Rev. Rul. 84-111: Assets-Over, Assets-Up, and Interests-Over Methods

Revenue Ruling 84-111 is the IRS’s guidance on converting a partnership, or an LLC taxed as a partnership, into a corporation without triggering an immediate tax bill. The ruling recognizes three distinct methods: assets-over, assets-up, and interests-over. Each produces the same economic result but different basis figures and holding periods, and the IRS will respect whichever form the partners actually carry out.¹ Choose the sequence that produces the best numbers for your situation, and watch out for the 80% control test and the Section 357(c) liability trap that can turn the deal taxable.

Why the Form of the Transaction Controls the Result

Most areas of tax law focus on economic substance rather than legal packaging. Revenue Ruling 84-111 is a notable exception. All three methods end with the same picture, partnership assets held inside a corporation owned by the former partners, but the tax consequences are not the same.¹ Basis differences compound over the life of the corporation through depreciation deductions, gain on future asset sales, and the partners’ eventual stock basis when they sell or liquidate.

So don’t pick a method at random. Run the numbers under all three approaches before committing.

The 80% Control Requirement

All three methods rely on Section 351 to avoid immediate gain recognition. Section 351 applies only when the people transferring property to the corporation own at least 80% of the corporation’s voting stock and at least 80% of every other class of stock immediately after the exchange.² Where all partners participate and no outsiders come in, this is easy: the former partners collectively own 100% of the new corporation.

Two situations trip people up. Stock issued purely for services does not count toward the 80% test, because a service partner who contributes no property is not a “transferor” under Section 351.³ And if outside investors receive stock in the same transaction, their shares dilute the transferors’ ownership. Drop below 80% and the entire exchange becomes taxable for everyone in it.

Assets-Over Method

The partnership itself transfers all of its assets to a newly formed corporation. The corporation assumes the partnership’s liabilities and issues its stock back to the partnership. The partnership then distributes that stock to the individual partners in a liquidating distribution and ceases to exist.

The IRS has confirmed that this transfer qualifies for nonrecognition under Section 351 even though the partnership loses control of the corporation the moment it distributes the stock to the partners.⁴ The corporation takes a basis in each asset equal to the partnership’s basis in that asset immediately before the transfer.⁵ Its holding period for those assets includes the time the partnership held them.

For the partners, stock basis equals their adjusted basis in the partnership interests they surrendered. Section 358 starts stock basis at the basis of the property exchanged, then reduces it by the amount of any liabilities the corporation assumed.⁶ The partners’ holding period for the stock includes the time they held their partnership interests, provided those interests were capital assets in their hands.

This method tends to work well when the partnership’s basis in its assets is higher than the partners’ aggregate bases in their interests. The corporation inherits the higher asset-level basis and preserves larger depreciation deductions.

Assets-Up Method

This one reverses the order. The partnership first distributes all of its assets and liabilities to the individual partners in a complete liquidation. Each partner briefly holds a share of the business property, then transfers that property to the new corporation in exchange for stock.

p>The critical difference is how basis gets determined. On the partnership liquidation, each partner’s basis in the distributed assets is generally equal to their adjusted basis in the partnership interest, reduced by any cash received in the same transaction.⁷ If the partner receives multiple assets, Section 732(c) allocates that basis first to any receivables and inventory at partnership basis, then spreads the remaining basis among other assets using a method that accounts for unrealized appreciation and fair market values. The corporation then takes a transferred basis from each partner under Section 362.⁵

The partnership liquidation itself generally does not trigger gain for the partners, except to the extent that any cash distributed exceeds a partner’s basis in their interest.⁸ Where a partner’s interest basis differs from the partnership’s aggregate asset basis, the Section 732 allocation reshuffles the numbers, and that is where a step-up or step-down in corporate asset basis can appear compared to the assets-over approach.

Partners choose this method when they want control over how basis lands among the corporation’s assets. The Section 732(c) allocation can concentrate basis in assets that will be sold or depreciated sooner, accelerating tax benefits. The trade-off is complexity: every asset must be tracked individually through the partnership liquidation and the subsequent contribution to the corporation.

Interests-Over Method

The partners transfer their individual partnership interests directly to the new corporation in exchange for stock. The corporation becomes the sole owner of the partnership. A partnership by definition requires at least two partners, so the entity ceases to exist and its assets are treated as owned directly by the corporation.

The corporation’s basis in the acquired assets traces back through the partners’ bases in their partnership interests. Each partner’s basis in the new stock equals the adjusted basis they held in their partnership interest, following the same Section 358 rules that apply to the other methods.⁶ The holding period for the stock includes the time each partner held their partnership interest. For the corporation, the holding period for the assets includes the period the partnership held them.¹

The practical advantage is simplicity. No one has to retitle individual assets from the partnership to the partners and then again to the corporation. For partnerships holding real estate, intellectual property, or contracts that require consent to assign, avoiding two rounds of title transfers can save significant legal fees. The tax results, though, are locked in by the partners’ aggregate interest bases, so there is less room to optimize basis allocation across individual assets.

Choosing Among the Three Methods

The three methods are not interchangeable. A rough way to frame the trade-offs:

Assets-over works best when the partnership’s total basis in its assets exceeds the partners’ combined basis in their interests. The corporation inherits the higher asset-level basis and preserves larger depreciation deductions.
Assets-up works best when the partners want to reallocate basis among corporate assets. The Section 732(c) allocation can shift basis toward assets that depreciate faster or are likely to be sold sooner. Most flexible, most paperwork.
Interests-over works best when the partnership holds hard-to-transfer assets like real estate or government contracts. Avoids retitling. Least flexible on basis allocation.

In all three, the partners end up with the same economic position: stock in a corporation that holds the former partnership’s assets. The difference is in the tax numbers. A side-by-side comparison of corporate asset basis and partner stock basis under each method, run before execution, is the single most important step in the process.

The Section 357(c) Liability Trap

The most dangerous pitfall happens when the total liabilities assumed by the corporation exceed the total adjusted basis of the property transferred. The excess is treated as taxable gain.⁹ This catches people off guard because the entire point of the incorporation was to avoid recognizing gain.

Partnerships with significant debt and low-basis assets are most at risk. A real estate partnership that has depreciated its buildings close to zero but still carries a large mortgage can easily land in this position. The gain equals the difference between total liabilities and total asset basis, characterized as capital gain or ordinary income depending on the nature of the underlying assets.

One narrow exception: liabilities whose payment would give rise to a tax deduction, such as accrued but unpaid expenses of a cash-basis partnership’s accounts payable, are excluded from the Section 357(c) calculation, as long as the liability did not create or increase the basis of any property.⁹ Beyond that, the only way to avoid the trap is to reduce liabilities before the transfer or to contribute additional property with enough basis to absorb the excess.

Cash or Other Non-Stock Consideration

Section 351 provides tax-free treatment only to the extent that transferors receive stock. If a partner also receives cash, promissory notes, or any other non-stock property from the corporation as part of the exchange, gain is recognized up to the fair market value of that additional consideration.³ No loss is recognized even if the partner’s basis exceeds the total value received.

Practically, the new corporation should issue only stock in the initial exchange. Partners who need cash from the deal should take it as a later distribution or salary rather than building it into the incorporation transaction. Even a small amount of non-stock consideration can create an unexpected tax bill.

Section 1244 Small Business Stock

Incorporating a partnership creates an opportunity many partners overlook. If the new corporation qualifies as a small business corporation, the stock issued in the incorporation can be designated as Section 1244 stock. This matters if the business later fails: losses on Section 1244 stock are treated as ordinary losses rather than capital losses, up to $50,000 per year, or $100,000 on a joint return.¹⁰ Ordinary losses can offset wages and business income, while capital losses are limited to $3,000 per year against ordinary income.

To qualify, the total money and property the corporation receives for stock, plus any paid-in capital contributions, cannot exceed $1 million at the time the stock is issued. The stock must also be issued in exchange for money or property, not services. And during the five tax years before the loss, more than half of the corporation’s gross receipts must come from active business operations rather than passive sources like rents, royalties, or investment income.¹⁰

A wrinkle specific to partnership incorporations: if property contributed for stock has a fair market value below its adjusted basis at the time of transfer, any Section 1244 ordinary loss is limited to the property’s fair market value at the transfer date rather than the higher basis amount. Partners contributing depreciated property should plan around this cap.

S Corporation Election and the Form 2553 Deadline

Revenue Ruling 84-111 addresses only the mechanics of moving assets into a corporation. It does not dictate whether the new entity will be a C corporation or an S corporation, and that choice dramatically affects the partners’ ongoing tax situation. A C corporation pays its own income tax. An S corporation passes income through to shareholders much like the partnership did.

If the partners want S corporation status, they must file Form 2553 no later than two months and 15 days after the corporation’s first tax year begins.¹¹ Miss that window and the corporation defaults to C corporation status for its entire first tax year, which may be difficult or impossible to unwind retroactively.

S corporations also have eligibility rules that partnerships do not. The corporation cannot have more than 100 shareholders, cannot have nonresident alien shareholders, and can only issue one class of stock. Verify all of these before executing the incorporation.

Filings and Documentation

The incorporation process starts at the state level with articles of incorporation filed with the secretary of state. Filing fees and processing times vary by state. After the state approves the new corporation, the federal tax paperwork begins.

The corporation needs a new Employer Identification Number. The IRS is explicit that a partnership must obtain a new EIN when it incorporates.¹² The old partnership EIN does not carry over to the corporation, even though the underlying business is the same.

Every person or entity that transferred property in the exchange must attach a statement to their tax return for the year of the transaction. Treasury regulations require the statement to describe the property transferred, the amount of stock received, any liabilities assumed by the corporation, and the fair market value of any non-stock consideration.¹³ The corporation files a parallel statement on its own return. Missing these statements does not automatically disqualify the tax-free treatment, but it invites IRS scrutiny and can extend the statute of limitations on the return.

The partnership files a final Form 1065 covering the short tax year up to the date of termination. The new corporation files Form 1120, or Form 1120-S if the S election is in place, for the period from incorporation through the end of its tax year. Both returns should reflect consistent valuations and basis figures for the transferred assets. Discrepancies between the two are among the most common audit triggers in partnership incorporations.

1
Internal Revenue Service. Rev. Rul. 2004-59
2
Office of the Law Revision Counsel. 26 USC 368 – Definitions Relating to Corporate Reorganizations
3
Office of the Law Revision Counsel. 26 U.S. Code 351 – Transfer to Corporation Controlled by Transferor
4
Internal Revenue Service. Rev. Rul. 2003-51
5
Office of the Law Revision Counsel. 26 U.S. Code 362 – Basis to Corporations
6
Office of the Law Revision Counsel. 26 USC 358 – Basis to Distributees
7
Office of the Law Revision Counsel. 26 U.S. Code 732 – Basis of Distributed Property Other Than Money
8
Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
9
Office of the Law Revision Counsel. 26 USC 357 – Assumption of Liability
10
Office of the Law Revision Counsel. 26 USC 1244 – Losses on Small Business Stock
11
Internal Revenue Service. Instructions for Form 2553
12
Internal Revenue Service. When to Get a New EIN
13
eCFR. 26 CFR 1.351-3 – Records to Be Kept and Information to Be Filed