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 nile also applies to a partnership to LLC conversion (See, e.g., PLR 95250C5).
Under Regulations section 1.752-1(c), a decrease in a partner's share of partnership liabilities is treated as a distribution of monev to the partner. IR( 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. …