Many partnerships have loans from the partners on the books, especially if they are just starting up or have cash-flow problems. At some point, the partners may determine they want to convert the debt to equity for business reasons. It is important to be aware of the income tax effects of a debt to equity conversion. If not properly analyzed and planned, it could result in an unintended additional tax liability. The basic force behind these consequences is the equation used to calculate a partner's tax basis. The tax basis for a partnership interest is calculated by combining the partner's equity and allocated debt. By converting part of that debt to equity, a partnership alters the fundamental allocations used to calculate tax basis. Whether a partner is new to the partnership or is an existing partner, suspended losses, the allocation of debt among partners and the financial health of the partnership all shape the resulting change in tax liability.
It is possible an existing partner's debt conversion may not trigger any income tax consequences. If the converting partner was previously allocated all of the debt, rather than it being split among partners, the converting partner's tax basis in its partnership interest would not change. Additionally, none of the nonconverting partners' tax basis would change since the allocation of debt basis is the same after the conversion.
If the converted debt was allocated among partners, the conversion becomes more complex. The converting partner would receive a tax basis increase since, instead of only receiving a portion of the debt, the partner would now receive the entire amount in the form of equity. If the converting partner had suspended losses, this can provide an immediate income tax benefit. For example, Partner A has $50 in suspended losses from prior years and a loan to the partnership of $100. Assuming only $20 of the debt had been allocated to him for tax basis purposes, if Partner A converts the debt to equity in the current year, he would receive additional tax basis of $80 ($100 of converted debt, less $20 previously allocated), therefore, allowing Partner A to deduct the previously suspended loss of $50. If Partner A is subject to the highest income tax rate - 35 percent, this would represent an income tax benefit of $17.50.
In another scenario, one partner's conversion may be detrimental to the nonconverting partners. Upon the debt conversion, any reduction in debt basis to the remaining partners is treated as a distribution to those partners. If the nonconverting partner did not have enough tax basis to absorb the distribution, it would be taxed as a long-term capital gain, even though cash was not received. Assuming the same facts as the previous example, if Partner B had a tax basis of $10, but was allocated the remaining $80 in debt before the conversion, Partner B would be deemed to receive an $80 distribution when the conversion occurs. Since Partner B only has $10 in tax basis, it would be a distribution in excess of basis of $70 ($10 basis - $80 deemed distribution). At a 15 percent tax rate, this would result in a tax liability for Partner B of $10.50.
If a converting partner increases the ownership percentage upon conversion, rather than just increasing the tax basis, it may have an additional income tax effect. The additional benefit would be a result of the purchase price being greater than the adjusted tax basis of the same percentage of partnership assets. If this occurs, the partnership could make an election when it files its tax return to step up the partnership assets to the purchase price. This step up is allocated only to the converting partner and could result in that partner receiving current income tax benefits, such as depreciation, rather than having to wait to receive the benefit until the partner sells the interest or the partnership liquidates.
For new partners looking to convert, the treatment would be similar. The partnership could make the election and step up the new partner's basis commensurate with the purchase price. The existing partner would reduce their basis for the deemed distributions as a result of the debt reduction so it could cause an income tax effect depending on the partner basis as explained previously.
Converting partnership debt to equity can have far-reaching consequences. Consult a tax adviser to determine if the conversion is the right move.
Eric Pilcher, a CPA with Cherry, Bekaert & Holland LLP, can be reached by email at firstname.lastname@example.org.