Category: Partnerships & LLCs; Nontaxable
Exchanges; Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Superficially, Section 351 is potentially valid no matter whether A) partnership assets are transferred in exchange for stock; or B) the partnership interests are transferred. Both forms are acceptable as far as Section 351 is concerned provided that all the requirements of the statute are met. Revenue Ruling 84-111, 1984-2 CB 88, provides that a partnership may be validly incorporated under Section 351 in any one of three methods: A) the partnership transfers its assets in exchange for stock then liquidates distributing the stock to the partners; B) the partnership liquidates and the partners join together in contributing the former partnership assets to the controlled corporation; or C) the partners contribute their partnership interests to the controlled corporation. The ruling points out that while the consequences under Section 351 are the same for each possible means of incorporation, i.e., a valid Section 351 transaction is possible under all three scenarios, the various three methodologies can produce different results with respect to basis, holding period, liabilities in excess of basis, etc. The implication of the ruling is that the form in which the incorporation is cast will be respected by the Service and can produce variations in results with respect to the items just mentioned. I urge you to read the text of the ruling and pursue any differences that may exist as between any of the alternatives methods presented in the ruling which you deem viable after consideration of your legal and practical constraints. Please let me know if you need a copy of the text of the ruling. In addition, it is often overlooked that the various different methodologies of incorporation may yield different results from the standpoint of state and/or local income, property tax, or sales tax perspectives. These considerations can be significant and should be carefully considered. As we discussed, I believe that under the facts you have described, it is essential that the partnership be dissolved if partnership assets are contributed to the controlled corporation in exchange for stock pursuant to Section 351. The transferors under Section 351 must be in control of the transferee corporation immediately after the transfer. With only a minor exception not applicable here, only direct stock ownership counts for control purposes. In other words, none of the various constructive ownership rules apply for this purpose. Accordingly, if partnership assets are contributed in exchange for stock and the partnership is not immediately dissolved, ownership of the transferee corporation will be split between the partnership and the partners. Since the partners were not contributors and since the constructive ownership rules do not apply, the stock owned by the partners does not count towards the 80% control requirement. Accordingly, the 80% control requirement of Section 351 and 368(c) may be violated thus destroying Section 351 treatment. Finally, there seems to be a fourth alternative: the current owners of the corporation could contribute their shares to the partnership in exchange for partnership interests. This should be tax free under Section 721. As a result, the partnership would then own 100% of the stock of the corporation. Thereafter, the partnership could contribute all its assets and liabilities to the corporation in exchange for stock of the corporation. In this case, it would not be necessary to dissolve the partnership in order to meet the control requirement under Section 351 and 368(c). I strongly recommend that the taxpayers carefully document the form in which the transaction is to be cast including the following precautions.
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