Tax the Rich?

A few days ago, an opinion piece that appeared in the Wall Street Journal[i] began as follows:

“President Biden’s effort to pass the largest tax increase in U.S. history is based on the verifiably false claim that Americans with high incomes don’t pay their ‘fair share.’ In no other country do the rich bear a greater share of the income-tax burden than they do in the U.S.”

The author briefly described data from the OECD, the Joint Committee on Taxation, and the Congressional Budget Office which, the author states, support the above claim.[ii]

The article then takes a turn when it asserts that the Administration’s tax plans are not actually targeting the super-rich, or even large corporations,[iii] for whom the Democrats seem to have carved out a tenth circle in Dante’s Inferno.[iv]

According to the author, in a “classic bait-and-switch” – to which they refer as the Democrats’ “tax-the-rich ruse” – the Administration and Congress are really seeking to raise the taxes on upper-middle-income families which “aren’t rich enough to use tax-advantaged investments effectively,” and who already pay “a higher share of the income-tax burden relative to their income than any other taxpayers on earth.”[v]

“For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle.” – Winston Churchill

Or Maybe Not?

I can neither confirm nor deny the above claims, though I must admit there are some tax-related measures included in the Democrats’ 2022 budget bill, as approved by the House Ways and Means Committee over a month ago,[vi] that are difficult to reconcile with the budget’s revenue-raising/tax function or with the “tax-the-rich” mantra that so many in the Party have adopted.[vii]

One budget provision that I find especially intriguing would permit an S corporation that was in existence on May 13, 1996 to convert to a tax partnership without incurring any immediate adverse tax consequences.[viii]

Specifically, a domestic corporation that transfers substantially all its assets and liabilities to a domestic partnership may elect[ix] not to recognize the gain inherent in its assets if (1) the corporation was an S corporation on May 13, 1996 and at all times thereafter,[x] and (2) the transfer results in the complete liquidation of the S corporation before January 1, 2024.[xi]

This proposal flies in the face of thirty-five years of tax law. Moreover, it bestows a very valuable economic benefit upon a not insignificant number of individuals.[xii] To appreciate the extent of this benefit, some historical background may be in order.

“The taxpayer: that’s someone who works for the federal government but doesn’t have to take a civil service examination.” Ronald Reagan

General Utilities Rule

In General Utilities,[xiii] the U.S. Supreme Court decided that a corporation which distributes appreciated property[xiv] to its shareholders as a dividend, in redemption of shares, or as a liquidating distribution, was not required to recognize, and pay tax on, the gain inherent in such property.[xv]

The effect of the Court’s decision in General Utilities was to allow the appreciation in the property accruing during the period it was held by a corporation to escape tax at the corporate level via a distribution of the property to the shareholders.

Although the distributee-shareholders were required to include the fair market value of the property in their gross income (on which they would be taxed), the shareholders also obtained a stepped-up, fair market value basis in the property, with the associated additional depreciation or amortization deductions, or with the ability to immediately dispose of the property without incurring additional tax.[xvi]

The foregoing “General Utilities rule” was eventually codified and remained in the Code until the Tax Reform Act of 1986.[xvii]

“All taxes discourage something. Why not discourage bad things like pollution rather than good things like working or investment?” Lawrence Summers

Repeal of General Utilities

Congress subsequently enacted several statutory exceptions to the General Utilities rule. For example, the corporate nonrecognition under General Utilities was reversed for nonliquidating distributions: the general rule became (and remains) that a corporation recognized gain on a distribution of built-in gain property as a dividend or in redemption of its stock.[xviii] The distributing corporation is treated as if it had sold the property for an amount equal to its fair market value on the date of the distribution.

Congress eventually realized that the rule could create significant distortions in business behavior; after all, from an economic perspective, a liquidating distribution is indistinguishable from a nonliquidating distribution, yet the Code provided a substantial preference for the former.

Congress also determined that the rule tended to undermine the corporate income tax – where the General Utilities rule applied, assets generally were permitted to leave corporate solution and to take a stepped-up basis in the hands of the shareholder-transferee without the imposition of a corporate-level tax.

Finally, in 1986, the Code was amended to provide the current rule that gain or loss generally is recognized by a corporation on liquidating distributions of its property as if the property had been sold at fair market value to the distributee.[xix] Exceptions were provided for distributions in which an 80-percent corporate shareholder receives property with a carryover basis in a liquidation of its corporate subsidiary,[xx] and for certain other distributions and exchanges involving property that may be received tax-free by the shareholder.

S Corporations

The ’86 Act also made certain conforming changes in the provisions relating to S corporations. For example, the Act modified the treatment of an S corporation that was formerly a C corporation. It provided for the imposition of a corporate-level tax on any gain that arose prior to the conversion from C-to-S corporation status (the “built-in” gain) and that was recognized by the S corporation through a sale, distribution, or other disposition within ten years (now five years[xxi]) after the date on which the S election took effect.

The total amount of gain that must be recognized by the corporation, however, is limited to the aggregate net built-in gain of the corporation at the time of conversion to S corporation status.[xxii]

“If you get up early, work late, and pay your taxes, you will get ahead – if you strike oil.”– J. Paul Getty

From S corporation to Partnership – Current Law

Consistent with the repeal of General Utilities, the “conversion” of a corporation to a partnership – including a limited liability company (“LLC”) that is treated as a partnership for tax purposes[xxiii] – is treated as a liquidating distribution by the corporation; meaning that the corporation is treated as having sold its assets at fair market value.

Assets Over

For example, if the corporation contributed its assets to an LLC in exchange for all the membership interests in the LLC, of which it then made a liquidating distribution to its shareholders, the corporation would be treated as having sold the membership interests for their fair market value (presumably the value of the contributed assets).

Assets Up

The same result would follow if the corporation first distributed its assets to its shareholders, who then contributed such assets to an LLC in exchange for its membership interests. The assets would be treated as having been sold.


The merger, in accordance with state law,[xxiv] of the corporation with and into an LLC, with the LLC surviving, would also be treated as a taxable sale of its assets by, and the liquidation of, the corporation.

Formless Conversion

In some states, no actual transfer of assets from a corporation to an LLC is required to effectuate the conversion; indeed, no second entity needs to be organized. In Delaware,[xxv] for example, one need only file a certificate of conversion for the corporation and a certificate of formation for the LLC with the Department of State, Division of Corporations. When a corporation has been converted to an LLC in this manner, the LLC is deemed, as a matter of law, to be the same entity as the corporation for all state law purposes, with the same assets, liabilities, etc.

For purposes of the tax law, however, this “formless conversion” is treated as a taxable liquidation of the corporation – a sale of its assets – followed by a contribution of the assets to the LLC (the tax partnership).

Check the Box

Finally, when the entity classification, or “check the box,” regulations were finalized in 1996, the preamble accompanying them reminded taxpayers that a change in classification, no matter how achieved, will have certain tax consequences that must be reported.

The regulations then explained that if an association[xxvi] elects to be classified as a partnership, the association is deemed to liquidate by distributing its assets and liabilities to its shareholders; then, the shareholders are deemed to contribute all the distributed assets and liabilities to the partnership.[xxvii]

Built-in Gain

If the S corporation in question in subject to the built-in gains tax and the conversion occurs within the five-year recognition period, the corporation itself will be subject to a corporate-level tax, the responsibility for which would be assumed by the distributee-shareholders or the successor LLC.


In each of the “conversion methods” described above, the shareholders will take the property deemed to have been distributed to them by the corporation with a basis that has been stepped up to the property’s then fair market value. After the shareholder “contributes” the property to the partnership, the now-former shareholder will hold their interest in the partnership with the same starting basis.[xxviii]

“It is a paradoxical truth that tax rates are too high today and tax revenues are too low, and the soundest way to raise the revenues in the long run is to cut the tax rates.”John F. Kennedy

S corporation to LLC[xxix] – Tax Consequences Under Current Law

When an S corporation makes (or is treated as making – see above) a liquidating distribution to its shareholders, it is deemed to have sold its assets for consideration equal to their fair market value.[xxx]

The amount of gain from the deemed sale passes through to the corporation’s shareholders and is included in their gross income for purposes of determining their taxable income. The character of such gain in the hands of the shareholders is determined as if such gain were realized directly from the source from which realized by the corporation.[xxxi]

The character of the gain from the deemed sale is determined by looking at the assets “sold.” Thus, capital assets and Section 1231 assets[xxxii] for which the S corporation has a holding period of more than one year will generate long-term capital gain; assets such as inventory and receivables, and assets with depreciation recapture[xxxiii] will generate ordinary income.

However, it is important to keep in mind that special rules apply to sales or exchanges between “related” parties. Under one such rule, the gain from the sale (or deemed sale) of property between certain related persons will be treated as ordinary income (not capital gain) if the property is depreciable in the hands of the transferee – in this case, the shareholders.[xxxiv]

For example, the distribution of improved real property from an S corporation to its shareholders,[xxxv] consisting of a parent and their children, will cause that portion of the gain that is attributable to the building and other improvements (but not the land) to be taxed as ordinary income. This ordinary income will flow through to the shareholders for tax purposes.[xxxvi]

Another item of which to be aware: if the S corporation is subject to the built-in gains tax,[xxxvii] the deemed sale will also generate corporate-level tax.

Finally, a shareholder may recognize gain upon their receipt of the property distributed if its fair market value exceeds the shareholder’s basis for their shares of stock in the distributing corporation, adjusted to reflect the gain allocated to the shareholder from the deemed sale.[xxxviii]

“In 1790, the nation which had fought a revolution against taxation without representation discovered that some of its citizens weren’t much happier about taxation with representation.” Lyndon B. Johnson

Post-Conversion Advantages – Current Law

The tax liability that would be incurred under current law upon the conversion from corporate to LLC/partnership form should be accounted for in determining the overall economic costs[xxxix] from the conversion and then comparing them to the expected benefits, of which there are many.

With the conversion from S corporation status to LLC/partnership status for tax purposes, a whole new world of opportunities may present itself to the business and its owners.

No longer will they be limited to issuing a single class of stock,[xl] and no longer will they be limited to admitting, or selling equity to, only U.S. individuals and trusts.[xli] For example, the LLC would be able to issue preferred interests in exchange for capital from corporations, other partnerships, and foreigners.[xlii]


Moreover, a new investor will be able to make an in-kind contribution to an LLC in exchange for a less-than-controlling membership interest without recognizing gain. The same contribution to an S corporation would be treated as a taxable sale of the property.[xliii]

Not only is it “easier” to contribute property to an LLC, at least from a tax perspective, it is also less costly, from a tax perspective, to withdraw property from an LLC as compared to a corporation. In general, a distribution of property by an LLC to its members will not be treated as a taxable disposition; thus, the LLC may be able to distribute a property to a member in liquidation of their interest without either party incurring a tax liability.[xliv] Similarly, the LLC may split up into two or more LLCs with each taking a different property, without adverse tax consequences.[xlv]

On the death of an owner, and the resulting step-up in basis[xlvi] for the membership interest passing from the decedent to their successor, the LLC may be able to adjust the successor’s share of the LLC’s “inside basis” for its assets to reflect the fair market value of the intertest which, in turn, may generate more deductions for the successor, and/or the allocation of less gain to the successor on a later sale of such assets.[xlvii]

Finally, the LLC may be able to borrow against the equity in its assets, and then distribute the proceeds to its members tax-free. That’s because when an LLC borrows money, the indebtedness is allocated among its members as though they had borrowed the funds and then contributed them to the LLC, thereby increasing their basis for their membership interests.[xlviii] A distribution of money by an LLC to a member is taxable only to the extent it exceeds the distributee-member’s basis for their interest.[xlix]

“A liberal is someone who feels a great debt to his fellow man, which debt he proposes to pay off with your money.” – G. Gordon Liddy

“Build Back Better”: S corporation to LLC Conversion

Based on the foregoing, one might say that the members of a business organized as an LLC enjoy many benefits over their counterparts who are shareholders of an S corporation.

Of course, where the LLC is the product of a conversion from corporate form, the shareholders, and perhaps the S corporation,[l] had to pay a price – they incurred a tax liability on the deemed sale of the corporation’s assets.

However, under the Ways and Means Committee’s bill, an eligible S corporation may convert to an LLC treated as a partnership for tax purposes without recognizing any gain and without any tax being imposed upon its shareholders.[li]

Under general principles, the unrecognized gain should be preserved under the post-conversion structure. Thus, the LLC should take the assets of the corporation with the same basis they had in the hands of the corporation; likewise, the former shareholders should take the same basis for their membership interests as they had in the stock of the S corporation.

There is a benefit to such tax deferral, especially when one considers the other advantages afforded the LLC over the S corporation, as described above.

“I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money.” Arthur Godfrey

The Question

Which begs the question: “Why?”

This is the Congress that is aiming to “tax the rich,” to make sure the rich “pay their fair share.” This Congress has already proposed to increase the rate on individuals’ ordinary income, increase the rate on long-term capital gains and dividends, increase the rate on C corporations, expand the reach of the tax on net investment income, introduce a new surcharge on larger incomes, reduce the benefit of Sec. 1202 stock, etc.

This is the Administration that wants to eliminate the basis step-up at death, treat death as a gain recognition event, and restrict the availability of like kind exchanges.

Delve deeper – what is the significance of May 13, 1996? Why must an S corporation have existed as an S corporation on that date in order to be eligible for the proposed tax-free conversion benefit?

It turns out that May 13, 1996 is the date on which the entity classification, or check the box, rules were proposed.

So what?

Didn’t the preambles to the proposed and final regulations state that the conversion of an association (basically, a corporation for tax purposes) into a partnership should be treated as a taxable liquidation of the association? In any case, an incorporated entity would not be allowed to “check the box” under those regulations (it is not an “eligible” business entity) but would have to engage in one of the forms of conversion described above to change its status for tax purposes.

Here we are, over twenty-five years later – what has changed?  Can it be that the May 13, 1996 date is merely a red herring?[lii] I would say the odds are pretty good.

Maybe the author of the opinion piece in the Journal, described above, was right after all.


[ii] The Joint Committee is a nonpartisan committee of the Congress.

The CBO is a nonpartisan federal agency that supports the Congressional budget process. .

[iii] Most of the taxes imposed on corporations, the author claims, are passed on to consumers as higher prices and to employees as lower wages. Both have their limits. The bottom line, though, is irrefutable: the general public will bear the brunt, as it has for centuries.

[iv] It’s not clear to me where this new circle would fit among the nine original concentric circles that comprise Dante’s hell, beginning with Limbo (with the noble pagans) and ending with Satan in the center of the ninth circle, where he is trapped waist-deep in ice from which he cannot extricate himself – indeed, the beating of his wings only aggravates his situation.

[v] The “$400,000 of annual income per family” threshold, beyond which many individual tax benefits disappear, seems to support this hypothesis – at least among many families in downstate New York, in which I include Westchester.

“Westchester?” you ask. Yep. Winterfell claimed to be the North, except it was viewed as part of the South by the Wildlings who lived beyond The Wall. It’s all relative.

[vi] And there are others that may find their way into the budget – think relief from the cap on the SALT deduction for which many Democrats from high-tax states are campaigning, with New York and New Jersey at the forefront.

[vii] Together with the “canceling” of what they perceive as “unenlightened” views.

Where are the students of Voltaire or of Patrick Henry? The following words have been attributed to the French philosopher: “I disapprove of what you say, but I will defend to the death your right to say it.” Is it possible the 18th century Frenchman – a strong supporter of civil rights – has been canceled for not being sufficiently “progressive”?

[viii] See Sec. 138509 of the bill approved by the House Ways and Means Committee.

[ix] Yes, the provision is elective. The IRS is directed to determine how the election is to be made. The election must be made no later than the due date for the taxable year in which the qualified liquidation is completed.

[x] An “eligible S corporation.”

[xi] A “qualified liquidation.”

[xii] At least based upon the number of inquiries I have received over that period from individuals who may now qualify for such benefit.

[xiii] General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).

[xiv] A property with a built gain, whether because the property’s basis was depreciated below its FMV or because the property’s FMV had increased beyond its basis.

[xv] The gain that would have been recognized by, and taxed to, the corporation if it had sold the property.

[xvi] The corporate-level tax was avoided entirely.

[xvii] P.L. 99-514 (the “’86 Act”).

[xviii] IRC Sec. 311(b). Loss is not recognized but see IRC Sec. 267(a) regarding complete liquidations.

[xix] IRC Sec. 336.

[xx] IRC Sec. 337.

[xxi] Courtesy of the American Taxpayer Relief Act of 2012, P.L. 112-240.

[xxii] IRC Sec. 1374.

[xxiii] Reg. Sec. 301.7701-3. All references herein to LLCs assume the LLC is a tax partnership.

[xxiv] See, e.g., Article X of New York’s LLCL.

[xxv] Sec. 18-214 of the DE Code.

[xxvi] An association is a business entity that is not treated as a corporation per se (for example, it was not formed under a state’s corporation law; see Reg. Sec. 301.7701-2), but that elects to be treated as one for tax purposes. Thus, a single member LLC – otherwise disregarded for tax purposes – may elect to be treated as an association.

[xxvii] Reg. Sec. 301.7701-3(g). For the preamble to the proposed regulations, see RIN 1545-AT91. The final regulations were issued at 61 FR 66584.

You will note that these regulations were proposed on May 13, 1996 – see the definition for an “eligible S corporation,” above.

[xxviii] Thus, there will not be any IRC Sec. 704(c) gain to be concerned about.

[xxix] Remember: we’re assuming a tax partnership.

[xxx] Don’t count on a discounted valuation based upon each shareholder’s being deemed to have received a “fractional” interest in each asset distributed. See Pope & Talbot Inc. v. Comm’r, 162 F.3d 1236 (9th Cir. 1999). The distributing corporation is treated as having sold the entire property in a single sale.

[xxxi] IRC Sec. 1366. In other words, the character of the gain also passes through to the shareholders.

[xxxii] “Section 1231” property means property used in a trade or business, of a character which is subject to the allowance for depreciation, held for more than 1 year, and real property used in the trade or business, held for more than 1 year, which is not held for sale in the ordinary course.

[xxxiii] IRC Sec. 1245.

[xxxiv] IRC Sec. 1239.

[xxxv] Or the sale between a commonly owned S corporation and partnership.

[xxxvi] As an aside, if the property distributed was real property located in New York, the mere change exemption should prevent the imposition of any transfer tax, thanks to the identity of beneficial ownership in the property (including percentage interests) of the transferor and the transferee. 20 NYCRR Sec. 575.10.

[xxxvii] Either because it was a C corporation or acquired assets from a C corporation on a “tax-free” basis. IRC Sec. 1374.

[xxxviii] IRC Sec. 1367 and Sec. 1368. The shareholder would be treated as having sold the stock. Thus, if the shareholder has held the stock for more than one year, the gain will be treated as long-term capital gain.

[xxxix] Which may be prohibitively expensive.

[xl]  Meaning that each outstanding share must have the same rights to current and liquidating distributions as every other share. IRC Sec. 1361(b); Reg. Sec. 1.1361-1(l).

[xli] IRC Sec. 1361.

[xlii] This may be of interest:

[xliii] IRC Sec. 721 and Sec. 351.

That said, However, the contributor must be attuned to the partnership “disguised sale” rules, which may treat the contributor as having sold all or some of the property to the partnership; for example, where he mortgages the property to withdraw equity therefrom just prior to contributing the property (subject to the indebtedness) to the LLC.

The contributor must also be careful of “shifting” liabilities, as where he contributes mortgaged property to an LLC; if the contributor is not personally liable for the indebtedness, it will be “re-allocated” among all the partners, and he will be treated as receiving a distribution of money that may be taxable to him. IRC Sec. 731 and Sec. 752.

[xliv] IRC Sec. 731.

Of course, the disguised sale and mixing bowl rules must be considered. IRC Sec. 707, Sec. 704(c)(1)(B), and Sec. 737.

[xlv] A corporation may do the same, but only after satisfying the very demanding rules of IRC Sec. 355.

I should also note that a so-called “drop and swap” like kind exchange transaction may be possible in the case of an LLC but is not an option for a corporation that owns real property. Let’s see if the like kind exchange survives this Congress. It made it past the Ways and Means Committee.

[xlvi] IRC Sec. 1014. The President had proposed eliminating the basis step-up, but the House bill has left it in place.

At this point, who knows where we’ll end up.

[xlvii] IRC Sec. 754. There is no comparable election for an S corporation. When a shareholder dies, the basis for their shares of stock will be adjusted to the date of death fair market value, but the corporation’s basis for its assets will not change.

Query why Congress has not prohibited the depreciation/amortization deductions arising from this adjustment to inside basis.

[xlviii] This principle also enables a member of an LLC to claim deductions for expenses paid using borrowed money; it also allows depreciation deductions arising from property acquired with borrowed funds to flow through to a member.

[xlix] IRC Sec. 731 and Sec. 752.

[l] If it was subject to the built-in gains tax.

[li] I should note, the proposed legislative text states that the “liquidation” of the S corporation into the LLC would be treated as a liquidation described in IRC Sec. 332, with the LLC being treated as the 80 percent corporate parent described in IRC Sec. 337. Query whether the reference to Sec. 332 would exclude an insolvent S corporation from the benefit of the proposed conversion rule in the same way that an insolvent subsidiary corporation would be excluded? If this provision is enacted, the IRS is authorized to “prescribe such regulations or other guidance as may be necessary or appropriate to carry out” the provision.

Presumably, the nonrecognition would also cover any built-in gain tax exposure of the S corporation. This is likely to be addressed by regulation, assuming the rule is enacted.

[lii] Do you know how many NYC buildings are owned by S corporations that were created in the 1970s, right around the time of the City’s fiscal crisis? A lot.

The flight from the City, the empty buildings, the trash, the crime, the City’s near bankruptcy all contributed to a buyer’s market.

Do you know what those properties must be worth today? (Or at least before De Blasio and COVID.)