Maximizing the tax benefit of incorporating an insolvent partnership

ARTICLE | May 12, 2025

Authored by RSM US LLP

Executive summary

Incorporating an insolvent partnership that expects significant cancellation of debt income can yield tax benefits because of favorable tax rules applicable to corporations. However, taxable income for partners still may result. Consider structuring the incorporation to maximize the tax basis benefit arising from carryovers of interest expense previously disallowed under section 163(j). The different methods of incorporating a partnership can provide differing tax results.

Incorporating a partnership when anticipating cancellation of debt income

Partnership classification for a business entity can be beneficial. Single-level taxation typically is one benefit: federal income tax (Tax) applies at the partner level only, not at the partnership level. However, in some situations partnership classification is not Tax-beneficial when compared with corporate classification. One example is a cancellation of debt (COD) income situation.

An insolvent corporation excludes its COD income from its gross income for Tax purposes to the extent of its insolvency.^[1] By contrast, an insolvent partnership does not receive this exclusion benefit. Instead, each partner’s share of the partnership’s COD income is excludable only to the extent that partner is insolvent.^[2] Any COD income allocated to solvent partners would not qualify for the insolvency exclusion, but would be generally taxable to those partners.^[3]

As a result, a partnership that anticipates realizing COD income in a debt restructuring or workout may plan to incorporate. If a corporation undergoes the debt restructuring and operates the business going forward, the expected COD income often may be excluded.^[4]

An incorporation of a partnership generally may be accomplished without recognition of income or gain for Tax.^[5] However, an exception often applies for many partnerships that are insolvent or expect to realize COD income. Taxable gain must be recognized under section 357(c) to the extent that the liabilities assumed by the new corporation exceed the tax basis of the assets transferred to it (357(c) Gain).^[6]

The different methods of partnership incorporation may lead to different 357(c) Gain results. The 357(c) Gain can be minimized in some situations by using the “interests over” incorporation method rather than the “assets over” method. Each of these methods is described below.

Partnership incorporation methods—Rev. Rul. 84-111

Various methods can be used to incorporate a partnership. From a business perspective, some methods are simpler than others. State law conversions and Tax elections may require only one relatively simple filing. By contrast, more complicated conversion methods may involve transfers of partnership interests, transfers of business assets and/or subsidiary equity.

When considering Tax results of the incorporation, the simplest method may or may not be preferable. It is good to look before you leap into using the simplest available incorporation method. There are three potential tax treatments that apply to a partnership incorporation, as set out in Rev. Rul. 84-111:^[7]

1. Assets over

An “assets over” incorporation of a partnership involves these steps: (1) the partnership transfers its assets to a corporation in exchange for corporate stock, then (2) the partnership liquidates, distributing the corporate stock to its partners. These steps may actually occur, or they may be deemed to occur. These assets over steps are deemed to occur for Tax purposes when the simplest methods of partnership incorporation are used—namely, (a) state law conversion of a partnership to a corporation, or (b) Tax election.^[8]

2. Interests over

An “interests over” incorporation of a partnership involves these steps: (1) the partners transfer their partnership interests to a corporation in exchange for corporate stock, then (2) the partnership ceases to exist for Tax purposes since its interests are all owned by a single entity.^[9] Typically, using the interests over form is a bit more complicated from a business perspective than a state law conversion, but not extremely so.

3. Assets up

An “assets up” incorporation of a partnership involves these steps: (1) the partnership distributes its assets to the partners in liquidation, then (2) the partners contribute the assets to a corporation in exchange for corporate stock. The assets up form is rarely used, since distribution of the partnership’s assets to the partners typically would be cumbersome or undesirable.

The Tax consequences of these three partnership incorporation forms vary somewhat. The chart below illustrates potential Tax results. The illustration assumes that all parties qualify for the most favorable tax consequences generally available; it is here to show that partnership incorporations may require complex Tax computations, not to detail the computations. This article focuses on only one element of the computations: differing treatment of partner’s “excess business interest expense” carryforwards under section 163(j) (discussed below the table).

Insolvent partnerships with section 163(j) carryforwards

The table above applies a simplified view of the Tax rules to illustrate potential Tax results. Even that simplified view makes apparent the multiple relevant factors that affect the Tax results. Tax basis is an important factor, and tax basis can in turn be affected by business interest expense of the partnership previously disallowed under section 163(j).

The partners generally carry forward this disallowed partnership interest expense from one year to the next.^[10] However, immediately before a partner’s disposition of its partnership interest, the partner increases its tax basis in the partnership interest by the remaining carryforward of section 163(j)-disallowed interest expense.^[11] When incorporating a partnership that has generated these interest expense carryforwards, the effects of this tax basis increase will vary based on which incorporation method is chosen, as illustrated in this example:

Example:

An insolvent partnership is modeling the estimated Tax consequences of two types of incorporation. Its partners have section 163(j) interest expense carryforwards totaling $2 million. As is typical for an insolvent partnership incorporation, recognition of taxable 357(c) Gain is expected to occur.

Assets over:

The most commonly used partnership incorporation methods, state law conversion and Tax election, both receive assets over tax treatment. The first assets over step is the partnership’s contribution (or deemed contribution) of its assets to a new corporation. That step is expected to result in 357(c) Gain.

The next step is distribution by the partnership to its partners of the corporate stock in liquidation (or deemed liquidation) of the partnership. In connection with that second step, the $2 million of the partners’ section 163(j) interest expense carryforwards add to the partners’ tax basis in their equity. That is, the $2 million amount ends up adding to the tax basis in the corporate stock.

Interests over:

If the partnership incorporates using the interests over method, the first step will be the partners’ contribution of their partnership interests to a new corporation. That first step is expected to result in 357(c) Gain. Immediately prior to the contribution, the partners’ tax basis in their partnership interests is increased in the aggregate by the $2 million of the partners’ section 163(j) interest expense carryforwards. The $2 million of additional tax basis would reduce the amount of taxable 357(c) Gain by $2 million. The interests over method permits the partners to recover that $2 million of tax basis in the incorporation transaction, rather than keeping the $2 million of tax basis in the corporate stock for potential recovery on a subsequent sale of the stock.

Summary

When planning a conversion from a partnership to a corporation, modeling out the Tax consequences of different incorporation methods can be beneficial. For an insolvent partnership whose partners have section 163(j) interest carryforwards, using the interests over incorporation form may reduce the amount of taxable gain recognized on the incorporation transaction.

[1] Section 108(a)(1)(B). This article does not detail the Tax principles affecting whether incorporation will successfully cushion a COD income blow. An article written by two RSM US LLP tax partners in 2013 discusses some of those principles.

Unless otherwise stated or clear from the context, all references to “section” in this memorandum are to the Internal Revenue Code of 1986, as amended (the Code), and all references to “regulation” or “regulation section” are to the regulations promulgated under the Code.

[2] Section 108(d)(6). Our
article provides a detailed comparison of the tax rules applicable to corporations and partnerships realizing COD income. Another article of ours highlights differences between COD income tax rule applications for corporations and partnerships.

[3] Certain partners may benefit from considering some of the partnership’s debt when figuring their insolvency for this purpose. See Rev. Rul. 2012-14, 2012-24 I.R.B. 1012. However, partners with substantial assets other than their interest in the partnership realizing COD income typically face Tax liability.

[4] Whether or not incorporation of an insolvent partnership will lead to better Tax results depends on the situation. This article does not detail the Tax principles affecting whether incorporation will successfully cushion a COD income blow. An article written by two RSM US LLP tax partners in 2013 discusses some of those principles.

[5] See section 351(a).

[6] See section 357(c).

[7] Rev. Rul. 84-111, 1984-2 C.B. 88.

[8] Reg. section 301.7701-3(g)(1)(i); Rev. Rul. 2004-59, 2004-1 C.B. 1050.

[9] See section 708(b)(1).

[10] See generally section 163(j)(4)(B).

[11] Section 163(j)(4)(B)(iii)(II).