Tax-Free Conversion of S Corporations to LLCs?

Take-Away: Overlooked in the recent House Ways and Means Committee’s released legislative text for the budget reconciliation bill is a proposal that would allow an S corporation to convert to partnership status on a tax-free basis for a two-year period that begins on December 31, 2021.

Background: There are some advantages to conducting a business as a partnership compared to an S corporation. For example-

• Classes of Shares: An S corporation may not have more than one class of stock, excluding differences in voting rights. There are no similar restrictions with regard to a partnership.
• Limits on Shareholders: There are statutory limitations on who may be a shareholder in an S corporation. For example, an S corporation may not: have: (i) more than 100 shareholders; (ii) a nonresident alien; (iii) an estate; (iv) certain trusts; and (v) certain exempt organizations as a shareholder. There are no similar restrictions for who may be a partner in a partnership.
• No IRC 754 Election: Upon the death of a partner, or on a sale of a partnership interest, the partnership may make an IRC 754 election to adjust the basis of its assets with respect to the deceased partner’s estate or the purchasing partner. This election to adjust the basis in partnership assets allows the estate or the purchaser to take depreciation deductions similar to if the estate or purchaser had purchased a share of the partnership’s assets. This election is important if the partnership holds real estate. There is no similar provision for an S corporation.

Conversion: If an S corporation converts to a partnership, it is treated as a liquidation of the corporation. As a result, the S corporation would be deemed to have sold its assets at their fair market value, and the S corporation’s shareholders would be taxed on the gain. In some limited cases, there would also be a corporate level tax on the appreciation of the S corporation’s assets.

Ways and Means Proposal: The House Committee’s proposal would allow an existing S corporation, including an LLC that elects to be taxed as a corporation, that was a corporation on May 13, 1996 and at all times after that date, to convert to partnership status on a tax-free basis during a 2-year period that begins on December 31, 2021.

Conclusion: An S corporation, or an LLC that has elected to be taxed as a corporation, may want to take advantage of this window in which to convert to partnership status, assuming the Committee’s proposal becomes law.