Partnership mergers and incorporation of partnerships into corporations

Converting or combining partnerships reshapes taxable income, inside and outside basis, and the timing of built-in gain recognition, so deal teams map every step from liabilities assumption to post-close depreciation schedules before drafting the conversion agreement.

Section 708 governs statutory and technical partnership mergers.

When one partnership’s members receive interests in another and the first partnership ceases to exist, the surviving entity inherits all assets and liabilities at carryover basis.

If neither partner group gains more than a 50 percent capital or profits stake, the transaction still counts as a merger but the surviving partnership must allocate pre-merger income and loss on a closing-of-the-books basis. The 2018 repeal of the “technical termination” rule removed the need to restart depreciation lives or a new tax year, yet book systems still segment pre- and post-merger capital accounts for Code §704(b) reporting.

Incorporation by state-law conversion triggers § 351 non-recognition—if requirements hold.

Partners contribute appreciated assets to a newly created corporation solely for stock and immediately control at least 80 percent of vote and value.

Liabilities boot rules: when contributed liabilities exceed basis, gain equals the excess under § 357(c). Debt allocated back to contributing partners under § 752(b) lowers outside basis first, often preventing unwanted gain. Drafting the conversion agreement to shift recourse debt to corporate level only after contribution avoids partner-level gain on incorporation day.

Illustrative journal entry — corporate books at conversion

Dr Equipment $10 000 000

Dr Customer Relationships $5 000 000

Dr Goodwill $4 000 000Cr Common Stock $14 000 000

Cr Assumed Debt $5 000 000

Book goodwill amortizes for IFRS impairment testing but not for U.S. tax; a § 754 election inside the former partnership before conversion can step up basis and increase future depreciation for the corporation.

Section 704(c) layers persist inside the new corporation.

Built-in gain formerly tracked for partner capital accounts now shifts to corporate stock basis differentials. The corporation must preserve pre-conversion § 704(c) layers when it later allocates depreciation or disposes of assets, or risk accelerating taxable gain under § 704(c)(1)(B) “mixing-bowl” rules.

A subsequent sale within seven years of conversion invokes § 737, requiring recognized gain to the extent of the built-in gain in distributed property exceeding the partner’s outside basis in stock.

Partnership mergers with corporate partners require anti-churning vigilance.

When a corporate subsidiary and its parent’s partnership merge, intangible assets that were self-created before August 10, 1993 cannot convert to amortizable § 197 intangibles through the merger. Audit teams tag customer lists, trademarks, and software with in-service dates to avoid disallowed amortization.

Liability shift and disguised sale pitfalls.

Contributions followed by rapid debt-financed distributions may re-characterize part of the transfer as a taxable sale under § 707(a)(2)(B). Treasury regulations use a two-year presumption period: if a partner receives cash within two years of contributing appreciated property and debt allocation supports the cash, expect IRS scrutiny.

Model cash-out distributions beyond the two-year window or pair them with true risk-bearing equity to defend § 351 non-recognition.

State conversion statutes interact with federal non-recognition.

Many states allow statutory cross-entity conversions that deem the partnership dissolved and the corporation formed simultaneously. Federal tax treats the same steps as (i) partnership distributes assets to partners in liquidation and (ii) partners contribute assets to corporation. Drafting a “direct conversion” statement in the plan and filing timely Form 8832 for the pre-conversion partnership reinforce single, non-recognition treatment under Rev. Rul. 2004-59.

Financial-statement impact crosses ASC 323, ASC 805, and ASC 740.

Partners previously reporting equity-method investment derecognize partnership basis, record corporate shares at carryover book value, and test for goodwill after push-down. Deferred-tax balances arise when book goodwill is not amortizable for tax, and former § 704(c) deferred-tax liabilities migrate into the corporation’s purchase-accounting schedules.

Auditors require a schedule reconciling partner capital to new paid-in capital, including any gain under § 357(c) or disguised-sale recharacterization.

Ongoing compliance after conversion.

1. Final Form 1065: File a short-period return through the day before incorporation; attach a statement describing the conversion and liabilities assumed.

2. Initial Form 1120: Start the corporation’s tax year on conversion date; carry over accounting methods unless automatic-consent procedures require change.

3. Depreciation elections: Decide whether to retain partnership MACRS lives or restart ADS lives under new corporate policy; file Form 4562 to document selection.

4. State registrations: Update EIN, payroll tax accounts, and sales-tax permits to reflect corporate status.

Early modelling of liability shifts, careful § 704(c) layer tracking, and watertight conversion agreements let partnerships merge or incorporate without triggering unexpected gain, denied amortization, or future anti-abuse recapture.

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