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From Partnership to Corp: Option 1
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-1
Corp
Stock
Tax Impacts:• No gain or loss recognized
• Partnership’s asset basis transfers to C corp
• Partnership terminated
• Owner’s stock basis equals basis in partnership interest (adjusted for debt transfers to corp)
• Owners not original issuees – 1244 impact and potential S election impact in year 1
Owners
Partnership
Assets & liabilities
Stock inliquidation
From Partnership to Corp: Option 2
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-2
Corp
Stock
Tax Impacts:• No gain or loss to Partnership or Corp
• Partnership terminated
• No gain or loss to owners unless money in excess of basis is distributed
• Owners’ basis in assets equal basis in partnership interests, which carries over to Corp and determines Owners’ basis in stock
• Owners original issuees of stock
Owners
Partnership
Assets & liabilities
Assets and liabilities in liquidation
From Partnership to Corp: Option 3
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-3
Corp
Stock
Tax Impacts:• No gain or loss to Partnership or Owners
• Partnership terminated
• No gain or loss to Corp unless money in excess of basis is distributed
• Owners’ basis in stock equals basis in partnership interests, which carries over to Corp and determines Corp’s basis in assets
• Owners original issuees of stock
Owners
Partnership
Partnership Interests
Assets and liabilities in liquidation
Check The Box
• No need to form corp or transfer assets and liabilities
• Entity remains the same – only tax status changes
• Reduces paperwork and third party hassles
• Tax consequences same as option 1- Partnership contribution followed by Partnership liquidation
• No corporate “trappings” benefits
• No S status capacity
• No tax-preferred employee benefits to owner/employees
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-4
From Partnership to Corp: Option 4
Piece of Cake
• No entity change nor need to transfer assets and liabilities
• Entity remains the same – only tax status changes
• Revoke S election (takes majority) or cease to qualify as S
• Specify effective date to ease accounting and tax hassles. Default date is first day of next taxable year unless revocation before 15th day of 3rd month of current year
• Mid-year effective date creates short S year and short C year – allocation options
• No election back into S status for 5 yrs
• Bailout S earnings that have already been taxed to shareholders – 1371(e) one year bailout period
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-5
From S status C status
Problem 5-A: Colson Inc.
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-6
C Corp
Three Golfer Owners
Two LimitedPartnerships
One ToilerOwner
Two Golfer Owners
Common & PreferredCommon & Preferred
Big Loans
Common &Preferred
Common &Preferred
Challenge: Convert to Pass Thru Entity
Convert to LLC or Partnership?
• Prohibitively tax expensive
• Full recognition of all asset gains at corporate level
• Full recognition of capital gains at shareholder level
• S corp only viable option
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-7
Problem 5-A: Colson Inc.
Election Mechanics
• Election effective on first day of following year • 2 ½ month retroactive election not possible because
not eligible shareholder on 1st day of current year
• Must be eligible for S at time of election – no disqualified shareholders or 2nd class of stock
• S tax year calendar year unless sustain business purpose proof burden for fiscal year
• All shareholders must consent (Form 2553) – community and joint interest owners
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-8
Problem 5-A: Colson Inc.
S Eligibility Problems
• Limited partnerships not eligible S shareholders
• Preferred stock not permitted with S status
• Shareholder loans could trigger one class of stock requirement
• Any stock options held by toiler owner or other owners could violate one class of stock requirement
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-9
Problem 5-A: Colson Inc.
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-10
Getting rid of ineligible shareholders:
• Partnership shareholders: Redeem stock or have stock distributed to eligible partners
• Corporate Shareholder: Redeem stock; merge or reorganize to eliminate corporate shareholder; have corporate shareholder distribute or sell stock to eligible S shareholders
• Non-qualified trusts and estates: Redeem stock or distribute to qualified S shareholders
C to S Conversion: Getting Eligible
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-11
Getting rid of second class of stock issues:
• Preferred stock: Redeem or E Reorg (“Reclassification”)
• Risky debt: Reform to fit within safe harbor of 1361(c)(5)(B)
• Options and warrants “in the money”: Buy back or have them exercised.
• Options and warrants “not in money”: Make sure strike price is at least 90% of FMV. May present too tough of a valuation issue. Best course may be to buy back or trigger exercise.
C to S Conversion: Getting Eligible
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-12
Nothing Too Tough:
• Written unconditional promise to pay on demand or at time certain
• Interest rate and payments not contingent on profits, discretion, etc.
• Debt not convertible to stock
• Creditor eligible S shareholder or party in business of loaning money
Note: Safe Harbor protects only S election – has no impact on broader tax debt-equity issues
Debt Safe Harbor of 1361(c) (5) (B)
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-13
1. LIFO Inventory Trap – LIFO inventory reserve recaptured over four years
2. C Corp E & P Trap – Post-conversion distributions in excess of S corp accumulated adjustment account will trigger taxable dividends to shareholders to extend of C corp E & P
3. The Passive Income Trap of 1375
4. The BIG Tax Trap of 1374
Potential Conversion Tax Traps
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-14
• Royalties
• Dividends
• Interest
• Annuities
• Sales or exchanges of stocks or securities
Note: Looks more like portfolio income. But for 1375 purposes, called “passive income”
DO NOT CONFUSE WITH 469 PASSIVE INCOME
S Passive Income – Not Like the Other Passive
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-15
Passive Income S Penalties
Penalty One: S Corp has accumulated earnings and profits for three years and passive S receipts more than 25% total receipts.
S election terminated. 1362(d)(3)
Penalty Two: S Corp has accumulated earnings and profits and passive S receipts more than 25% total receipts. Entity level tax equal to 35% of “excess net passive income.” How to calculate:
- First, “net passive income” = passive income less passive expenses
- Second, ratio with numerator equal passive income over 25% of gross receipts and denominator equal to total passive income
- Third, multiple “net passive income” by ratio to arrive at “excess passive income”
- Limit – excess passive income can’t exceed corp’s taxable income
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-16
1. Be aware – keep an eye on receipts
2. Bail accumulated C Corp E & P at 15% rate with 1368(e)(3) election
3. Distribute or sell investments that trigger passive S to get below 25%
4. Increase active receipts relative to passive – do more business or stick additional operation or active business in S
Stay Clear of Passive S Penalties
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-17C to S: The “BIG” Tax Trap
• Huge exception to “no entity tax” rule
• Applies only when C corp has converted to S corp
• Purpose is to limit ability to convert and then sell and strip income with no double tax hit
• “BIG” stands for “Built-in-Gain”
• May also have built-in loss
• Major factor in converting from C to S corp.
• Although BIG tax can be rough, nothing compared to going from C Corp to partnership or LLC
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-18How “BIG” Trap Works
• Determine built-in gain or loss at time of conversion for all assets. This is gap between FMV and basis. Requires appraisals
• If asset sold during 10 years after conversion (“recognition period”), any gain or loss recognized up to “Built-in” amount taxed at corporate level
• Tax rate is highest corporate rate – 35%
• Income still taxed at shareholder level, but BIG tax treated as loss. 1366(f)(2)
• BIG income may not exceed corp income for year if taxed as C corp. Carry forward any excess
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-19How “BIG” Trap Works
• BIG income from any sale may not exceed total BIG income at conversion less BIG income previously recognized.
• Carry-over BIG income potential in non-recognition transactions (i.e. 1031, 1034), tax-free corporate reorgs.
• Installment sales during 10 year period that defers income beyond ten year window doesn’t help. Recognition period extended.
• Recognized BIG losses during 10 year window can offset recognized BIG income.
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-20
• Convert early, carefully document assets at conversion
• Pre-conversion – hang onto losers, but watch out for “loss stuffing”
• Collect zero basis receivables before conversion. May require factoring
• Accrue bonuses and similar expenses prior to conversion – counts in reducing total built-in amount at conversion
• Match BIGs and BILs during 10 year recognition period to extent possible
• Use non-recognition transaction (1031, 1033) to get through non-recognition period
• Work goodwill/going concern valuation
Strategies to Mitigate BIG Tax
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-21
• No termination of partnership for tax purposes under 708
• No sale, exchange or liquidation of owners’ interests
• No close of the entity’s tax year
• No tax year close with respect to any owner
• No need to obtain new federal tax ID number
From Partnership to LLC Status (Rev. Rule 95-37)
Problem 5-B: Larson Electronics, LLC
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-22
LLC
80% LLCInterests
Admit two new partners – each 10%
• Tax status of entity converts from sole proprietorship to partnership.
• Joel deemed to have sold 20% of each asset in taxable transaction. Recognizes gain.
• Joel and new partners deemed to have made tax-free 721 transfers to a new partnership
• New partners’ basis in partnership interest is amount paid Joel. Joel’s basis is basis in assets deemed transferred.
• LLC takes carryover basis and tacked holding period
Joel
New Partners
80% of Assets
20% of Assets
20% LLC Interests
20% of Assets
Cash & notes
Problem 5-B: Larson Electronics, LLC
Copyright 2005 Dwight Drake. All Rights Reserved.Business Planning: Closely Held Enterpriseswww. drake-business-planning.com
5-23
LLC
Conversion to C Status
Joel and New Owners make 351 tax free transfer of LLC interests to new C corp for stock.
• Joel and New Owners stock basis equal to LLC basis. Tacked holding period.
• On liquidation of LLC, C corp’s basis in assets equals basis in LLC interests received from Joel and New Owners.
• No gain or loss to C corp. unless money in excess of basis received. No gain to LLC.
• Joel and New Owners original issuees of C corp stock
Joel
New C Corp
Assets inLiquidation
20% LLC Interests
NewOwners
Stock
80% LLC Interests
Stock