In general, as a Denver small business attorney, I would recommend that most small businesses consider a pass through entity for their business ventures. If a business is operating as a C Corporation, the business may be able to make the S Corporation election. However, a business entity may not qualify as a “small business” under Internal Revenue Code Section 1361(b), or the corporation may have accumulated earnings and profits, and passive investment income that would be subject the double taxation under Internal Revenue Code Section 1375, and thus ultimately terminate the S Corporation election. In the situation above, a business attorneys may advise a client to consider a partnership spin-off. The article below has been drafted by a Denver small business attorney to provide a brief outline of a partnership spin-off.
Through a partnership spin off a C Corporation contributes property that is expected to appreciate to a partnership. In exchange, the partnership gives the C Corporation a preferred interest in the partnership. Thereafter, some or all of the C Corporation shareholders, individually or through a pass through entity (such as a limited liability company) contribute cash or other property for the remaining interest in the partnership. This remaining interest in the partnership could be considered analogous to the common stock of a corporation. Thus, the future appreciation will belong to the shareholders of the C Corporation, but outside of the C Corporation and thus a portion of the appreciation can avoid double taxation or disadvantageous C Corporation issues.
The partnership in this partnership spin off can be a general or limited partnership or a limited liability company (LLC). This partnership can generally be formed with no tax liability because under Internal Revenue Code Section 721, generally, gain or loss is not recognized by a partnership or by a partner when cash or property is transferred to the partnership in exchange for an interest in the partnership. However, one issue to consider is that a partner can recognize gain when the net amount of the debt from which they are relieved on the transfer of property that is subject to a liability exceeds the basis of the property transferred (see Internal Revenue Code Sections 752 and 731(a)).
It is also important to keep in mind that the partnership could recognize gain if the partnership is an investment company within the meaning of Internal Revenue Code Section 351(e).
The partnership must be classified as a partnership for federal income tax purposes. Further, the C Corporation’s interest in the applicable partnership must constitute an equity interest in the partnership and not debt. The corporation should also receive some of the partnership profits and losses as opposed to solely receiving guaranteed payments from the partnership.
Once you have met the above requirements, the most important issue may be valuation. The value of the property contributed by the corporation must equal the value of the interest received by the corporation. If the value of the property exceeds the interest received, the corporation is deemed to have distributed the excess amount to the partners of the partnership, which could be deemed a dividend distribution.
Please contact The McGuire Law Firm to speak with a Denver business attorney or tax attorney. Free consultation!