the partners.

The tax results when Section 351 applies are not elective. When you meet the Section 351 requirements, the tax results are what they are. One result is that there cannot be any taxable loss in a Section 351 incorporation.

To avoid unnecessary complications, the partnership should target its conversion to a C corporation and then to an S corporation for the first day of the corporation’s tax year (generally January 1).

Note: with an LLC that’s treated as a partnership, the LLC can bypass the incorporation route, elect corporate status, and use IRS Form 2553 to elect S corporation status.

If you would like to talk about converting your Partnership into an S Corp, please call me on my direct line at 509-543-7600 or send a request HERE.

September 2022

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