A Few Foot Faults to Avoid When Converting a Flow-Through Entity Into a §1202-Eligible Corporation

• 05/19/2025

We’re avoiding commenting on the pending tax legislation, as the rhetoric by the major tax-reporting publishers is doing just fine and the Senate has not yet weighed in. We note, however, that there is nothing in the House Bill that would eliminate the §1202 exclusion of 100% of the gain on the sale of qualifying C corporation stock. In most circumstances, we do not believe that a “potential” §1202 gain exclusion merits operating a closely held business as a C corporation; however, §1202 stock certainly has a place at some dinner tables. Nevertheless, the current draft of the House Bill, which proposes an increase in the §199A deduction from 20% to 23%, would result in the effective rate for the owner of a flow-through business to drop by approximately one percent.

If a client is operating in a flow-through entity, but the decision is made to convert to C corporation status in order to qualify for the §1202 exclusion, there are a few points we want to bring to your attention. Converting a partnership to a C corporation generally does not present many obstacles, except keep §357(c) in mind, i.e., gain recognition if “assumed” liabilities exceed the tax basis of contributed assets. There are many forms of conversion: assets-over, assets-up, interests over and filing a Form 8832 (a “check-the-box” election). The reasoning behind using a particular form of conversion is a topic beyond the scope of this communication (although we have discussed it at prior Tax Planning Forum presentations). Rumor has it that there are some tax professionals who believe that a partnership that makes a check-the-box election is not §1202-eligible because the entity is not a corporation organized under state law; however, our strong view is that this is an invalid concern.

More care is required when converting an S corporation (“Oldco S”) to a C corporation for §1202 purposes. A revocation of an S election doesn’t work, because one of the §1202 requirements is that §1202 stock must originally be issued by a C corporation. Also ineffective is the contribution of S corporation stock to a C corporation, because §1202 stock cannot be issued in exchange for a contribution of stock. What is required is that the S corporation contribute its assets to a C corporation in exchange for C corporation stock. (Keep in mind that an S corporation can own §1202 stock.)

If assets are not easily transferrable, the shareholders of Oldco S can do the following:

1) form Newco S;
2) contribute the Oldco S stock to Newco S;
3) cause a QSub election to be made for Oldco S;
4) have Newco S form a single-member LLC (“Newco LLC”);
5) cause Oldco S (now a QSub) to merge into Newco LLC; and finally
6) cause Newco LLC to a file a Form 8832 to be classified as a corporation.

When the dust clears, Newco S will own stock of a §1202-qualifying C corporation. (Some professionals believe that revocation of the QSub election is all that needs to be done to accomplish the desired result; however, we believe that caution dictates the above steps, again, a topic beyond the scope of this communication.)

While the Tax Forum presents two flow-through programs – the Tax Planning Forum and the Fundamentals of Flow-Through – a presentation would not be complete without some discussion of §1202 stock. This discussion is included in our one remaining spring Fundamentals (June 17-19) program, as it is in our full slate of fall and winter virtual and in-person programs. In addition, limited space still is available for our complimentary June 11th webinar entitled “Hidden Gems in the Partnership Basis Adjustment Rules.”