The Ultimate Business Upgrade - 04-15-25

Looking to cut down on self-employment taxes on your partnership income? Converting your partnership into an S corporation might be the answer.

If you currently run your business as a partnership or an LLC taxed as a partnership, you’re probably familiar with the sting of self-employment taxes. Unlike shareholder-employees of an S corporation, who only pay Social Security and Medicare taxes on their salaries, partners typically get hit with self-employment taxes on their entire share of the business’s net income. That can add up fast.

By transitioning to an S corporation, you can restructure how you take your income—splitting it between salary and profit distributions. The big advantage? Those profit distributions are not subject to self-employment tax, potentially saving you thousands each year.

So, if reducing your tax burden sounds appealing, listen in as we break down how a tax-free Section 351 incorporation works and what you need to know before making the move.

This podcast is meant for entertainment purposes only. For the more thorough, complete, and accurately written version of this article which includes citations, visit us at http://www.tottb.tax

Transcript

Alright. Welcome everyone to another deep dive. Today, we're getting into something I know a lot of you tax pros out there are dealing with all the time. Yeah. Partnership to s corp conversions.

Absolutely. Big topic. Big topic. And one with a lot of potential benefits if you get it right. Huge potential, especially when it comes to self employment taxes.

Exactly. Self employment taxes, we're talking big numbers here. 15.3% on the first hundred seventy six thousand one hundred dollars of earnings in 2025 and then 2.9% beyond that. Ouch. Yeah.

That can really eat into a partner's profits. It absolutely can. So today, we're gonna go deep on this conversion process, really break down the steps, the potential pitfalls, and the strategies you can use to minimize those tax hits for your clients. We're talking section three fifty one in corporations, check the box elections, even statutory conversions, all the tools you need to be a true expert in this area. Sounds good.

So let's start with the foundation. Most tax advantage conversions, they hinge on section three fifty one of the internal revenue code. Okay. Section three fifty one. What's the big deal with that?

Well, basically, it lets you transfer a property to a brand new corporation, and you get the corporation's stock in return. But the cool thing is if you hit all the requirements, you don't recognize a gain or loss on that transfer right then anyway. Tax free. Right. That's the holy grail.

So for our listeners out there who are advising partnerships, what are the key conditions they need to meet to make this happen? Alright. So there are four main things you gotta nail down. First, the transfer has been made by one or more individuals. Individuals.

So that includes the partners themselves. That's right. It could be the partners themselves, or it could be the partnership as an entity. Gotcha. Second, the exchange has gotta be solely for stock in the corporation.

No side deals, no extra goodies, just stock. Straightforward enough. What's next? Third, whoever's doing the transferring, they have to control at least 80% of the corporation right after the transfer's so control is key. Exactly.

And we're talking real control here. 80% of the voting power and 80% of all the other shares. That's what section three sixty eight c spells out. Makes sense. And the final condition.

The whole thing has to have a solid business purpose. Not just trying to dodge taxes. Right. There's gotta be something legit. Like, maybe the partners wanna shield themselves from personal liability or they're setting up a succession plan for the business.

Those are definitely solid reasons. So as long as those four boxes are checked, we're good to go on the tax free front. In theory, yes. But there are always wrinkles. Of course, there are.

And one of those wrinkles that our listeners need to know about is this thing called boot. Boot. Yeah. That's the tax term for anything you get in exchange that's not stock. So cash, property.

Exactly. Cash, property, debt instruments. If it's not stock, it's boot. And boot can cause problems. Right?

Tax problems. It can? See, even if the whole deal qualifies under section three fifty one, getting boot can trigger a taxable gain. Ah, so there's that catch. There is.

But remember, you can't recognize a loss in a three fifty one exchange. Even if you get boot, that's important to keep in mind. No losses, only potential gains. So if boot does rear its ugly head, how do we figure out how much of that gain is taxable? Alright.

It's the lesser of two things. First, the actual gain you realized on the transfer. That's the fair market value of what you put in minus your adjusted basis. Okay. That's the realized gain.

What's the other side of the equation? The other side is the actual amount of boot you received, cash plus the fair market value of any non stock stuff. So even if the gain's bigger, the taxable amount's capped by the boot. Exactly. That's the limit.

Now another tricky thing to watch out for is debt assumption, when the corporation takes on the partnership's liabilities. Yeah. Our sources mentioned that debt assumption can sometimes be treated as boot under section three fifty seven. See? Right?

That's right. Basically, if the corporation's taking on more debt than the basis of the property contributed by a partner, that excess amount can be considered boot. And, you guessed it, potentially a taxable game. Wow. So debt can be a real trap for the unwary.

It can. But there's a saving grace, especially for cash basis partnerships. An exception to the rule. You know it. Revenue ruling 80 dash nineteen eighty clarifies that accounts payable, if you're on the cash basis, they're not considered liabilities for this purpose.

That's a big relief for a lot of service based partnerships. Mhmm. So once we've navigated the minefield of boot and debt, what happens to the tax basis of the stock the partners receive? Okay. So if everything's squeaky clean, no boot at all, then the stock basis just carries over from what the partner had in the assets they contribute.

You're like stepping into the old shoes. Exactly. But if there was boot involved and they had to recognize some gain, then the stock basis calculation gets a little fancier. More math. It is.

You take the basis of the property they transferred, add any gain they recognize, and then subtract the boot they received. And remember, boot includes not just cash and property, but also that assumed debt minus those cash basis payables we talked about. Got it. So we've got the partner stock basis all figured out. What about the corporation itself?

What's its basis in the assets it received from the partnership? Typically, it's a carryover basis. The corporation steps into the partnership's shoes, so to speak. Inherits the basis. Nice and simple.

Usually, yes. But if the partnership or the partners had to recognize a gain because of boot, then the corporation's basis in those specific assets gets bumped up by the amount of that gain. Interesting. So the boot can actually have a positive effect on the corporation's side? In that specific way, yes.

Okay. So let's say we formed our corporation and everything's gone smoothly on the tax front. We're not home free yet, are we? Not quite. We still have to officially make it an s corp.

Right. It doesn't just happen automatically. You've gotta file form two fifty five three with the IRS, the election by a small business corporation. Form two fifty five three, the s corp election form. That's what makes it official.

That's it. But the timing of this filing is crucial. If you want the election to take effect in the corporation's first tax year, you have to file it within seventy five days of incorporation. Seventy five days. That's a pretty tight window.

It is. Miss that deadline, and the election gets pushed to the next tax year. And that could really mess up a client's tax planning. So no room for error here. What happens if, despite our best efforts, we miss that deadline?

Is there any hope? Don't panic. The IRS does have art sometimes. They do? Well, they have a process for late elections.

If you can show a reasonable cause for missing the deadline, they might grant you some relief. Two. Okay. Good to know. So where do we find the details on this late election process?

You can check out the instructions for form two fifty five three itself. They outline the general procedures. And then there's revenue procedure twenty thirteen dash 30, which gets into more specifics about when they might grant a late election. Alright. So we've got a backup plan if things go wrong.

Let's shift gears a bit and talk about the different ways to structure the section three fifty one incorporation itself. Our source material outlines three main approaches. Right. And each one has its own pluses and minuses depending on the situation. As tax advisers, we need to know which approach is best for each client.

So walk us through these methods starting with the first one. Okay. The first one's pretty straightforward. The partnership, as an entity, transfers everything it's got, assets and liabilities, to the new corporation, gets stock in return, then it distributes that stock to the partners and shuts itself down. A clean sweep for the partnership.

When does this approach make the most sense? It's usually the best option when the partnership's basis and its assets is higher than the total basis the partners have in their partnership interests. Because of the carryover basis rules we talked about earlier? Exactly. You want that higher basis to flow through to the corporation.

Now the second method's a little different. Okay. What's the second method? Here, the partnership first distributes all its assets and liabilities to the partners according to their ownership percentages. Then each partner individually contribute their share of that stuff to the corporation and get stock in return.

So a two step process. Why would you choose this method over the first one? It can be advantageous when the combined basis of the partner's interests is higher than the partnership's basis in its assets. So the opposite of the first scenario. Right.

Because when the partnership liquidates and distributes the assets, the partners might get a step up in basis on those assets. So they go into the corporation with a higher basis. Exactly. And that can translate to bigger depreciation deductions for the corporation down the line or a smaller gain when they sell those assets. Makes sense.

So basis step up is the key here. It is. Now the third method's a bit unique. Alright. What's the third option?

In this one, the partners, they contribute their partnership interests directly to the corporation. Interesting. So the partnership itself doesn't really do anything. Not really. The partnership automatically dissolves once the partners have given up their interests.

And when would you use this approach? It's typically the most advantageous when, again, the partner's total basis in their interests is higher than the partnership's basis in the assets. So similar to the second method? In terms of the basis advantage, yes. But the mechanics are different.

Here, it's the basis of the partnership interests that drives the potential step up. So once again, it all comes down to basis. Absolutely. Analyzing inside basis versus outside basis, that's crucial for tax pros to figure out the best strategy. No shortcuts there.

Now let's talk about a potential shortcut for certain partnerships. Our sources mentioned the check the box election. What's that all about? The check the box election, a favorite among tax professionals, especially for those multimember LLCs out there that are already being treated as partnerships for tax purposes. So this is for LLCs that are already taxed like partnership?

Exactly. It lets them switch to s corp status without going through the whole section three fifty one incorporation rigmarole. Streamlining the process. I like it. How does it work exactly?

What happens from a tax standpoint when an LLC checks that box? Well, the IRS treats it as if the LLC transferred all this stuff to a brand new corporation, got stock back, and then immediately liquidated, giving that stock to its members. So same ending point as a three fifty one corporation, but a much simpler path to get there. Exactly. Saves everyone a lot of paperwork and headaches.

Can you give us a real world example of how the timing would work for an LLC doing a check the box election? Sure. So you get an LLC taxed as a partnership, and they wanna be an s corp starting 01/01/2025. Okay. 01/01/2025, they wanna flip the switch.

First, they file form eight eight three two, the entity classification election, to choose to be treated as a corporation. First step, become a corporation. Then they gotta file form two fifty five three, the s corp election, pretty much at the same time. As long as that second form is filed within seventy five days of the corporate election taking effect, which would be March 15 in this case, they're good to go. They're an s corp for the whole year?

A whole year, starting January 1. Perfect. So check the box can be a real lifesaver for LLCs. Definitely. Yeah.

But it's not a magic bullet for every situation. Of course not. Nothing in tax law is that simple. Now even though we're all about those sweet, sweet self employment tax savings, we have to be upfront with our clients about the downsides of being an escort. Absolutely.

Escort come with their own set of rules and limitations. What are some of the key things our listeners should be warning their clients about? Okay. First off, gotta be a domestic corporation. No foreign entities allowed.

US based only. Got it. Then there's the shareholder limit. Can't have more than a hundred. Hundred shareholders, that's a lot, but still a limit to keep in mind.

Right. And only one class of stock. Can't get fancy with multiple share classes. It will be then simple. And, of course, the paperwork.

They'll have to file form eleven twenty dash s every year, reporting all their income deductions and credits. And they'll be issuing schedule k ones to the shareholders. The joys of tax compliance. Now when it comes to losses, things get a little tricky. Shareholders can only deduct losses up to their basis in the stock plus any direct loans they've made to the corporation.

So their investment in the company sets the limit on their loss deductions. That's the gist of it. And unlike partnerships, s corp can't do special allocations. Everything gets allocated pro rata based on ownership percentages. No fancy footwork there.

So while s corp status can save you on self employment taxes, it's not a free for all. Yep. Definitely gotta weigh the pros and cons carefully. Now our source mentioned another method for changing a business's structure, statutory conversion. What's that all about?

So a statutory conversion is basically a legal process that lets you change the legal form of a business, like going from a partnership to an LLC or to a corporation. Without having to shut down the old entity and start from scratch? Exactly. It's a smoother transition. Sounds convenient.

What's the most common type of conversion that our listeners are likely to see with partnerships? Probably converting a general or limited partnership into an LLC. Why is it so popular? Well, LLC members get limited liability protection, which is a big draw, and they still get the tax benefits of a pass through entity. That's to both worlds.

Pretty much. Now if a client wants to go the LLC route, what are the steps involved in making that happen? First, gotta make sure the state where they're operating actually allows statutory conversions. Not all states do. State laws are all over the place.

They are. Then you gotta draft a plan of conversion, spelling out all the terms of the change, and usually all the partners have to approve it. Everyone on board. Then you file the necessary documents with the state, certificate of conversion, articles of organization for the LLC, things like that. They might need a new EIN from the IRS too.

New name, new number. And don't forget to update all the business licenses, contracts, bank accounts, all that good stuff. Administrative fund. Oh, yeah. California, for example, their corporation's code, sections eleven fifty to eleven fifty nine, lays out the whole process for conversions in that state.

So plenty of legal hoops to jump through. What about converting a partnership directly into a corporation? Is that even an option? It is in some states. Not as common as the LLC conversion, but it's possible.

So going straight to c corp or s corp status. Exactly. And the steps are pretty similar to the LLC conversion. Check the state laws, get partner approval, file the right paperwork, you know, certificate of conversion, articles of incorporation for the new corporation. Issue stock to the former partners, get a new EIN, the whole nine yards.

Yep. And if they wanna be an s corp, gotta file that form two fifty five three in time. Now from a tax standpoint, can a direct conversion to a corporation be done tax rules of section three fifty one. No boot. Partners have to control at least 80%.

Same on song and dance. Yep. But if they do it right, they can avoid that immediate tax hit. And then with s corp status, they can start taking advantage of that salary distribution split to lower their self employment taxes. Smart move.

Now what about states that don't allow direct conversions to corporations? What are our options then? Alright. Well, if a direct conversion's off the table, a statutory merger is a good alternative. Basically, you form a new entity, either an LLC that'll elect s corp status or a corporation straight up.

Okay. So you create this new entity as a holding company partnership is gone. The old partnership is gone. Absorbed into the new entity and the tax implications. You can usually structure a merger so it qualifies for tax free treatment under section three fifty one.

So indirect route, same tax free destination. Exactly. Another option, though it can be a bit more messy, is a non statutory asset transfer. Basically, the partnership transfers everything to a new corporation, gets stock back, and then liquidates. More steps, more paperwork.

It can be. But sometimes, it's the only way to get it done. Really highlights why it's so important to know the ins and outs of each state's laws. State specific knowledge is key. Absolutely.

Alright. Let's wrap things up with some key takeaways for our listeners. What are the main points they should be walking away with today? Actionable advice. That's what we're all about.

Okay. First and foremost, converting from a partnership to an s corp, it can often be done tax free. Section three fifty one is your friend. Tax free is always a good thing. It is.

Yeah. Now if you can swing it, converting on January 1 makes life a lot easier. Simplifies everything. Totally. Tax filings, the s corp election, everything's cleaner.

And for those LLCs out there that are already taxed as partnerships, remember that check the box election. It's a beautiful thing. A beautiful streamlined thing. Now deadlines, deadlines, deadlines. Gotta hammer that home, especially that seventy five day window for the s corp election.

Miss that, and you're in trouble. Trouble with a capital t. And once they're in s corp, compliance is key. Those ongoing requirements could trip people up if they're not careful. So much to keep in mind.

It is. But the potential for self employment tax savings, it's a huge motivator for a lot of partnerships. Absolutely. That can be a game changer for their bottom line. So tax pros, when you're talking to your partnership clients about this, remember all the nuances we've discussed today.

Boot, debt assumption, basis calculations, state law variations. This is where your expertise really shines. Guiding clients through the maze, that's what we do. Now before we sign off, here's a final thought for everyone. A parting shot.

Yes. A parting shot. Self employment tax savings, they're great, but they're not the only thing that matters. Right. There's more to the decision than just taxes.

Exactly. Think about the administrative burden of being an s corp. The liability issues, even if the partners already have some limited liability protection, and the long term goals for the business. Does s corp status fit into their vision? Big picture stuff.

Absolutely. And as tax advisers, we need to help our clients see that big picture, make sure they're not making a decision based solely on the immediate tax benefits. Holistic advice, that's what they need. That's what they need, and that's what we provide. Thanks for joining us for this deep dive.

We'll see you next time. See you then.