Tax Reform 2021 – Build Back Better: Temporary Rule for S-Corporation Conversions to Partnerships

One of the surprises contained in the current version of the proposed Build Back Better Act legislation (going against the general grain of proposing increased taxes on the wealthy) is a provision that would allow only certain “S-corporations” an election to reorganize or convert to a domestic partnership without the recognition of gain. 

Under current law, the conversion of an S corporation to a tax partnership is a taxable event; gain is recognized on the appreciation of any assets inside the S-corporation and there may be gain recognition with respect to the stock surrendered by the owners.  The amount of tax due upon such a conversion often dissuades many taxpayers from proceeding with a conversion.  This proposal would be beneficial to S-corporations (and their owners) with significant built-in-gain that desire to convert to a partnership.

For some background, per 2015 IRS statistics, an S-corporation is the most popular form of business entity (excluding sole proprietorships). 

The classification of an entity for tax purposes as partnerships (LLCs, LPs, GPs, and other entities) generally has advantages over S-corporations.  Partnerships often provide more planning flexibility than do S-corporations.  Additionally, certain types of business activities are clearly better carried out under a partnership structure.  These activities include owning real estate or other passive investments, for example.  Other business needs such as having multiple types of ownership or equity rights also drive the business entity selection choice (that discussion is generally beyond the scope of this article). 

There are S-corporation advantages over partnerships that should not be ignored in any entity choice analysis.  One example includes the state and local taxation of S-corporation earnings after payment of reasonable salaries compared to the flow-through earnings from a partnership.  Another benefit has been the historical treatment of S-corporation earnings escaping the self-employment assessed on partnership income.  Corporate status may also offer better personal liability protection than partnerships.   

To be an eligible S-corporation, there are certain requirements that need to be met; these requirements may also present planning restrictions. 

S-corporation requirements

• Be a domestic corporation,
• No more than 100 shareholders,
• Only U.S. individuals and certain trusts, estates and charitable organizations can be shareholders,
• No more than a single class of stock is permitted requiring all income and distributions to be pro-rata (Certain arrangements can be reclassified as a second class of stock), 
• Not be an ineligible corporation (i.e., certain financial institutions, insurance companies, and domestic international sales corporations).

For an S-corporation to be eligible for the elective tax-free conversion proposed in the current version of the Build Back Better legislation, it must have been an S-corporation at all times since May 13, 1996.  Additionally, such conversion or reorganization must occur within a two-year period beginning on Dec. 31, 2021.  Without going into the technicalities of the proposed legislation, if the election is made in accordance with rules the Treasury promulgates, the result should be a tax-free liquidation of the S-corporation followed by a formation of the new partnership.  

The proposed legislation grants the Secretary the authority to “prescribe such regulations or other guidance as may be necessary or appropriate to carry out” this proposed section.  This granting of authority by Congress to the Treasury may present its own problems, since there are certainly unanswered questions raised by this proposal, given the short window of time within which an election needs to be made, and given the current IRS workload that is already backlogged.  

As noted above, there are unanswered questions that will require guidance from the IRS.  For example, the impact on QSUBS is unknown.  Further, the impact on potential built-in-gains tax, on excess business interest expense carryovers under Section 163(j), and shareholder debt basis would need to be considered.  Also, the state law impact needs to be addressed by taxpayers.  Not all states follow the rules of the Internal Revenue Code.  Those states that do generally follow federal rules often have different effective dates of adoption.  Accordingly, the conversion might not be tax-free for all state tax purposes.  

This proposal is certainly one to watch for S-corporations and their shareholders as the BBB Act moves through the legislative process.  The window to act would be two years beginning December 31, 2021; so, it’s not too early to begin consideration of whether this election is beneficial to eligible entities.  Please don’t hesitate to reach out to your Schneider Downs tax advisor for more information and guidance. 

We will continue to monitor developments as these proposed changes move through the legislative process.  Additional articles and analyses will be provided in the coming weeks.  In the meantime, if you have any questions, please reach out to your Schneider Downs tax consultant or contact us at [email protected].