IRS officials have publicly stated that this year represents a “perfect storm” for closely-held businesses to convert to tax partnerships. Tax partnerships are the preferred vehicles for holding real estate and other appreciating assets, in part, because of their tax efficiency and limited liability.
Individuals, families, closely-held businesses and professional service corporations holding real estate and other appreciated assets in corporate entities may receive an unexpected tax planning opportunity during 2010. Tax experts view 2010 as an opportunity to take advantage of depressed property values and low tax rates – two key factors mitigating the tax consequences of an entity conversion. Tax cuts enacted by the Bush administration are expected to expire in 2011, and tax rates on qualified dividends, capital gains and the marginal tax brackets are expected to increase.
Shareholders owning appreciated property in corporate entities have been forced to live with these ownership structures because of the prohibitive cost of converting to more tax efficient forms of ownership. This additional protection came at the price of tax efficiency. Corporations paid tax up to 35% on corporate income. Corporate shareholders paid additional tax on income distributed to them by their corporation in the form of a dividend. This dual level of taxation proved costly and diverted an inordinate amount of cash away from corporate owners to federal and state coffers.
Conversion of a corporation normally has negative tax consequences. The most direct method of converting is simply to liquidate the corporation by transferring the corporate assets to the corporation’s shareholders, who then contribute the assets to an LLC or LP. When a corporation liquidates, the corporation is deemed to sell all of its assets to the shareholders at their current fair market values. Corporate assets can include cash basis accounts receivable and corporate goodwill.
For a C corporation, a conversion will result in double taxation. The corporation will pay tax on the gain, equal to the fair market value less the corporation’s basis in its assets. The shareholders will pay tax on their gain, equal to the fair market value of the assets they receive less their basis in stock.
For an S corporation, the corporation will recognize the gain on the deemed sale, which passes through to its shareholders. In most cases, there will not be double taxation because the corporate gain increases the shareholder’s basis in stock and the amount received by the shareholder will not exceed the basis in the stock.
This basic form illustrates the cost associated with converting from a corporation to a tax partnership. It also illustrates the tax planning opportunity this year. Depressed property values will reduce corporate gain on the deemed sale of its assets and the distribution to its shareholders, taxable at the current low rates. As property values rise and tax rates increase, the tax cost of operating as a corporation or converting to a tax partnership will also increase.
California requires certain corporate formalities in a conversion. The corporate board must approve a plan of conversion and file certificates with the California Secretary of State. As a practical matter, the new business will need to prepare a partnership or operating agreement to address governance, ownership interests and allocations/distributions.
California also requires a corporation owning real property to file documents with the local county recorder upon its conversion. The county will want to determine if a change of ownership has occurred for property tax purposes. Structured appropriately, real property will not be reassessed for property tax purposes in a corporate conversion. If ownership interests change hands before or after the conversion, then there may be property tax consequences.
Taxpayers owning appreciated assets in corporations have been waiting for years for an opportunity to escape their corporate structure. The current business climate – lower tax rates and depressed property values – enables business owners the opportunity to streamline their ownership structure. If you are a business owner or trusted advisor, then now may be the time to evaluate the cost of a conversion versus the future cost of remaining stagnant.