One of the most interesting provisions of the Build Back Better Act, for me anyway, is the opportunity it provides for a tax-free conversion into a partnership for certain S corporations. There may be people who don’t find it exciting to think that partnerships and S corporations are both middleman, so it’s six of one, half a dozen of the other. But there are big differences. And this arrangement can be a great opportunity for some.
The way the opportunity is structured is to treat the liquidation of Company S into a domestic partnership as if it were the liquidation of a wholly owned subsidiary of a company into its parent company (Section 332 ( b)). To be eligible, the corporation must have been an S corporation on May 13, 1996.
Why May 13, 1996? That’s when the “tick the box” regulation came out. The regulation replaced a complex factor analysis that determined whether an entity could be taxed as a partnership. Simplistically, the regulations allowed you to choose whether an entity that was not a corporation would be treated as a corporation or a partnership (or an ignored entity if there were not multiple owners). Essentially, pre-registration entities have the option of checking the box.
A different provision that will apply net investment income tax to the income of high-income taxpayers takes some of the fun of being an S corporation (i.e. the ability to avoid certain security taxes social security and health insurance as long as a “reasonable wage” is paid.)
Why partnership can be better
S corporations face a number of restrictions. There is the single class rule of stock unlike the wide variety of ways in which partnerships can allocate income. This can be a reason why people do not like the form of partnership, as it leads to the adoption of complex structures. Just because you can complicate things doesn’t mean you have to.
There are also much stricter limitations on who can be a shareholder of S Corporation. Basically it’s about individuals who are American people and certain types of trusts. No strangers, companies or partnerships. Partnerships don’t have those kinds of restrictions.
It is probably in the area of seating that the partnership form really shines. It deserves a discussion on its own.
About the base
If you and your siblings start a business with capital contributions, run it debt-free, and don’t have other owners coming and going, chances are your individual returns will be about the same. , whether it is the partnership or the company S. form is used. That’s until one of you wants to be redeemed or, you know, dies while the other goes on.
Partners have an additional basis in their partnership interest based on their share of the partnership liabilities. The shareholders of S Corporation do not. S Corporation shareholders who have problems with basic loss limits often show up in tax litigation and it doesn’t turn out well for them. You can consider some examples here and here. The way the partnership attribution rules work, it’s actually quite handy to attribute a loss to someone that they have no basis for.
Considering our siblings (let’s call them Robin and Terry) who, having happily worked together for twenty-five years, now want to go their separate ways, this arrangement could be wonderful. Imagine that RT Inc has amassed a substantial amount of goodwill. If RT Inc buys Terry with a substantial gain, Terry has a substantial gain and that’s pretty much the end of the story from a tax standpoint. With RT Partners, an election of 754 would give Robin a stronger base in goodwill, which could be written off. The same magic would work for Terry’s heirs.
Then there is the issue of valued assets, which can be distributed from a partnership without being recognized.
Overall, this arrangement will create a great opportunity. I am totally mystified by how this has found its way into BBB. It’s probably a great story and I wish I had the investigative resources to find it out.
The good news for tax professionals who know how to bill is that this provision will require study. Each S corporation old enough to have a master’s degree will need to be examined to determine if it would be preferable for it to be a partnership. One problem is what’s going on with the base. The rule in a 332 liquidation is that the successor company has a deferral basis in the assets. So, if there is an excess base in the inventory, liquidation 332 causes that base to become “poof”.
But what about the liabilities? The successor “corporation” is not a corporation, it is a partnership. And the basis of a partner in his partnership interest includes his share of the liabilities. Will this basis of liability apply in one way or another to the assets? It will be necessary to clarify these questions to determine if the conversion might be a good decision.
There is a clause that prevents the partnership from reverting to an S corporation faster than it could have if it were a corporation.
Another complex analysis will be the effect the change might have on state and local income tax and possibly property tax. Remember Reilly’s Fifth Tax Planning Law – A tax plan that ignores SALT or AMT is not really a tax plan.
Finally, a partnership requires “partners”. The provision does not appear to allow the liquidation of a sole proprietorship S Corp into an ignored entity. I can think of getting around this obstacle, but I would wait for advice before offering it.
This relief will be available for the two-year period starting December 31, 2021.
PWC mentions the provision as well as several others in Changes to the tax on flow-through entities in the construction of the house Better invoice. Their commentary on state matters is well done.
While the conversion of the S corporation would be exempt from tax for federal income tax purposes under these proposals, it will be important to examine the state and local tax jurisdictions in which the S corporation operates. Suspected gains may be triggered for state and local tax purposes due to non-compliance with the applicable tax code as revised if this provision is enacted. State and local adoption of the Internal Revenue Code varies widely, but is generally done on an ongoing basis, on a fixed date, or in accordance with certain provisions. To the extent that a jurisdiction does not adopt the Internal Revenue Code on an ongoing basis, there could be unanticipated national and local tax consequences of a conversion to an S corporation.