Converting a General Partnership to a Limited Liability Company

You have a going business which you formed some years ago as a general partnership. Now you decide that you would be better off operating the business as a limited liability company (LLC). You wonder: How you can convert your business from a general partnership to an LLC?

Why would a partnership wish to convert to a limited liability company?

The first question is “why?” You operated as a general partnership for some time, so why switch? The main reason for a partnership converting to an LLC is to enable the partners to avoid personal liability for the debts of the business. In a general partnership each partner has joint and several liability for the debts of the business. However, a member in a limited liability company is not responsible for the debts of the company. A member’s liability is generally limited to his contribution to the LLC.

How to Convert a Partnership to an LLC

So, you’ve decided that the business should be an LLC from this point forward. Now what? The process of converting a general partnership to an LLC varies from state to state. In the early years of LLCs, few states had specific statutory provisions for converting any existing entity into an LLC, and a general partnership was no exception. In those cases, you needed to dissolve the partnership, distributing the assets and liabilities of the partnership to all of the partners. The partners would then need to contribute the assets and liabilities to a newly-formed LLC.

Now, many states have statutory provisions that allow a partnership to be converted into an LLC in one simple step. For example, in California, a general partnership may file Form LLC-1A (Limited Liability Company Articles of Organization – Conversion), filling in the appropriate conversion information.

Tax Issues of a Partnership-LLC Conversion

Fortunately, the fact that you first chose to operate as a general partner and now want to switch is not painful from an income tax perspective. In several private letter rulings, the IRS has considered the conversion of a general partnership into an LLC. The rulings have clarified several tax issues. When a general partnership converts into an LLC that is treated as a partnership:

  • no gain or loss is recognized upon the conversion (under IRC Section 721).
  • the conversion does not terminate the old partnership under Sec. 708, because the business continues in a form recognized as a partnership for tax purposes and the conversion is not a sale or exchange.
  • the partner’s holding period in his partnership interest carries over to his LLC interest.

The IRS also has stated that the LLC resulting from the conversion of a general partnership is not required to obtain a new Employer Identification Number (EIN). It can continue to use the EIN that was originally issued to the partnership.

Note, however, that the rules stated above assume that the new LLC is treated as a partnership for federal income tax purposes. If the LLC elects to be treated as a corporation or an S corporation, the results are different.

Effect on Existing Liabilities When Converting a Partnership into an LLC

While operating your business as an LLC can protect against many future liabilities, what about the liabilities you incurred while the business was a general partnership? From a state law standpoint, it is not likely that a general partner will be released from personal liability by the partnership’s existing creditors for the business’s debts. The mere fact that the LLC has assumed the debt in connection with the conversion does not automatically let the former partners off the hook. In other words, members will be protected from personal liability for debts incurred by the LLC but will remain personally liable for debts of the general partnership which are transferred to and assumed by the LLC.

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