IRS Rules on Partnerships Converting to S Corporations

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June 03, 2009

The IRS has ruled in Rev. Rul. 2009-15 that an entity classified as a partnership for U.S. federal tax purposes that becomes a corporation may elect to be an S corporation without a deemed short year as a C corporation.

The ruling provides for two separate fact patterns. In the first fact pattern, a calendar-year partnership ("X") elected, pursuant to the "check-the-box" rules, to be classified as an association (i.e., a corporation for U.S. federal tax purposes) on Jan. 1, 2010. On Feb. 1, 2010, X elected to be taxed as an S corporation effective on Jan. 1, 2010.

In the second fact pattern, a calendar-year partnership ("Y") converted formlessly under state law to be classified as a corporation effective Jan. 1, 2010. As a result of the conversion, Y was classified as a corporation for U.S. federal tax purposes. On Feb. 1, 2010, Y elected to be taxed as an S corporation effective on Jan. 1, 2010.

The applicable law for Rev. Rul. 2009-15 includes the following:

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  • Treas. Reg. Sec. 301.7701-3(g)(i) provides that an eligible entity classified as a partnership that elects to be classified as a corporation is deemed to: (i) contribute all of its assets and liabilities to the corporation in exchange for stock in the corporation; and (ii) immediately thereafter, liquidate by distributing the stock of the corporation to its partners. Such transaction is deemed to occur immediately before the close of the day before the election is effective. Rev. Rul. 2004-59 provides that a partnership that converts formlessly under state law to a corporation is treated in the same manner under Treas. Reg. Sec. 301.7701-3(g)(i).
  • Section 1362(b)(1) provides that a "small business corporation" (as defined in Section 1361(b)) may elect to be treated as an S corporation for any taxable year: (i) at any time during the preceding taxable year; or (ii) on or before the fifteenth day of the third month of the taxable year as long as such corporation was a small business for each day of the taxable year.
  • Section 1361(b)(1)(B) provides that an S corporation cannot have a person (other than an estate, a trust described in Section1 361(c)(2) or an organization described in Section 1361(c)(6)) that is not an individual as a shareholder.

The IRS ruled in both fact patterns that X and Y were corporations eligible to elect to be taxed as an S corporation effective in their first taxable year by not being owned by a partnership for any portion of 2010. In other words, the momentary ownership of X and Y, as corporations, by a partnership that results from the deemed contribution of assets from the corporation by the partnership in exchange for corporate stock is ignored for determining S corporation eligibility. The IRS also ruled that X and Y would not be deemed to have intervening short taxable years in which either were C corporations.

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