What are the Benefits Associated with Conversion?
For many businesses exploring the possibility of converting a business entity from a C or an S corporation to a limited partnership, the following benefits are sought: 1) exemption from franchise tax; 2) business asset protection; and 3) compression in value of business for transfer tax purposes. Under the Texas Business Corporation Act, a corporation may convert to a limited partnership. Immediately after the conversion, the limited partnership may elect under the check-the-box regulations to be treated as a corporation by filing Form 8832. If the limited partnership (converted entity) elects to be taxed as a corporation, the conversion of the corporation to a limited partnership should be deemed a tax-free F reorganization, which is a mere change in identity, form, or place of organization of a corporation. The converted entity will inherit the federal tax attributes of the former corporation including: taxable year, employer identification number, and other tax elections.
1. Franchise Taxes.
When a closely held corporation or limited liability company is paying high franchise taxes, such business might consider converting to a limited partnership to avoid the franchise tax. For years, Texas legislators have introduced amendments to Section 171.001 of the Texas Tax Code to subject limited partnerships to taxation. Yvonne Davis, a legislator from Dallas, Texas, recently introduced House Bill 894 which proposed to amend Section 171.001(b)(3) to change the definition of “corporation.” The bill proposes to include in the definition of “corporation” “a business trust, limited liability company, or other entity that, for federal income tax purposes, is classified as a corporation . . .” If this bill passes, the number of conversions of corporations to limited partnerships motivated by the avoidance of the Texas franchise tax will taper off.
There is a way to eliminate the franchise tax in the State of Texas on an entity taxed as a corporation at the federal and state level. Find out more...
2. Asset Protection.
When the shareholders of a closely held corporation seek business asset protection, then such shareholders might consider converting to a limited liability company or limited partnership under Texas state law. As previously discussed, such entities offer superior asset protection capabilities compared to a corporation because the assets of the limited partnership and the limited liability company are protected from attachment by the judgment creditor of a limited partner or member. The superior asset protection attributes offered by the limited liability company and the limited partnership will be discussed at length later in this outline.
3. Compression in Value of Business Interests.
It is possible to obtain a greater compression in value of the assets inside a corporation if such corporation is converted to a limited partnership. This compression in value is due to the discounts a limited partnership interest receives as compared to a corporation. For example, a corporation might receive a discount for a block of shares owned by a shareholder if those shares represent a minority interest in the corporation. With a limited partnership, a limited partner can own a majority of the interests in such entity and still receive valuation discounts for lack of marketability, lack of control and lack of liquidity. These discounts ultimately give the interests owned by the limited partner a higher discount in value for transfer tax purposes in relation to the discounts achieved with the corporation’s minority shareholder’s block of stock.
Steps to Performing a Conversion in Texas:
- Determine What Type of Entity You Are Converting and How it Is Taxed.
- Determine Your Goal in Converting. Is the main goal to reduce franchise taxes, obtain better asset protection, or receive a compression in value?
- Structure Requirements for Different Entities:
a. Conversion of S Corporation into Limited Partnership. If an S corporation seeks to maintain its subchapter S status at the federal level while converting to a limited partnership with a limited liability company as a general partner at the state level, the limited liability company must be a single member limited liability company and, as a consequence, a disregarded entity at the federal level. If the limited liability company has more than one member, it will not be a disregarded entity for federal tax purposes. Rather, the multiple member limited liability company must be treated as either a corporation, S corporation, or partnership for federal tax purposes, and none of those entities are permitted shareholders of a subchapter S corporation.
After creation, the limited partnership must file Form 8832, electing to be taxed as an association taxable as a corporation, and Form 2553, electing to be taxed as a subchapter S corporation. This election will continue the prior taxation of the converted entity.
While the IRS has previously sanctioned the conversion of an S corporation into a limited partnership with a limited liability company as the general partner in a private letter ruling, it is currently unclear whether the IRS will determine that a business converting from an S corporation into limited partnership with a limited liability company as general partner for state tax purposes may maintain its subchapter S status for federal tax purposes. In a recent publication of revenue procedure, the IRS hinted that a limited partnership with a limited liability company as general partner might be deemed to have two classes of stock and fail to qualify for subchapter S tax treatment.
In light of the uncertainty the IRS has raised by their “no rule” policy on the issue of whether a limited partnership has two classes of stock, a more cautious, yet less direct approach might be to convert the S corporation to a Texas general partnership which elects to be taxed as an association taxable as a subchapter S corporation. Before such a conversion takes place, however, the S corporation should contribute all of its assets to a Texas limited partnership in which a limited liability company is the general partner. In exchange, the S corporation would receive a 99% limited partnership interest in the new limited partnership. After transferring the assets and receiving the limited partnership interests, the S corporation, whose primary asset is a 99% interest in the Texas limited partnership, should convert to a Texas general partnership. The resulting conversion should: 1) qualify as a tax-free F reorganization; 2) avoid the second class of stock issue raised by Rev. Proc. 99-51, 1999-52 IRB 760; and 3) provide the general partners of the converted entity (who are the former shareholders of the S corporation) with the limited liability of a limited partnership.
b. Conversion of C Corporation into Limited Partnership. The conversion of a C corporation is similar to the conversion of an S corporation except that Form 2553 need not be filed. Additionally, the second class of stock issue is irrelevant. It is important that the limited partnership (converted entity) maintain the same tax attributes as the C corporation (converting entity) by filing Form 8832 to avoid a liquidation event.
c. Conversion of S Corporation into Limited Liability Company. If an S corporation, seeking to enhance its liability protection, converts to a limited liability company, the limited liability company must File for 8832 and Form 2553 to continue the tax attributes of the S corporation (the converting entity) and avoid a liquidation event.
d. Conversion of Sole Proprietorship or General Partnership. With a partnership or sole proprietorship, the dissolution of the previous entity and the contribution into a new entity’s assets will be deemed a nontaxable event and no special filings such as articles of conversion are needed to be filed with the secretary of state.
|
