Rev. Rul. 84-52: Partnership Conversions Under Section 721

Changing your partnership interest from one type to another inside the same partnership is generally not a taxable event. Revenue Ruling 84-52 treats the switch as a contribution under Section 721, so no gain or loss is recognized on the conversion itself. The catch is that any drop in your share of partnership debt counts as a deemed cash distribution, and if that deemed distribution exceeds your basis, you owe tax on the excess. Swapping an interest in one partnership for an interest in a different partnership is a fully taxable exchange no matter which types of interest are involved. Those are the partnership interest conversion tax consequences in short; the details below matter because a conversion that looks like paperwork can produce a real tax bill.

Internal Conversions Fall Under Section 721

Revenue Ruling 84-52 addresses the two most common internal moves: general partner to limited partner, and limited partner to general partner. In both directions, the IRS held the conversion is not a sale or exchange. The partnership continues as the same entity, your economic stake in the business is unchanged, and no disposition has occurred under Section 741 or Section 1001.¹

The conversion is instead treated as a contribution of the old interest to the partnership in exchange for the new one. Section 721 provides that neither the partner nor the partnership recognizes gain or loss on a contribution of property in exchange for a partnership interest.² Because the partnership is a continuation of the original entity, the conversion also does not trigger a termination under Section 708.¹

Basis and Holding Period Carry Over

Because the conversion is a Section 721 contribution, your outside basis in the new interest carries over from the old one under Section 722.³ Whatever your basis was the day before the switch is your basis the day after, subject to the liability adjustments described next.

The holding period tacks as well. Time spent holding the original interest counts toward the holding period of the new one, which matters for long-term capital gains treatment when you eventually sell.

The Liability Shift That Can Still Trigger Gain

The most common surprise in a supposedly tax-free conversion comes from Section 752. A decrease in your share of partnership liabilities is treated as a cash distribution to you from the partnership.⁴ Section 731 then provides that a cash distribution in excess of your adjusted basis produces recognized gain, generally capital gain from the sale of a partnership interest.⁵

This bites hardest when a general partner converts to a limited partner. A partner’s share of recourse liabilities equals the portion for which the partner bears the economic risk of loss.⁶ General partners bear that risk on recourse debt; limited partners generally do not. Converting shifts recourse debt away from you.

A simple example. Suppose your outside basis is $50,000 and your share of recourse liabilities drops by $80,000 when you convert from general to limited. That $80,000 reduction is an $80,000 deemed cash distribution. Because it exceeds your $50,000 basis, you recognize $30,000 of capital gain, even though no cash changed hands.

The reverse direction rarely creates this problem. Moving from limited to general typically increases your share of liabilities, which is treated as a contribution that raises your basis instead of triggering gain.

How the Rule Applies to LLCs

Most multi-member LLCs are taxed as partnerships, and Revenue Ruling 84-52 applies to them directly. Revenue Ruling 95-37 confirmed that converting a domestic partnership into a domestic LLC classified as a partnership carries the same tax consequences as converting between partnership interest types, and the same holds for converting an LLC back into a partnership.⁷

The same treatment extends to internal restructurings within a single LLC, such as moving from member-managed to manager-managed. As long as the entity continues under state law and each member’s percentage share of profits, losses, and capital stays the same, the restructuring is a nontaxable conversion under Section 721.²

The Section 752 liability trap applies here too. If the operating agreement’s allocation of recourse debt changes when you convert, any decrease in a member’s share of liabilities is a deemed cash distribution, and any amount exceeding that member’s outside basis is taxable gain.⁴⁵ Comparing pre-conversion and post-conversion liability allocations is the only reliable way to know whether the conversion will cost you anything.

Exchanges Between Different Partnerships Are Taxable

The favorable treatment above applies only to conversions inside a single continuing partnership. Exchanging your interest in one partnership for an interest in an entirely different partnership is fully taxable, whether both interests are general, both are limited, or one of each. Section 741 treats the disposition as a sale or exchange of a capital asset, with gain or loss equal to the difference between the value received and your adjusted basis in the interest given up.⁸

Hot Assets Can Convert Capital Gain Into Ordinary Income

Section 741’s capital-gain characterization has a significant exception. If the partnership holds “hot assets,” which Section 751 defines as unrealized receivables and inventory items, part of your gain is recharacterized as ordinary income.⁹

The calculation runs in two steps. First, determine the ordinary gain or loss that would have been allocated to you if the partnership had sold all of its assets at fair market value immediately before the exchange. Then subtract that ordinary portion from your total gain; the remainder is capital.¹⁰ If the partnership holds inventory, accounts receivable, or other assets that would generate ordinary income on sale, run the hot-asset calculation before reporting.

Section 1031 Does Not Defer the Gain

Since the Tax Cuts and Jobs Act of 2017, Section 1031 applies only to exchanges of real property.¹¹ A partnership interest is not real property and falls outside the provision.¹²

One narrow exception exists. If a partnership has a valid Section 761(a) election to be excluded from Subchapter K, its partners are treated as holding interests in the underlying assets rather than in a partnership. If those underlying assets are real property, a like-kind exchange can potentially apply.¹³ This covers a specific co-ownership arrangement, not a typical operating partnership or LLC.

Planning Steps Before You Convert

The single most important step before an internal conversion is a pre-conversion liability analysis. Compare your current share of partnership liabilities with what your share will be after the conversion. That difference is your deemed distribution, and anything over your outside basis is taxable.

Several strategies can reduce the exposure:

Contribute additional capital before the conversion. A cash contribution raises your outside basis under Section 722, creating more room to absorb the deemed distribution.³
Guarantee a portion of the partnership’s recourse debt after converting. A personal guarantee can keep a share of the liability allocated to you under Section 752, shrinking the deemed distribution.
Restructure the partnership’s debt. Shifting recourse debt to nonrecourse debt before the conversion changes how liabilities are allocated among all partners and can reduce the shifting effect on any one partner.

For an external exchange between different partnerships, the exchange will be taxable no matter what. Planning shifts to timing the transaction in a year when the gain hurts least and running the Section 751 hot-asset analysis carefully so ordinary income is not mischaracterized as capital gain.

1
Internal Revenue Service. Private Letter Ruling 201605004
2
Office of the Law Revision Counsel. 26 USC 721 – Nonrecognition of Gain or Loss on Contribution
3
Office of the Law Revision Counsel. 26 USC 722 – Basis of Contributing Partner’s Interest
4
Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
5
Office of the Law Revision Counsel. 26 USC 731 – Extent of Recognition of Gain or Loss on Distribution
6
eCFR. 26 CFR 1.752-2 – Partner’s Share of Recourse Liabilities
7
Internal Revenue Service. Private Letter Ruling 201745005
8
Office of the Law Revision Counsel. 26 USC 741 – Recognition and Character of Gain or Loss on Sale or Exchange
9
Office of the Law Revision Counsel. 26 USC 751 – Unrealized Receivables and Inventory Items
10
Internal Revenue Service. Sale of a Partnership Interest – Practice Unit
11
U.S. Congress. Tax Cuts and Jobs Act – H.R. 1
12
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment
13
Office of the Law Revision Counsel. 26 USC 1031 – Exchange of Real Property Held for Productive Use or Investment – Section: Application to Certain Partnerships