Tax Alchemy?

How many of you remember Section 138509 of the Ways and Means Committee’s markup last September of what would have been the Build Back Better Act? (A moment of silence, please.)  Allow me to jog your memory. Its heading read as follows: “TEMPORARY RULE TO ALLOW CERTAIN S CORPORATIONS TO REORGANIZE AS PARTNERSHIPS WITHOUT TAX.”[i]

“Oh, that Section 138509. Of course.”

Yep. Under the proposal, any corporation that was an S corporation on May 13, 1996[ii] could have been reorganized as a partnership without triggering a tax liability,[iii] provided the corporation transferred substantially all of its assets and liabilities to a domestic partnership during the two-year period beginning on December 31, 2021.

I remember how surprised I was to encounter this provision. The Administration’s summary of the President’s tax plan certainly did not mention it. How did such a business-friendly proposal find its way into this “tax the rich” bill, under this Congress?

I thought that someone in the President’s Party – whether an elected official or a well-heeled supporter – must have had an urgent need to withdraw some highly appreciated real property from the S corporation in which the property had been inexplicably[iv] acquired years before, and they preferred to do so without incurring a huge income tax liability, especially if they could not have paid the tax without refinancing or selling the property.[v]

Well, some Congressional watchdog must have read the Ways and Means version of the bill very closely, because when the revised bill was released by the House Rules Committee in November of 2021, the above-described proposal was gone.

Why am I rehashing this chapter in the painful history of the Administration’s Build Back Better plan? Because I enjoy rubbing SALT into the wounds of its still bitterly disappointed proponents? Not at all.

Separating Shareholders

I am moved to revisit what would have been a very helpful, albeit short-lived, tax-free conversion rule because I have seen several situations lately in which the shareholders of S corporations that hold real property have expressed an interest in going their separate ways, situations in which they would have been much better served, at least from a tax perspective, if they had acquired the property in a partnership instead.

Tax-Deferred Division of Corporation

In a couple of these cases, the S corporation’s real estate activities rise to the level of an “active trade or business”[vi] that has been conducted throughout the 5-year period ending on the date of the desired separation;[vii] thus, it appears that a tax-deferred split-off or split-up may be possible,[viii] provided the shareholders and their respective corporations also satisfy certain other pre- and post-separation requirements.[ix]

Taxable Division of Corporation

In another, the corporate-owned properties are managed by an unrelated company; thus, the active trade or business requirement is not satisfied. Moreover, the S corporation’s shareholders have no interest in assuming any management responsibilities and getting their hands dirty over the next five years, or in acquiring a qualifying business on a “tax-free” basis,[x] so as to satisfy the active trade or business requirement for a tax-deferred division of the corporation.

Under these circumstances, the distribution of appreciated property by the S corporation in complete redemption of the shares of certain shareholders will be treated as a taxable sale of the property by the corporation[xi] and as a taxable exchange of their shares of stock by the distributee shareholders.[xii]

Because we’re dealing with an S corporation, the gain from the deemed sale of the real property by the corporation is allocated among all of its shareholders on a pro rata basis, including those whose shares are not being redeemed.[xiii] The amount of gain allocated to a shareholder is then added to such shareholder’s basis for their shares; thus, the amount of gain, if any, realized by a departing shareholder will be reduced by this basis increase.[xiv]

Tax-Deferred Division of Partnership

This result should be contrasted with the division of a partnership[xv] into two (or more) partnerships.[xvi] In general, the existing partnership[xvii] is treated as having contributed certain assets and liabilities to a new partnership in exchange for all the interests in such partnership[xviii] and, immediately thereafter, as having distributed these interests to some of its partners in complete liquidation of such partners’ interests in the distributing (i.e., the divided) partnership.

The Code provides that no gain or loss will be recognized by a partnership or by any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.[xix] The Code also provides that no gain will be recognized by a partner on the distribution of property by the partnership to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution.[xx]

Thus, a partnership may distribute real property to a partner as a current distribution[xxi] or as a liquidating distribution[xxii] on a tax-deferred basis.

Sale or Exchange of the Real Property

Then there are a couple of matters on my desk in which the shareholders of an S corporation that is planning to sell its real property have differing ideas of what to do with the net proceeds.

In one case, some of the shareholders want the S corporation to redeem all their shares for money, while the remaining shareholders want the corporation to engage in a like kind exchange and, thereby, defer recognition of the gain from the sale.

In the other, there are two groups of shareholders, each of which wants to engage in a like kind exchange; however, each group wants its “own” replacement property that it will manage independently of the other group, and the income and gain from which will redound only to its benefit, notwithstanding both replacement properties will be held by a single S corporation.

Today’s post will focus on these last two scenarios.

Like Kind Exchange

In general, the gain realized from the sale of property for money, or from the exchange of property for other property, is treated as income that must be recognized. The amount realized from a sale or other disposition of property is the sum of any money received plus the fair market value of any property (other than money) received.[xxiii]

The Code provides an exception from this general rule in the case of real property;[xxiv] specifically, a taxpayer will not recognize gain if real property held by the taxpayer for productive use in a trade or business or for investment (the “relinquished” property) is exchanged solely for other real property of like kind to be held by the taxpayer either for productive use in a trade or business or for investment (the “replacement” property).[xxv]

If an exchange of real properties would otherwise qualify as a tax-deferred like kind exchange if it were not for the fact that the property received in exchange consists not only of qualifying real property but also of other property or money, then the gain, if any, to the exchanging taxpayer will be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.[xxvi]

Same Taxpayer

It is implicit in the like kind exchange rules – and explicit in the above description of such rules – that the taxpayer who owned the relinquished property at the time of the exchange must also acquire the replacement property. But what if the “taxpayer” is a pass-through entity, such as a partnership or an S corporation?

According to the IRS, each of these entities is a separate “taxpayer” for purposes of the like kind exchange rules notwithstanding that neither entity is actually subject to income tax,[xxvii] and notwithstanding that any income or gain recognized by the entity is passed through and taxed to its partners or shareholders and that the character of such income or gain in their hands is determined as if it were realized by the partner or shareholder directly from the source from which it was realized by the partnership or corporation.[xxviii]

Departing Partner or Shareholder

It is not uncommon, when a partnership or S corporation (a business entity) has decided to engage in a like kind exchange,[xxix] for one or more partners or shareholders (an owner) to request that their interests in the partnership be liquidated by the entity in exchange for a sum of money.


The selling owner’s expectation is that some of the proceeds from the entity’s sale of its real property will be used by the entity to redeem their interest.

Unfortunately, when sale proceeds are “diverted” toward the buyout of an owner rather than toward the acquisition of a qualifying replacement property, the business entity will recognize gain.[xxx] Unless the owners agree otherwise, this gain will be allocated among, and taxed to, all of the owners in accordance with their equity interest in the entity notwithstanding that only the departing owners will actually receive money in liquidation of their equity interests.

Other Cash

Thankfully, business entities will generally have several options from which to choose that address this situation, though there are some that are not available to an S corporation with respect to a departing shareholder.

For example, the departing owner’s interest may be purchased by the remaining owners, or by a new owner, using their own cash. Alternatively, the business entity may use its excess cash to liquidate the departing owner’s interest.


Where neither the other owners nor the business entity has enough cash available, they may purchase the departing owner’s interest in exchange for a note payable over some number of years, assuming the selling owner is willing to wait and to assume the associated credit risk, which is often not the case.[xxxi]

If the business entity has at least two properties, inclusive of the relinquished property, it may be possible to borrow against the second property[xxxii] and use the loan proceeds for the buyout.

If the entity has just one real property, and the seller insists upon immediate payment, the entity may have to consider placing debt on the relinquished property prior to the exchange, or on the replacement property (or properties, if more than one is acquired) after the exchange.[xxxiii] Provided the new or increased debt is respected as having “independent economic substance,”[xxxiv] it should not be treated as boot received by the selling entity for purposes of determining the tax consequences of the like kind exchange.[xxxv]

Additional Partnership Options

As indicated earlier, a partnership may transfer property to a partner on a tax-deferred basis either as a current distribution or as a distribution in liquidation of the partner’s interest.

In-Kind Distribution

For example, the partnership may distribute one of its properties to the departing partner in liquidation of such partner’s interest in the partnership, generally without triggering a tax liability.[xxxvi]

If the only property available for disposition is the one that is to be sold as part of a like kind exchange, the partnership may distribute a tenancy-in-common interest to a departing partner in liquidation of such partner’s interest.[xxxvii] The departing partner then sells its TIC interest to a buyer in exchange for money or a note, while the partnership and the remaining partners sell their TIC interest to the same buyer as part of a deferred like kind exchange.[xxxviii]

Separate Like Kind Exchanges

Instead of selling its TIC interest in a taxable sale, the departing partner may use the proceeds from the sale to acquire its own replacement property as part of a deferred like kind exchange separate from that in which the partnership engages.

Alternatively, the partnership may acquire two replacement properties: one to be retained by the partnership and the other to be distributed to the departing partner in liquidation of their interest in the partnership at some time after the exchange.

These approaches may also be used to divide the partnership between two sets of partners.[xxxix]

Of course, for each case in which the partnership’s distribution of a TIC interest in relinquished property precedes a like kind exchange by the distributee-partner(s), or in which replacement property acquired by the partnership is distributed to one or more of its partners in liquidation of their interests in the partnership, one must be mindful of the requirements for like kind exchange treatment that both the relinquished and the replacement properties, respectively, have been held and will be held by the same taxpayer for investment or for use in a trade or business. The longer the distributee-departing partner holds the TIC interest in the relinquished property, the better their position that they held the property for the requisite purpose before exchanging it for replacement property; similarly, the longer the partnership holds the replacement property to be distributed to the departing partner, the stronger its position that it held the replacement property for the requisite purpose.[xl]

Each of the foregoing approaches involves a distribution of real property by a partnership. However, there is another avenue to be considered that does not present a risk as to the like kind exchange itself.

Like Kind Exchange with Boot

Specifically, the partnership may sell the relinquished property, then set aside enough of the money from the sale to redeem the departing partner’s interest, while using the balance of the sale proceeds to acquire replacement property. The money that was not used to purchase replacement property would constitute boot; without more, the gain attributable to such boot would be allocated among all the partners – both continuing and departing – in accordance with their interest in the partnership.

That said, what if the partners agreed to specially allocate all the boot-related gain from the like kind exchange to the departing partner, to whom the boot (money) was actually distributed? Such a special allocation would permit the remaining partners – those did not receive a distribution of money – to enjoy the deferral benefit of the like kind exchange, as represented by the replacement held by the partnership. Provided this special allocation is adopted by the partners in accordance with their partnership agreement, and provided further that it has substantial economic effect, it should be respected by the IRS.[xli]

Compare the S corp.

Unlike a partnership, an S corporation cannot distribute a single property, or a TIC interest in a property, to one of its shareholders in redemption of such shareholder’s interest in the corporation without triggering gain recognition.[xlii]

This gain will be allocated pro rata among all the shareholders, including those who did not receive a distribution.[xliii]

The same result will follow a like kind exchange where the corporation receives boot that will be used to redeem a departing shareholder – the gain associated with the boot will be allocated among all the shareholders.[xliv]

Moreover, this gain cannot be specially allocated to the departing shareholder under the S corporation single class of stock rule, which requires that all outstanding shares of stock confer identical rights to distribution and liquidation proceeds.[xlv]

In that case, might it be possible to negotiate the redemption price so as to “compensate” the remaining shareholders for the unwanted tax liability that was attributable entirely to the buyout of the departing shareholder? Perhaps. After all, IRS regulations indicate that a redemption agreement will be disregarded in determining whether a corporation’s outstanding shares of stock confer identical distribution and liquidation rights unless a principal purpose of the agreement is to circumvent the one class of stock requirement and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of or below the fair market value of the stock. Agreements that provide for the purchase or redemption of stock at book value or at a price between fair market value and book value are not considered to establish a price that is significantly in excess of or below the fair market value of the stock and, thus, are disregarded in determining whether the outstanding shares of stock confer identical rights.[xlvi]

In light of the foregoing, may the S corporation acquire two replacement properties (preferably in separate LLCs, each wholly owned by the S corporation), one of which would be operated by the shareholder who sought to be separated from the other shareholders, and to whom the benefits of such property would be limited? Again, this arrangement would be prohibited to an S corporation under the single class of stock rule. Moreover, under the circumstances described, the arrangement may be attacked as a constructive, and taxable, distribution of the replacement property.[xlvii]

Woe to the S Corp?

Where does this leave the S corporation? I mean aside from a bad case of partnership envy?

It would appear, in the absence of a real property business that constitutes an active trade or business under the Code’s spin-off rules, that the removal of an S corporation shareholder may only be accomplished in a taxable transaction, even where it is accomplished in the context of a like kind exchange.

Speaking of like kind exchanges, the S corporation and its shareholders may best be served, as a whole, by accomplishing the exchange to defer all the gain realized on the sale of the real property, and then borrowing the necessary funds to redeem the departing shareholder.

Until Congress addresses this significant S corporation disadvantage – a remote possibility at best – S corporation shareholders will probably reminisce about Section 138509.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

louis[i] It should go without saying that the “conversion” of an entity that is treated as a corporation for tax purposes into one that is treated as a partnership is treated as a liquidating distribution – a deemed sale under IRC Sec. 336 – by the corporation of its assets and liabilities to its shareholders followed immediately by the shareholders’ contribution of such assets (with a stepped-up basis) and liabilities to a newly formed partnership.

By avoiding the recognition of gain from the deemed sale of the property, the proposal also would have prevented the application of IRC Sec. 1239, pursuant to which some or all of the gain recognized from the sale of property that would have been depreciable in the hands of the shareholders may have been treated as ordinary income.

[ii] I.e., the date on which the “check the box” entity classification regulations were proposed under IRC Sec. Sec. 7701.

[iii] I can’t imagine this would have included any corporate-level built-in gain tax under IRC Sec. 1374; specifically, given the circumstances in which the proposal would have applied, the gain inherent in assets that were acquired with carryover basis by an otherwise eligible S corporation from a C corporation in an IRC Sec. 368 reorganization.

[iv] Seriously, folks. It’s as though everyone had forgotten about using limited partnerships with an S corporation holding a small interest as the general partner.

[v] Do you have a better explanation? Might this have been a form of “tax equity” that was intended to compensate S corporations and their shareholders for the years of injustice heaped upon them by a Congress that never understood their needs?

[vi] IRC Sec. 355(b)(2)(A).

[vii] IRC Sec. 355(b)(2)(B).

[viii] IRC Sec. 355.

In a split-off, the existing corporation organizes a new subsidiary, to which it contributes a portion of its assets and liabilities, then distributes the stock of the subsidiary to some of its shareholders in redemption of all their shares of stock in the distributing corporation.

In a split-up, the existing corporation organizes at least two subsidiaries, between which it divides its assets and liabilities, then makes a liquidating distribution of each subsidiary to a different group of shareholders.

[ix] For example, both corporations are engaged immediately after the distribution in the active conduct of a trade or business that satisfied the 5-year requirement, and they do not violate IRC Sec. 355(e).

It will often behoove the corporation and its shareholders to request a ruling from the IRS regarding the proposed separation.

The last PLR I obtained for a corporate-owned real property business under IRC Sec. 355 was for the split-off of a newly formed subsidiary to one group of shareholders. PLR 202211009 (Dec. 17, 2021).

[x] IRC Sec. 355(b)(2)(C).

[xi] IRC Sec. 311(b).

[xii] IRC Sec. 302(a) and Sec. 302(b)(3).

[xiii] IRC Sec. 1366(a).

Because the interests of one or more shareholders are being terminated, the corporation and all the “affected” shareholders may elect to close the corporation’s books with the date of the redemption, and to allocate the gain from the sale as if the corporation’s taxable year consisted of two separate taxable years, the first of which ends at the close of the day on which the shareholder’s entire interest in the S corporation is terminated. IRC Sec. 1377(a)(2); Reg. Sec. 1.1377-1(b).

[xiv] IRC Sec. 1367.

[xv] Including the division of an LLC that is treated as a partnership for tax purposes. Reg. Sec. 301.7701-3; IRC Sec. 761.

[xvi] Reg. Sec. 1.708-1(d).

[xvii] Which may be treated as continuing after the distribution described herein. Reg. Sec. 1.708-1(d)(1).

[xviii] The momentary existence of a single member “subsidiary” partnership is ignored for this purpose.

[xix] IRC Sec. 721.

[xx] IRC Sec. 731(a).

I am assuming for our purposes that none of IRC Sec. 704(c)(1)(B), 707, 737, 751, and 752 apply. Seems like a lot, but not really where the real properties held by the distributing partnership were acquired by the partnership, and any partnership debt is split proportionately between the distributing and the distributed partnerships.

[xxi] Basically, any distribution that is not a distribution in complete liquidation of the distributee-partner’s interest. Reg. Sec. 1.731-1(a)(1)(i).

[xxii] IRC Sec. 736(b): a distribution made in exchange for a partner’s interest in the underlying property of the partnership. Contrast a payment to a partner under IRC Sec. 736(a).

[xxiii] Reg. Sec. 1.1001-1(a).

[xxiv] As amended by the Tax Cuts and Jobs Act, P.L. 115-97.

[xxv] Under IRC Sec. 1031(a)(1), property held for productive use in a trade or business may be exchanged for property held for investment.

Similarly, property held for investment may be exchanged for property held for productive use in a trade or business.

IRC Sec. 1031 does not apply to an exchange of real property that is held primarily for sale.

[xxvi] IRC Sec. 1031(b).

[xxvii] IRC Sec. 701 and IRC Sec. 1363(a). there are exceptions for S corporations; for example, the corporate-level tax on built-in gain, though this relates to the certain C corporation attributes inherited or acquired by the S corporation.

[xxviii] IRC Sec. 702(b) and IRC Sec. 1366(b).

[xxix] For example, to relocate its investment to a lower tax jurisdiction, or to diversify or consolidate its real property holdings by exchanging its single real property for at least two replacement properties, or by exchanging multiple real properties for a single replacement property.

[xxx] But not more than the amount of gain realized in the exchange.

[xxxi] It should be noted that a partner whose interest is being liquidated will continue to be treated as a partner for purposes of the partnership tax rules until their interest is completely liquidated; i.e., until the note is satisfied. Reg. Sec. 1.736-1(a)(1)(ii).

[xxxii] Assuming there is enough equity to secure, and enough cash flow to service, the debt.

[xxxiii] Which is my own preference, where feasible, because the entity will still be liable for the debt. In that case, it is probably best not to have obtained the loan commitment prior to the like kind exchange.

[xxxiv] Garcia v. Comm’r, 80 T.C. 491 (1983), acq., 1984-2 C.B. 1.

[xxxv] See the ABA’s discussion in its 1992 “Report on Open Issues in Section 1031 Like-Kind Exchanges.”

[xxxvi] IRC Sec. 731(a).

If course, if the distribution causes a change in the allocation of partnership liabilities among the partners under IRC Sec. 752, including the departing partner, then the deemed cash distribution that follows may result in taxable gain for whichever partner experiences a net reduction in debt allocation. Reg. Sec. 1.752-1(f).

Again, I am assuming IRC Sec. 704(c)(1)(B), Sec. 707, Sec. 751, and Sec. 737 do not apply. Otherwise, each of these provisions must be considered.

[xxxvii] IRC Sec. 736(b) and Sec. 731(a).

[xxxviii] IRC Sec. 1031(a)(3); Reg. Sec. 1.1031(k)-1.

[xxxix] Reg. Sec. 1.708-1(d).

[xl] Practically speaking, how long would either the departing partner or the partnership want to remain tied to the other?

[xli] IRC Sec. 704(a) and (b).

[xlii] IRC Sec. 311(b); Sec. 1371.

[xliii] IRC Sec. 1366(a).

[xliv] The departing shareholder may recognize additional gain on the redemption/sale of its shares.

[xlv] IRC Sec. 1361(b)(1)(D); Reg. Sec. 1.1361-1(l)(1).

[xlvi] Reg. Sec. 1.1361-1(l)(2)(iii)(A).

[xlvii] Compare the situation in which the shareholders manage the properties separately but continue to share the economics on a pro rata basis. What if this arrangement was implemented to develop a 5-year history of engagement in an active business so as to qualify for an IRC Sec. 355 split-off down the road?