Final K-1 conversion to C Corp, recognize passive losses?

[dsross]

I am a limited partner in a business that converted to a C Corp on 12/31/2019. I have passive losses (including passive carry-over losses from prior years) for a small amount which is well under my basis. As the partnership ended my understanding is that I should be able to recognize the passive losses in 2019. All of my investment was at-risk.

In turbo-tax online, I am trying to figure out what to select to accomplish this. When I select partnership ended in the K-1 entry section, and "disposition not via sale", turbo-tax suspends the loss and tries to carry-over to 2020. I think this is incorrect as with the partnership being over, the passive loss should be recognizable.

If I choose complete disposition, turbo-tax asks for a sale amount for my partnership units. I did not receive any proceeds from the conversion, but did get ownership in the new C corp (specifics not disclosed by the new C corp). I am leaning towards choosing complete disposition and entering the same amount for basis and sale amount for the partnership units, creating a net zero gain/loss, and this does allow the passive losses to be recognized in the program for 2019. However, I am not sure how the partnership (now C corp) handled and reported the proceeds from converting my partnership units to the IRS.

Any idea on the best way to handle this in turbo-tax, and am I correct that I should be able to recognize the total passive losses (with carry-over) since the partnership is now a disregarded entity.

[Carl]

I am assuming IRS Form 8832 was filed for a Partnership or Multi-Member LLC to be "treated like a C-Corp" for tax purposes only. Let me reiterate that. *FOR* *TAX* *PURPOSES* *ONLY*. This is important to understand!

So what you do "on paper" with the 1065 and 1120 are not "conversions" per-se.

I should be able to recognize the passive losses in 2019.

No. Nothing was sold in 2019.

You should have two K-1's. First, you should have a "final" k-1 from the 1065 partnership, and your first K-1 from the 1120 C-Corp. The "final" box should be checked on the 1065 K-1. Then I would expect that 1065 K-1 to show a distribution of assets and capital to you.

Next, the 1120 K-1 should show a capital contribution from you, of the capital and assets that were distributed to you on the 1065 K-1.

Therefore, nothing was sold. So there's no recapture of depreciation (if applicable) and no realization of any losses. All losses, depreciation, assets and capital is transferred from the Partnership to the C-Corp, and you're just a "pass through entity" for that transfer since you have a stake in both the old partnership and the new C-Corp.

[Anonymous_]

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@dsross wrote:

I am not sure how the partnership (now C corp) handled and reported the proceeds from converting my partnership units to the IRS.

I would suggest contacting the partnership representative (or corporate liaison) and inquiring. Regardless, it appears as if the partnership has terminated after the conversion.

[Anonymous_]

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@Carl wrote:

You should have two K-1's. First, you should have a "final" k-1 from the 1065 partnership, and your first K-1 from the 1120 C-Corp. 

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C corporations do NOT issue K-1s.

[dsross]

Thanks for the all the replies so far. To clarify, this was NOT a conversion for tax purposes only.

On 12/31/2019, all partnership members contributed all of their units to a newly formed C Corporation (New name, new EIN), in exchange for shares under IRC Sec 351. As a result, the partnership became solely owned by the C Corp. A disregarded entity will be included in the C corp filings going forward. As another result, the K-1 was also marked final. The C Corp will not issue a K-1 in the future.

Looking up U.S. Code § 351 (https://www.law.cornell.edu/uscode/text/26/351), the very first entry under section (a), General rule says "No gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation"

So, I am left to believe that 1) The partnership is now a disregarded entity, and with this being the final K-1, passive losses can be recognized by limited partners because all units were disposed of (in exchange for shares of the new C corp) (this part I am not sure about) and 2) under IRC 351 I cannot recognize a gain or loss (this part I am sure about)

To get turbo-tax to calculate things correctly, it looks like I need to enter that there was a disposition of all shares (to trigger the passive loss to be used in 2019 and not suspended and carried forward), and as for proceeds, sale price = basis so that no gain or loss is recognized under IRC 351. However, this is clunky and I am not sure if there is a better way to handle things. 

[FitFinances]

I'm in the same exact situation - deciding whether to realize passive losses now (which are on the order of only a few dollars), or carry the tax basis forward to the new C Corporation stock until (when and if) I dispose of that.

The only thing that had me thinking is whether those "passive losses" were already accounted for in the past year's tax returns since the LLC is a pass-through entity.

To use simple numbers, assume I had a $500 original investment, and the Partner's ending capital account under Section L of the Schedule K-1 is $495 - do I realize the $5 in losses at the time of this conversion, or keep the original $500 cost basis for when and if the new C Corporation shares are disposed of? Or was that $5 loss technically already included in past year's returns, so I'm just going to use the $495 as the only basis for the new C Corporation shares?

Out of curiosity, what did you end up doing? 

[Anonymous_]

From Publication 925:

Any passive activity losses (but not credits) that haven’t been allowed (including current year losses) are generally allowed in full in the tax year you dispose of your entire interest in the passive (or former passive) activity. However, for the losses to be allowed, you must dispose of your entire interest in the activity in a transaction in which all realized gain or loss is recognized. Also, the person acquiring the interest from you must not be related to you.

See https://www.irs.gov/publications/p925#en_US_2019_publink1000104609

[dsross]

As for what I ended up doing: I was able to clarify that my original investment was basically traded for new shares in the C corp. To handle this in Turbotax, I "sold" all partnership units for my original investment cost. This allowed Turbotax to 1) Show no net capital loss/gain on the transaction (As required by U.S. Code § 351), and 2) allowed the passive losses to be recognized in 2019 since my units were in fact fully divested. The ending capital account under section L of K-1 did not matter, since U.S. Code § 351 requires there to be no gain or loss. If you enter the capital account balance, TurboTax will calculate a $5 loss, which is disallowed.

Hope this helps.

[danielb2]

https://www.thetaxadviser.com/issues/2017/apr/disposing-passive-activities.html

Suspended passive losses cannot be deducted when the passive activity is exchanged in a nonrecognition (i.e., tax-deferred) transaction, such as an exchange under Sec. 351 (transfers to a controlled corporation), Sec. 721 (contributions of property to a partnership), or Sec. 1031 (nontaxable exchanges), if no gain is recognized. However, the taxpayer recognizes any gain as passive activity income, against which passive losses can be deducted (Tax Reform Act of 1986, S. Rep't No. 99-313, 99th Cong., 2d Sess. 726-27 (1985)).