Category: Partnerships & LLCs
Subject: Conversion of General partnership to LLC
Title: Mechanics of Conversion, Related Tax Issues
IRC Sections: 731(a)(1)
Filename: 1270.html
Date Produced: 09/95

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Taxpayer (TP) is a general partnership desirous of converting to an LLC. If TP were dissolved (or deemed dissolved) for tax purposes, one or more of TP's partners would receive cash in excess of basis thereby triggering gain recognition under Section 731(a)(1).

For whatever reason, the conversion of TP from a partnership into an LLC will take the form of a contribution of TP interests by the partners to the newly formed LLC in exchange for LLC interests. Under applicable state law, TP will be dissolved.

As I understand it, a new federal identification number has been obtained for the LLC, and it is contemplated that the partnership tax year will be cut off at the date of the conversion. If TP's tax year were cut off by the conversion, the final partnership year would show income and the initial LLC year would show a loss due to aberrations of the cash method of accounting

Revenue Ruling 84-52, 1984-1 CB 157, provides that the conversion of a general partnership to a limited partnership by means of a change in the partnership agreement will not constitute a termination of the partnership for tax purposes. Revenue Ruling 95-37, 1995-17 IRB 10, provides that Revenue Ruling 84-52 applies to conversion of a partnership to an LLC. The ruling further holds that A) the tax year of the old partnership does not terminate as a result of the conversion; and B) the newly formed LLC need not obtain a new federal identification number.

The series of rulings set forth above clearly indicates that for tax purposes, the IRS views conversion of a partnership into an LLC as something other than a dissolution (for tax purposes) of the converting partnership. Accordingly, this would seem to put to rest the issue of gain recognition under Section 731 by virtue of a distribution (or deemed distribution) of cash in excess of the basis of a partner's interest: absent a deemed dissolution of the partnership for tax purposes, there can be no deemed distribution of cash in excess of interest basis. I am unable to find anything in my research (neither commentary, nor authoritative pronouncements, nor private rulings) to cast any more light on this situation.

I offer the following thoughts based on my own instincts.

1. It seems to me that TP is protected as long as the IRS does not change its mind on this issue by modifying or revoking existing rulings. Obviously, the IRS could reverse itself if it so chose. Further, the IRS is not bound to follow its own rulings.

2. I am strongly constrained to point out that there is a method of conversion that avoids the issue altogether: i.e., transfer of TP's assets to the LLC in exchange for LLC interests followed by a distribution of the LLC interests to TP's partners. I cannot think of a tax reason why this method should not be acceptable. If there is a state law problem resulting from the momentary situation in which the LLC has only one member, I suggest the partners of TP should each make a nominal contribution to the LLC in exchange for LLC interests. Thereafter, the assets of TP could be contributed in exchange for additional LLC interests, and the one-member problem could be entirely avoided.

3. As to the mechanical issues, consider the following.

A) Notwithstanding the existence of a new federal identification number for the LLC, Rev. Rul. 95-37 has provided specific guidance regarding this issue: i.e., no new FEIN is required and the partnership tax year is not terminated.

B) I see no reason to take a position contrary to Rev. Rul. 95-37 simply because a new FEIN has been obtained. Continue the tax year and FEIN notwithstanding the conversion. Undoubtedly, IRS will ultimately demand some kind of return for the new FEIN at which time an explanatory letter should be written. This should be dispositive of the matter.

C) Continuation of TP's tax year also avoids a potential problem with the cash method of accounting. Since the LLC would show a loss in its first short year if the conversion terminated TP's tax year, the LLC's continued use of the cash method of accounting could potentially be challenged under the so-called syndicate rules of Sections 448(a)(3), 448(d)(3), 461(i)(3)(B), and 1256(e)(3)(B).