By Timothy R. Koski
Unintended Tax Consequences
Converting a partnership to a limited liability company usually makes a lot of sense. Partners put their personal assets at risk to the extent the assets of a partnership are not sufficient to pay all its obligations. On the other hand, the exposure of an LLC owner is generally limited by the amount of her investment in the LLC. A conversion is even more enticing because, as a general rule, the conversion of a partnership to an LLC is treated the same as the conversion of a partnership to another partnership. This means the LLC can keep the same tax year-end and continue to be taxed as a partnership.
Caution and proper planning are crucial when converting to an LLC, because a change in the share of a partner's (now owner's) liabilities is treated as a distribution of money to the individual, which can have tax consequences.
The shift in liabilities generally occurs as a result of the new protection that LLCs offer owners. One liability-shifting event could be the lender requiring personal guarantees from one or more of the LLC owners before agreeing to the conversion. A much more complicated shift occurs when the partners' profit sharing percentages differ from their loss sharing percentages.
Conversion of a general partnership to a limited liability company (LLC) provides limited liability protection for owners while retaining partnership treatment for tax purposes. Because of this "best of both worlds" treatment, many partnerships have converted, or are considering converting, to LLCs. Although the conversion of a partnership to an LLC can be accomplished without adverse tax consequences, proper planning is essential, lest one or more partners find themselves with an unexpected tax bill.
Revenue Ruling 95-37 describes the tax consequences of the conversion of a partnership to an LLC. It states that a partnership to LLC conversion is treated as a partnership to partnership conversion and is subject to the rules set forth in Revenue Ruling 84-52. That ruling describes the tax consequences of the conversion of a general partnership into a limited partnership. The conversion does not cause a partnership termination under IRC section 708 or a sale, exchange, or liquidation of a partner's partnership interest under IRC section 706. Therefore, the taxable year of the partnership does not close with respect to any of the partners. The business (now an LLC in a partnership to LLC conversion) continues to be taxed as a partnership, and in most situations no adverse tax consequences occur.
Like a partnership to partnership conversion, however, a partnership to LLC conversion may result in a change in how the partners share liabilities. Such a change may result in one or more partners recognizing gain under IRC section 752. For example, Revenue Ruling 84-52 held that gain must be recognized by a partner to the extent that a deemed distribution exceeds the adjusted basis of that partner's partnership interest. The IRS has made it clear in several private letter rulings that this rule also applies to a partnership to LLC conversion (See, e.g., PLR 9525065).
Under Regulations section 1.752-1(c), a decrease in a partner's share of partnership liabilities is treated as a distribution of money to the partner. IRC section 733 provides that such a deemed distribution reduces a partner's basis in the partnership interest. A deemed distribution in excess of basis results in capital gain to the partner under IRC section 731. Because of this potential gain recognition, the impact of IRC section 752 on each partner should be considered before converting a partnership to an LLC.
Not every partnership to LLC conversion will result in a liability shift. If a partnership has only nonrecourse liabilities, for example, partnership liabilities will retain their character as nonrecourse after the conversion, and no liability shift will occur. If a partnership has recourse liabilities, however, a liability shift may occur, and the tax consequences should be completely analyzed prior to the conversion.
A shift in a partner's share of partnership liabilities is likely to occur in two situations. First, a shift in liability sharing may occur if one or more, but not all, partners personally guarantee partnership debt after conversion to an LLC. The second potential shift in liability sharing occurs when partners share profits and losses in different ratios. Both of these situations are reviewed below.
Personal Guarantee of Partnership Debt
It is likely that the conversion of a general partnership to an LLC will not be permitted under the terms of existing partnership loan agreements. It is equally likely that, before agreeing to the conversion, the lender will ask for the personal guarantee of one or more partners. The personal guarantee of one or more, but not all, partners will result in a significant liability shift under IRC section 752. As the following example illustrates, such a liability shift may result in capital gain to one or more partners.
Example 1: Ann, Betty, and Carla are general partners in ABC Partnership. The partners share partnership profits and losses equally. Each partner has a basis in her partnership interest of $10,000, including a $30,000 share of the partnership's $90,000 recourse liability. The partnership converts to an LLC. In order for the lender to agree to the conversion, Ann and Betty personally guarantee the $90,000 liability. Carla does not personally guarantee the liability.
As a result of the conversion, Ann and Betty's partnership liabilities increase from $30,000 to $45,000. Carla's share of partnership liabilities, on the other hand, decreases from $30,000 to zero. Under Regulations section 1.752-1(c), this decrease in a partner's share of partnership liabilities is treated as a distribution of money to the partner. As a result, Carla's basis in her partnership interest is reduced to zero and she recognizes a $20,000 capital gain. The impact of the partnership to LLC conversion on Ann, Betty, and Carla is summarized in Exhibit 1
Planning to Avoid Gain Recognition
Gain recognition resulting from a shift in partnership liabilities among partners can be avoided with proper planning. An obvious and simple solution in the example is to have all three partners personally guarantee the entire amount of partnership debt. If one of the major reasons for the LLC conversion, however, was to reduce the amount of liabilities that Carla is personally responsible for, a full guarantee of partnership debt may not be an acceptable alternative.
Another possibility, if the lender agrees, would be for Ann, Betty, and Carla to guarantee the debt on a pro rata basis. There is no liability shift, and, therefore, no gain recognition would occur. This strategy would enable Carla to be relieved of liability for some, but not all, partnership debt.
Even if some or all of the partners personally guarantee existing partnership liabilities, the conversion to an LLC will still provide limited liability protection with respect to other potential liabilities arising in the course of business, as well as partnership debt that the owners do not personally guarantee.
Gain recognition can also be avoided by making an additional cash contribution to the partnership. In the above example, Carla would make an additional $20,000 contribution to the partnership, which would increase the basis in her partnership interest under Section 722. As illustrated in Exhibit 2, the increase in basis resulting from the additional cash contribution would offset the deemed distribution resulting from the shift in partnership liabilities; therefore, Carla would avoid recognizing any capital gain. The $20,000 Carla contributed to the partnership (now an LLC) would be at risk, but Carla would avoid both gain recognition and personal liability on the existing partnership debt. Carla could receive a $20,000 distribution from the partnership at some time in the future when she has sufficient basis in her partnership interest to do so without recognizing any capital gain.
There may be instances where a partner is willing to accept a reduction in basis, or even recognition of a small amount of capital gain, in return for release from liability. In any event, proper planning and full disclosure of the tax consequences to each partner are important.
Potential Gain Recognition: Different Profit and Loss Sharing Ratios
Shifts in liability sharing may also occur in a conversion to an LLC if partners share profits and losses in different ratios. The shift is possible because there are different rules for determining how recourse and nonrecourse liabilities are allocated among partners. The recourse liability sharing rules are set forth in Regulations section 1.752-2. These rules require a complex constructive liquidation analysis, in which it is assumed that the partnership is liquidated. The economic risk of loss, which is the obligation of each partner to make payment to creditors or a contribution to the partnership to satisfy partnership liabilities, must be determined for each partner. In most situations, application of this constructive liquidation analysis results in partners sharing recourse liabilities in accordance with their loss sharing ratio.
The nonrecourse liability sharing
rules are set forth in Regulations section 1.752-3. In general, although the minimum gain rules of IRC section 704(b) must be considered, nonrecourse liabilities are shared in accordance with the partners' profit sharing ratio.
If there are no personal guarantees involved, the conversion of a general partnership to an LLC will result in recourse liabilities becoming nonrecourse liabilities. If recourse liabilities are apportioned in accordance with loss sharing ratios and nonrecourse liabilities apportioned in accordance with profit sharing ratios, a liability shift may occur. The following example illustrates how this might result in gain recognition.
Example 2: Debbie and Edith are general partners in DE Partnership. The partners share profits equally. Losses, however, are allocated 70% to Debbie and 30% to Edith. The partnership has $100,000 of recourse liabilities. Because DE is a general partnership, these liabilities are recourse to both Debbie and Edith before the conversion. Assume that application of the constructive liquidation rules of Regulations section 1.752-2 results in the sharing of partnership liabilities in accordance with loss sharing ratios. Assume also that Debbie's basis in her partnership interest is $10,000, including her 70% share of partnership liabilities. Edith's basis in her partnership interest is $10,000, including her 30% share of partnership liabilities. The partnership converts to an LLC and neither Debbie nor Edith personally guarantee any partnership debt.
After the conversion to an LLC, the partners are no longer liable for debts of the organization that aren't personally guaranteed, and the existing partnership liabilities will eventually become nonrecourse. Nonrecourse liabilities are allocated between partners in accordance with the nonrecourse liability sharing rules set forth in Regulations section 1.752-3. The nonrecourse liabilities are shared by Debbie and Edith in accordance with their profit sharing ratio. Because the 50/50 profit sharing ratio rather than the 70/30 loss sharing ratio is used to determine basis, Debbie's share of partnership liabilities decreases by $20,000, while Edith's increases by $20,000. As illustrated in Exhibit 3, this shift in liabilities results in Debbie recognizing a $10,000 capital gain.
As has been demonstrated, an analysis of partnership liabilities is an essential part of any partnership to LLC conversion because of the potential for gain recognition. Although a shift in how liabilities are shared is the most likely cause of gain recognition, it is not the only one. Other potential gain recognition exists under the at-risk rules of IRC section 465. If the conversion of a partnership to an LLC results in a reduction in the amount a partner has at risk in the enterprise (e.g., the partnership has recourse debt that is not personally guaranteed), the at-risk recapture rules of IRC section 465(e) must be considered. That section says gain recognition occurs if a partner has recognized losses in previous years and a reduction in the amount she has at risk causes the amount to become negative. At-risk recapture is only a concern in cases where the partnership is subject to the at-risk rules and losses have been recognized in prior years.
A change in entity composition also requires careful analysis. The admission of a new partner, for example, will result in a shift in partnership liabilities. The type of partner to be admitted must also be considered. If, for example, a partnership that uses the cash method of accounting admits a C corporation as a partner in an LLC conversion, it may lose the ability to use the cash method because of the limitations set forth in IRC section 448. This prohibition does not apply to an entity engaged in farming, or one with gross receipts of not more than $5 million. If the entity is required to change from the cash method of accounting to the accrual method, gain recognition under IRC section 481 may result. *
Timothy R. Koski, JD, LLM, PhD, CPA, is an attorney specializing in taxation and an assistant professor of accounting at the University of Southern Indiana.
The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.