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Privately held entities are often organized as a nontaxable entity, such as a partnership. However, it is common, as part of a plan to go public, that an entity organized as a partnership effects a transaction that will result in its conversion to a C corporation. The change in tax status would require the recognition of deferred tax assets and liabilities for the initial temporary differences between the book bases and tax bases of the entity’s assets and liabilities at the time of the change in status. The initial recognition of deferred tax assets and liabilities is recorded in income from continuing operations.
If the partnership had net liabilities for tax purposes (i.e., the tax basis of the partnership’s assets were less than the tax basis of its liabilities), the partners would report a taxable gain, calculated based on the value of the net liabilities assumed by the corporation upon conversion. As a result, the new C corporation would obtain a step-up in tax basis of the assets in an amount equivalent to the gain. The question arises whether this step-up in tax basis results from (a) the change in tax status, the effects of which are recognized currently in continuing operations under ASC 740-10-25-32 or (b) a transaction “with or among shareholders,” the effects of which are recognized in equity in accordance with ASC 740-20-45-11.
We believe that the additional taxable gain recognized by the former partners, which prompted the step-up in tax basis, is a direct consequence of the change in tax status. Therefore, the deferred tax benefit from the recognition of that step-up in tax basis should be recorded in income from continuing operations, in accordance with ASC 740-10-45-19. In other words, the impact of the change in tax status that is recognized in continuing operations is determined after taking into account the step-up in basis that results from payments made by the individual partners. While an argument could be made for equity treatment in accordance with ASC 740-20-45-11, the original EITF consensus from which that guidance was codified specifically excluded changes in tax status from its scope.
Example TX 8-6 illustrates the accounting implications related to the conversion of a partnership to a corporation.
EXAMPLE TX 8-6
Conversion of a partnership to a corporation
Company A is a limited liability company. For tax purposes, Company A is treated as a partnership, and therefore does not pay tax at the entity level and has no deferred taxes. During the year, Company A contributed its assets and liabilities into a newly formed wholly-owned C corporation. The transfer is a tax-free transaction and Company A plans to operate in this manner for the foreseeable future. The financial reporting will continue to be done at Company A's level but will now include the assets, liabilities, and operations of the wholly-owned, consolidated C corporation subsidiary.
What are the accounting implications relating to the conversion?
Analysis
As a result of the contribution of assets and liabilities into a taxable entity, deferred taxes will need to be recognized by the C corporation for the difference between the initial tax bases in the assets and liabilities, generally carryover tax basis, and their respective carrying amounts in the financial statements (i.e., the carrying amount in Company A’s financial statements prior to the contribution). The transaction is accounted for as a change in tax status, and under ASC 740-10-45-19 the effect of recognizing deferred taxes is included in income from continuing operations at the date the nontaxable enterprise becomes a taxable enterprise.
However, if the financial reporting was done at the C corporation level only, excluding the parent limited liability company, the initial recording of the deferred taxes would be recognized in shareholders’ equity. The contribution of assets and liabilities into the C corporation would be recorded as a capital contribution. Therefore, pursuant to ASC 740-20-45-11(c), the tax effects should also be reported in equity. Thus, whether a transaction is a change in tax status or a capital contribution from a shareholder has a significant impact on the manner of reporting the recognition of deferred taxes.
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