Let’s say you’re considering converting your partnership into an S corporation. The reason might be to reduce exposure for you and the other owners to Social Security and Medicare taxes, which come in the form of the self-employment tax for partners.
Specifically, each partner’s share of net partnership income is usually fully exposed to the self-employment tax. For 2022, the self-employment tax rate is a painful 15.3 percent on the first $147,000 of net self-employment income. On net self-employment income above $147,000, the self-employment tax rate drops to 2.9 percent.
For a shareholder-employee of an S corporation, the Social Security and Medicare taxes come in the form of the FICA tax. But for shareholder-employees, the FICA tax hits only amounts paid as salaries. Distributions of the remaining corporate cash flow are FICA-tax-free.
Whatever the reason for wanting to convert your partnership into an S corporation, here’s an explanation and a summary of the key federal income tax implications.
Good news: You can transfer the business assets, liabilities, and operations of your partnership to a C corporation by incorporating the partnership. This can potentially be a totally federal-income-tax-free transaction under Section 351 of our beloved Internal Revenue Code. Or it can be mostly tax-free.
Then you can turn the C corporation into an S corporation.
Section 351 treatment for the incorporation of a partnership is allowed when all the following requirements are met.
1. One or more persons (which can include the partnership itself or its partners) transfer property (assets, which can include cash) to the corporation.
2. The transfer is solely in exchange for stock of the corporation.
3. The person or persons (the partnership itself or its partners) are in control of the corporation immediately following the transfer. Control means owning at least 80 percent of the stock.
4. The transaction has a business purpose. The IRS created this additional requirement, but meeting it should not be a problem. For instance, incorporating to take advantage of the liability protection offered by the corporate form of doing business would be an acceptable purpose. So would providing for the orderly transfer of ownership of a business from one generation to the next.
The tax results when Section 351 applies are not elective. When you meet the Section 351 requirements, the tax results are what they are. One result is that there cannot be any taxable loss in a Section 351 incorporation.