While flow-through taxation still is generally the way to go for the closely held business, it is not uncommon for a partnership to incorporate with a view of engaging in an exit transaction after five years via a stock sale that qualifies for the 100% exclusion of gain provided by §1202. The specifics of this Code section could fill a full-day’s continuing education program; however, let us fill you in on a nuance that came up in our practice.

When incorporating a partnership, one cannot ignore §357(c), which provides for gain recognition in the event the tax basis of the transferred assets is less than the liabilities deemed assumed by the corporation. (There is carryover basis for the transferred assets, increased by the amount of any gain recognition under §357(c).) We recently encountered a partnership incorporation situation in which the partnership’s tax basis for its assets exceeded the amount of the assumed liabilities (so no gain recognition on incorporation under §357(c) and carryover basis for the transferred assets); however, one of the partners had a negative tax capital account. As a result, that partner would recognize gain on the transaction, which was not an issue of concern.

However, the issue of the day was whether the corporation was going to obtain a basis step-up in the contributed assets to correlate with the partner’s gain recognition under the contemplated incorporation via a check-the-box election (because it would appear that the gain would be deemed to occur immediately after the incorporation resulting in no basis step-up). However, Rev. Rul. 84-111 permits an incorporation under the “assets-up” method, which involves a distribution of the partnership assets and liabilities to the partners followed by the contribution of those items by the partners to the newly formed corporation. Under this form of incorporation, our partner’s gain would be recognized under §357(c), rather than under §731, which gain would be recognized on the contribution of the assets to the corporation by the partner, and, consequently, would result in a corresponding basis step-up in the contributed assets in the hands of the corporation.