PRACTISING LAW INSTITUTE
TAX PLANNING FOR DOMESTIC & FOREIGN
PARTNERSHIPS, LLCs, JOINT VENTURES &
OTHER STRATEGIC ALLIANCES 2013
December 2012
Use of Limited Liability Companies in
Corporate Transactions
Mark J. Silverman
Steptoe & Johnson LLP
Washington, D.C.
Copyright © 2012 Mark J. Silverman, All Rights Reserved
-iTABLE OF CONTENTS
Internal Revenue Service Circular 230 Disclosure: As provided for in Treasury regulations, advice (if
any) relating to federal taxes that is contained in this communication (including attachments) is not
intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the
Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or
arrangement addressed herein.
Page
I.
INTRODUCTION ......................................................................................................................... 1
II.
CHECK-THE-BOX REGULATIONS .......................................................................................... 1
III.
A.
In General ........................................................................................................................... 1
B.
Eligible Entities .................................................................................................................. 3
C.
Election .............................................................................................................................. 6
D.
Waiting Period ................................................................................................................... 9
E.
Applicability of Check-the-Box Regulations to Elections by Foreign Entities ................. 9
WHAT IS A DISREGARDED ENTITY? ................................................................................... 13
A.
In General ......................................................................................................................... 13
B.
Determination of Single Owner ....................................................................................... 19
C.
Assessment and Collection Issues .................................................................................... 21
D.
IV.
1.
Liability for Tax ................................................................................................... 21
2.
Collection of Tax.................................................................................................. 22
Examples .......................................................................................................................... 24
1.
Transactions Between Disregarded Entities and Their Owners ........................... 24
2.
Corporate Structures Involving Disregarded Entities .......................................... 28
TREATMENT OF CLASSIFICATION CHANGES .................................................................. 30
A.
In General ......................................................................................................................... 30
B.
Timing .............................................................................................................................. 30
C.
Treatment of Elective Classification Changes ................................................................. 33
1.
In General ............................................................................................................. 33
2.
An Association Elects to be Classified as a Partnership ...................................... 33
3.
A Partnership Elects to be Taxed as an Association ............................................ 35
4.
An Association Elects to be a Disregarded Entity ............................................... 36
5.
A Disregarded Entity Elects to be Classified as an Association .......................... 37
- ii Page
6.
D.
E.
F.
V.
Treatment of Automatic Classification Changes ............................................................. 39
1.
Partnership to a Disregarded Entity – Rev. Rul. 99-6 .......................................... 39
2.
Disregarded Entity to a Partnership – Rev. Rul. 99-5 .......................................... 41
3.
Conversion of an Ineligible Entity into an Eligible Entity................................... 42
4.
Overlap between Automatic and Elective Classification Changes ...................... 43
Treatment of Actual Conversions of An Existing Entity Into An LLC ........................... 44
1.
Converting Existing Corporations Into LLCs ...................................................... 45
2.
Converting Existing Partnerships Into LLCs Classified as Partnerships ............. 56
Solvency of Electing or Converting Entity ...................................................................... 57
1.
In General ............................................................................................................. 57
2.
Deemed Incorporation of Insolvent Entity........................................................... 62
SALE OF A SINGLE-MEMBER LLC ....................................................................................... 64
A.
B.
VI.
Legal Effect of Deemed Transactions .................................................................. 38
Sale of All of the Membership Interests .......................................................................... 64
1.
Sale of All of the Membership Interests to a Single Buyer.................................. 64
2.
Sale of All of the Membership Interests Through a Cash Merger ....................... 65
Sale of Less than All of the Membership Interests .......................................................... 66
1.
Sale of Less than All of the Membership Interests .............................................. 66
2.
Initial Public Offering of LLC Interests ............................................................... 69
REORGANIZATIONS INVOLVING SINGLE-MEMBER LLCS ............................................ 71
A.
A Reorganizations Involving Single-Member LLCs ....................................................... 71
1.
Definition ............................................................................................................. 71
2.
History of Regulations ......................................................................................... 71
3.
General Definition of Statutory Merger or Consolidation ................................... 74
4.
All of the Assets Requirement ............................................................................. 78
5.
Ceasing Separate Legal Existence Requirement .................................................. 81
6.
Definition and Existence of Transferee and Transferor Units ............................. 85
7.
Upstream Merger ................................................................................................. 92
8.
Two-Step Acqusitions of Target Corporation ...................................................... 93
9.
Forward Triangular Merger ................................................................................. 96
10.
Divisive Mergers Involving LLCs ....................................................................... 97
11.
Application of the Final Regulations in the Context of Foreign Entities ............. 99
- iii Page
B.
B Reorganization............................................................................................................ 104
C.
C Reorganization............................................................................................................ 105
D.
D Reorganizations .......................................................................................................... 108
E.
F.
VII.
1.
Acquisitive D Reorganization ............................................................................ 108
2.
Divisive D Reorganization ................................................................................. 110
F Reorganizations........................................................................................................... 111
1.
Basic F Reorganization ...................................................................................... 111
2.
Partnership Formation as F Reorganization ....................................................... 112
3.
F Reorganization Preceding an Acquisition ....................................................... 113
Use of LLCs in Spin-Off Transactions .......................................................................... 116
1.
Spin-Off ............................................................................................................. 116
2.
Distribution of LLC Interests as a Spin-Off ....................................................... 118
3.
Avoiding the Requirements of Section 355 ....................................................... 120
4.
Avoiding the Requirements of Section 355: Distribution of Assets ................. 121
5.
Section 355(e) Transaction ................................................................................ 123
USE OF LLCS IN CONSOLIDATED RETURN CONTEXT ................................................. 126
A.
B.
C.
D.
E.
Selective Consolidation.................................................................................................. 126
1.
In General ........................................................................................................... 126
2.
Selective Consolidation...................................................................................... 126
Avoiding SRLY Limitations .......................................................................................... 127
1.
In General ........................................................................................................... 127
2.
SRLY Limitations .............................................................................................. 128
Avoiding Intercompany Transaction Rules ................................................................... 128
1.
In General ........................................................................................................... 128
2.
Intercompany Sale .............................................................................................. 129
3.
Intercompany Debt ............................................................................................. 131
Deconsolidation of Two-Member Consolidated Group ................................................. 131
1.
In General ........................................................................................................... 131
2.
Deconsolidation Using a Single-Member LLC ................................................. 132
Avoid Triggering Restoration of Excess Loss Accounts ............................................... 132
1.
In General ........................................................................................................... 132
2.
Avoiding Trigger of ELAs ................................................................................. 133
- iv Page
VIII.
USE OF MULTI-MEMBER LLCS IN CORPORATE TRANSACTIONS ............................. 134
A.
Merger of Target Corporation Into LLC ............................................................ 134
2.
Merger of LLC Into Acquiring Corporation ...................................................... 136
Multi-Member LLCs in the Consolidated Return Context ............................................ 137
C.
Recognizing Losses Using Multi-Member LLCs .......................................................... 138
D.
Change in Number of Members of Multi-Member LLC ............................................... 139
1.
Conversion of Multi-Member LLCs Into Single-Member LLCs ...................... 139
2.
Conversion of Multi-Member LLCs Into Single-Member LLCs in the
Consolidated Return Context ............................................................................. 140
Treatment of Holder of Multi-Member LLC Interest as General or Limited Partner .... 142
1.
Section 469 Passive Activity Loss Rules ........................................................... 142
2.
Self-Employment Tax ........................................................................................ 143
DISADVANTAGES OF USING LLCs..................................................................................... 143
A.
B.
C.
X.
1.
B.
E.
IX.
Mergers Involving Multi-Member LLCs ....................................................................... 134
Certain LLCs Cannot Be Parties to Reorganizations ..................................................... 143
1.
In General ........................................................................................................... 143
2.
Achieving Results Similar to a Tax-Free Reorganization.................................. 144
Spinning Off a Lower Tier LLC .................................................................................... 145
1.
In General ........................................................................................................... 145
2.
Spin-off of an LLC ............................................................................................. 146
Loss of Basis in the Stock of a Corporate Subsidiary .................................................... 147
1.
In General ........................................................................................................... 147
2.
Disappearing Basis ............................................................................................. 147
OTHER ISSUES ........................................................................................................................ 148
A.
B.
Treatment of Indebtedness ............................................................................................. 148
1.
Whose Debt Is It—the Disregarded Entity’s or the Owner’s? ........................... 148
2.
Cancellation of Debt (“COD”) Income .............................................................. 150
3.
Indebtedness to Owner of Disregarded Entity ................................................... 151
Treatment of Outstanding Interests as Equity ................................................................ 153
1.
Automatic Classification Change ....................................................................... 153
2.
Convertible Debt ................................................................................................ 153
3.
Granting Nonvested Equity Interests to Employees .......................................... 154
-vPage
C.
Start-Up v. Expansion Costs .......................................................................................... 154
D.
Like-Kind Exchanges ..................................................................................................... 155
In General ........................................................................................................... 155
2.
Qualifying property ............................................................................................ 155
3.
Acquiring Replacement Property ....................................................................... 156
E.
Personal Holding Companies ......................................................................................... 157
F.
Employment Issues ........................................................................................................ 158
G.
XI.
1.
1.
Employer Identification Number (“EIN”) ......................................................... 158
2.
Employment and Withholding Taxes................................................................. 158
3.
Employee Retirement Plans ............................................................................... 162
4.
Incentive Stock Option Plans ............................................................................. 163
Filing Requirements ....................................................................................................... 163
STATE TAX CONSIDERATIONS .......................................................................................... 164
A.
State Treatment of LLCs ................................................................................................ 164
B.
Achieving Consolidated Results In States That Prohibit Consolidation........................ 167
C.
Achieving Section 338(h)(10) Results in States That Do Not Recognize the Election . 167
1.
General ............................................................................................................... 167
2.
Achieving Section 338(h)(10) Treatment for State Tax Purposes ..................... 168
- vi Page
Examples
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
Contribution to Disregarded Entity ...................................................................................................
23
Distribution From Disregarded Entity .............................................................................. 24
Debt Between a Disregarded Entity and its Owner .......................................................... 25
Transactions Between Commonly Owned Disregarded Entities ..................................... 25
Multiple Disregarded Entities ........................................................................................... 27
Preservation of S Corporation Status................................................................................ 28
Corporate Contribution of Assets to an LLC Classified as Either a
Partnership or a Disregarded Entity Followed by Corporate Liquidation ........................ 45
Formation of LLC by the Corporation and its Shareholders Followed by
Liquidation of Corporation ............................................................................................... 46
Merger of Corporation Into Multi-Member LLC ............................................................. 48
Merger of Corporation Into Single-Member LLC ............................................................ 51
Merger of Wholly Owned Subsidiary Into Single-Member LLC .................................... 53
Partnership-to-LLC Conversion ....................................................................................... 55
Sale of All of the Membership Interests to a Single Buyer .............................................. 63
Sale of All of the Membership Interests Through a Cash Merger .................................... 64
Sale of Less than All of the Membership Interests ........................................................... 65
Initial Public Offering of LLC Interests ........................................................................... 68
Merger Into LLC (Base Case) .......................................................................................... 75
Sprinkling of Assets Among Transferee Unit .................................................................. 79
Consolidation .................................................................................................................... 81
Forward Triangular Amalgamation ................................................................................... 83
Merger of Disregarded Entity Owned by Partnership ...................................................... 85
Merger into LLC in Exchange for LLC Interests ............................................................. 86
Merger of Corporate Partner into Partnership .................................................................. 88
Upstream Merger .............................................................................................................. 91
Merger Into LLC Followed by Merger Upstream ............................................................ 92
Acquisition of T Stock Followed by Alternative Transfers to P ...................................... 93
Forward Triangular Merger .............................................................................................. 95
LLC Merger Into Corporation .......................................................................................... 96
Merger of Corporation into Multiple LLCs ...................................................................... 97
Transaction Effected Pursuant to Foreign Law ................................................................ 99
Merger with Foreign Entity .............................................................................................. 100
Drop and Check vs. Check and Drop ............................................................................... 101
B Reorganization .............................................................................................................. 103
C Reorganization .............................................................................................................. 104
Acquisitive D Reorganization .......................................................................................... 107
Divisive D Reorganization ............................................................................................... 109
Basic F Reorganization ..................................................................................................... 110
Conversion as F Reorganization ....................................................................................... 111
F Reorganization Preceding an Acquisition ..................................................................... 112
Spin-Off ............................................................................................................................ 115
Distribution of LLC Interests as a Spin-Off ..................................................................... 117
Avoiding the Requirements of Section 355 ...................................................................... 119
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Examples
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
Avoiding the Requirements of Section 355: Distribution of Assets ...............................
Section 355(e) Transaction ...............................................................................................
Selective Consolidation ....................................................................................................
SRLY Limitations.............................................................................................................
Intercompany Sale ............................................................................................................
Intercompany Debt ...........................................................................................................
Deconsolidation Using a Single-Member LLC ................................................................
Avoiding Trigger of ELAs ...............................................................................................
Merger of Target Corporation Into LLC ..........................................................................
Merger of LLC Into Acquiring Corporation.....................................................................
Multi-Member LLCs in the Consolidated Return Context ...............................................
Recognizing Losses Using Multi-Member LLCs .............................................................
Conversion of Multi-Member LLCs Into Single-Member LLCs .....................................
Conversion of Multi-Member LLCs Into Single-Member LLCs in the
Consolidated Return Context............................................................................................
Achieving Results Similar to a Tax-Free Reorganization ................................................
Spin-off of an LLC ...........................................................................................................
Disappearing Basis ...........................................................................................................
Convertible Debt...............................................................................................................
1031 Exchange .................................................................................................................
Achieving Section 338(h)(10) Treatment for State Tax Purposes ...................................
120
122
125
127
128
130
131
132
133
135
136
137
138
139
143
145
146
152
154
167
I.
INTRODUCTION
The check-the-box regulations provide a host of planning opportunities for taxpayers,
particularly with respect to the use of disregarded entities, such as single-member limited
liability companies (“LLCs”). However, the fact that an entity may be disregarded for
federal tax purposes generally does not affect the rights and obligations of the owners
under state law. Reg. § 301.7701-1(a). Thus, if a state does not sanction the use of
single-member LLCs or follow the check-the-box regulations, an entity that is
disregarded for federal tax purposes may be classified differently for state tax purposes.
The consequences of classification as a disregarded entity are not fully addressed either
in the regulations or the amendments thereto. The regulations simply provide that “if the
entity is disregarded, its activities are treated in the same manner as a sole proprietorship,
branch, or division of the owner,” and that the entity classification rules apply for all
federal tax purposes. See Reg. §§ 301.7701-1, -2(a).1 As a result, it is not always clear
how a disregarded entity is treated when it is involved in corporate transactions. This
outline focuses primarily on the federal tax consequences of converting, disposing,
reorganizing, and otherwise using single-member LLCs in domestic corporate
transactions. The outline will also address some uses of multi-member LLCs and some
state tax issues relating to the use of LLCs in corporate transactions.
II.
CHECK-THE-BOX REGULATIONS
A.
In General
1.
On December 17, 1996, the Internal Revenue Service (the “Service”)
issued final regulations under section 7701, which greatly simplified the
classification of business entities for federal tax purposes. These so-called
“check-the-box” regulations became effective on January 1, 1997.
2.
The check-the-box regulations govern the classification of organizations
that are recognized as separate entities. Reg. § 301.7701-1(b). The
regulations provide, in general, that an “eligible entity” with two or more
members can elect to be classified as either an association taxed as a
corporation or as a partnership. Reg. § 301.7701-3(a). An eligible entity
with only one owner can elect to be classified as a corporation or to be
“In the context of a business organization, a ‘branch’ is defined as a ‘division of a
business’, and a ‘division’ as an ‘area if * * * corporate activity organized as an administrative or
functional unit.’” Dover v. Commissioner, 122 T.C. 324, 351 (2004) (quoting American
Heritage Dictionary (4th ed. 2000)).
1
-2disregarded as an entity separate from its owner (a “disregarded entity”).
Id.2
3.
Certain default rules are provided in the regulations. Under these default
rules, a multi-member entity will be classified as a partnership, unless it
elects to be classified as a corporation; a single-member entity will be
disregarded, unless it elects to be treated as a corporation. Reg.
§ 301.7701-3(b)(1).3
4.
A domestic or foreign bank cannot treat a wholly owned nonbank entity as
a disregarded entity for purposes of applying the special rules of the Code
applicable to banks. Reg. § 301.7701-2(c)(2)(ii).
5.
The validity of the check-the-box regulations has been challenged and
upheld by the courts. See McNamee v. IRS, 488 F.3d 100 (2d Cir. 2007);
Littriello v. United States, 484 F.3d 372 (6th Cir. 2007), cert. denied, 28 S.
Ct. 1290 (Feb. 19, 2008); Kandi v. United States, 2006-1 U.S.T.C. ¶
50,231 (W.D. Wash. 2006), aff’d per curiam, 295 Fed. Appx. 873 (9th Cir.
2008); Stearn & Co., LLC v. United States, 499 F. Supp. 2d 899 (E.D.
Mich. 2007); L&L Holding Company, LLC v. United States, 2008-1
U.S.T.C. ¶ 50,234 (W.D. La. 2008); Med. Practice Solutions, LLC v.
Commissioner, 132 T.C. 125 (2009), aff’d per curiam, 2010-2 U.S.T.C. ¶
50,584 (1st Cir. 2010).4
a.
Applying a Chevron analysis, the courts concluded that the statute
was ambiguous, because sections 7701(a)(2) and 7701(a)(3) do not
make a clear distinction between an “association,” which is treated
as a corporation and a “group, pool or joint venture,” which is
treated as a partnership. The growth of different state law entities
has exacerbated this ambiguity. Then the courts concluded that the
check-the-box regulations were a permissible construction of the
2
Although this outline refers primarily to single-member LLCs, other entities may be
treated as disregarded entities, including qualified REIT subsidiaries, qualified S corporation
subsidiaries, or any other eligible entity with a single owner that does not elect to be taxed as a
corporation.
3
The default rules differ for foreign eligible entities. Under these rules, a multi-member
entity will be classified as an association if all members have limited liability, or a partnership if
one or more members does not. A single-member entity will be classified as an association if the
member has limited liability, or as a disregarded entity if the member does not. Reg.
§ 301.7701-3(b)(2).
4
See also Med. Practice Solutions, LLC v. Commissioner, T.C. Memo. 2010-98 (2010),
addressing subsequent tax periods.
-3statute, representing a more formal version of the informally
elective regime under the old Kintner regulations. See Littriello,
484 F.3d 372; McNamee, 488 F.3d 100; Kandi, 2006-1 U.S.T.C. ¶
50,231.
B.
5
Eligible Entities
1.
An “eligible entity” is defined as an entity that is neither trust under Reg.
§ 301.7701-4 nor a “corporation” as defined in Reg. § 301.7701-2(b).
Reg. §§ 301.7701-2(a), -3(a).
2.
Thus, under the check-the-box regulations, a corporation as defined in
Reg. § 301.7701-2(b) is always classified as a corporation for federal tax
purposes (i.e., it is “per-se” a corporation). A “corporation” includes:
a.
A business entity organized under a federal or state statute that
describes the entity as incorporated, a corporation, body corporate,
body politic, joint-stock company, or joint-stock association, Reg.
§ 301.7701-2(b)(1), (3), see also P.L.R. 200139020 (June 29,
2001) (concluding that a company organized under a state
cooperative LLC act was an eligible entity, because the act did not
refer to the entity as incorporated, a corporation, body corporate, or
body politic);
b.
An insurance company or state-chartered bank, Reg. § 301.77012(b)(4), (5);
c.
A business entity wholly owned by a state or political subdivision
thereof or a foreign government, Reg. § 301.7701-2(b)(6);
d.
A business entity that is taxable as a corporation under a provision
of the Code other than section 7701(a)(3), Reg. § 301.77012(b)(7); and
e.
Those foreign entities listed in Reg. § 301.7701-2(b)(8).5
Treasury and the Service update the list of per se corporations as necessary. For
example, the regulations were amended in December 2005 to include newly recognized public
limited liability companies in Europe (Societas Europaea, or SE), Estonia (Aktsiaselts), Latvia
(Akciju Sabeidriba), Lithuania (Akcine Bendroves), Slovenia (Delneska Druzba), and
Liechtenstein (Aktiengesellschaft). See Reg. § 301.7701-2(b)(8)(i), T.D. 9235, 70 Fed. Reg.
74,658 (Dec. 16, 2005). In Notice 2007-10, Treasury announced that since Bulgaria will become
a member of the European Union on January 1, 2007, it is appropriate to add the Bulgarian
aktsionerno druzhestvo to the list of foreign business entities that are considered to be per se
corporations for purposes of Reg. § 301.7701-2(b)(8). The Bulgarian aktsionerno druzhestvo
was added to the regulations in March 2008. See Reg. § 301.7701-2T(b)(8)(vi), T.D. 9388, 73
(Continued …)
-4f.
3.
4.
However, the Service has concluded that an otherwise per-se
corporation that is administratively dissolved by the state’s
Secretary of State for failure to comply with state corporate law
requirements loses its per-se status and becomes an eligible entity.
See I.L.R. 200852001 (Sept. 4, 2008).
Clarification for Dually-Chartered Entities – Regulations clarify the
classification of entities that are created or organized in more than one
jurisdiction. See T.D. 9246, 71 Fed. Reg. 4815-18 (Jan. 30, 2006). These
regulations adopted, with minor modifications, the temporary regulations
that had been issued on August 12, 2004.
a.
The final regulations provide that if the entity would be treated as a
corporation as a result of its formation in any of the jurisdictions in
which it is organized, then it is treated for federal tax purposes as a
corporation even though its organization in the other jurisdictions
would not have caused it to be treated as a corporation. Reg.
§ 301.7701-2.
b.
Additionally, the final regulations clarify that a dually-chartered
entity will be treated as domestic if it organized as any form of an
entity in the United States, regardless of how it is organized in any
foreign jurisdiction. Reg. § 301.7701-5.
c.
The final regulations added a transition rule. For dually chartered
entities existing on August 12, 2004, the final regulations apply as
of May 1, 2006. However, these entities may rely on the final
regulations as of August 12, 2004. See Reg. § 301.77012(e)(3)(ii). Otherwise, the final regulations apply to all business
entities existing on or after August 12, 2004. See § 301.77012(e)(3)(i).
Series LLCs
Fed. Reg. 15,064 (March 21, 2008). Although these regulations were finalized on November 28,
2008, Treasury and the Service clarified that the Bulgarian aktsionerno druzhestvo is not an SE,
but is a public limited liability company organized in Bulgaria that is nonetheless a per se
corporation. See Reg. § 301.7701-2(b)(8)(i), T.D. 9433, 73 Fed. Reg. 72345, 72346 (Nov. 28,
2008).
In addition, the Japanese Yugen Kaisha (“YK”), which was not a per se corporation, was
abolished under Japanese law, and any existing YK will continue as a Tokurei Yugen Kaisha
(“TYK”). The Service ruled that a TYK will remain an eligible entity. Rev. Rul. 2006-3, 2006-1
C.B. 276.
-5a.
On September 13, 2010, Treasury and the Service issued proposed
regulations on the classification for federal tax purposes of a series
of a domestic series LLC, a cell of a domestic cell company, or a
foreign series or cell that conducts an insurance business. Prop.
Reg. § 301.7701-1(a)(5).
(i)
Delaware was the first state to authorize series LLCs in
1996. See Del. Code § 18-215. Since then, several other
states have enacted series LLC statutes (e.g., Illinois, Iowa,
Nevada, Oklahoma, Tennessee, Texas, and Utah).
b.
The Service previously ruled that each series of a series LLC will
be viewed as a separate entity for purposes of the entity
classification election. P.L.R. 200803004 (Oct. 15, 2007).
c.
The proposed regulations define a series as a segregated group of
assets and liabilities that is established pursuant to a series statute
by agreement of a series organization.
d.
(i)
A series organization is a juridical entity that establishes or
maintains a series – e.g., series LLC, series partnership,
series trust, protected cell company, segregated cell
company, segregated portfolio company, or segregated
account company.
(ii)
A series statute provides for the organization or
establishment of a series of a juridical person and
permits—
(a)
Members or participants to have rights, powers, or
duties with respect to the series;
(b)
A series to have separate rights, powers, or duties
with respect to property or obligations; and
(c)
The segregation of assets and liabilities such that
none of the liabilities of the series organization or
any other series are enforceable against a particular
series.
Under the proposed regulations, a domestic series or cell generally
is treated as an entity formed under local law for federal tax
purposes regardless of whether it is a juridical person for local law
purposes.
(i)
The proposed regulations provide that classification of a
series or cell that is treated as a separate entity for federal
tax purposes is determined under Reg. § 301.7701-1(b).
-6Ownership of interests in a series and of the assets
associated with a series is determined under general tax
principles.
e.
C.
(ii)
Although the proposed regulations do not apply to series or
cells organized or established in a foreign jurisdiction, an
exception is provided for a foreign series or cell that
conducts an insurance business.
(iii)
Treasury and the Service considered other approaches,
rejecting for example, an approach in which the series
would be disregarded as separate from the series
organization.
(iv)
The proposed regulations do not address how a series
should be treated for federal employment tax purposes or
the ability of a series to maintain employee benefit plans.
(v)
Aside from a limited exception, when final regulations
become effective, taxpayers treating series differently than
series are treated under the final regulations will be
required to change their treatment. General tax principles
will apply to determine the consequences of any required
change in treatment, such as a conversion from a single
entity to multiple entities. See Prop. Reg. § 301.6011-6.
Example – Series LLC has three members (1, 2, and 3) and
establishes two series (A and B) pursuant to a series statute. Under
general tax principles, Members 1 and 2 are the owners of Series
A, and Member 3 is the owner of Series B. Series A and B are
each treated as an entity that may elect its classification under the
check-the-box regulations. The default classification of Series A is
a partnership and of Series B is a disregarded entity. Reg.
§ 301.7701-1(a)(5)(x), Ex. 1.
Election
1.
An eligible entity makes an entity classification election by filing Form
8832, Entity Classification Election. Reg. § 301.7701-3(c)(1)(ii).
a.
2.
Because the election is made by the eligible entity, the transfer of
all of the interests in that entity, whether by sale, tax-free
reorganization, or otherwise, will not terminate the election. Rev.
Rul. 2004-85, 2004-2 C.B. 189.
Certain entities are deemed to have filed elections. Reg. § 301.77013(c)(1)(v).
-7-
3.
4.
a.
An eligible entity that has been determined, or claims, to be
exempt from tax under section 501(a) is deemed to have elected to
be classified as a corporation.
b.
An eligible entity that files an election to be treated as a real estate
investment trust is deemed to have elected to be classified as a
corporation.
c.
The Service extended this rule to S corporations. Under Reg.
§ 301.7701-3(c)(1)(v)(C), if an eligible entity files an S
corporation election, it is deemed to have elected to be classified as
a corporation.
The election will be effective on the date specified by the entity on Form
8832, or on the date filed if no date is specified.
a.
The effective date of an election cannot be more than 75 days prior
to the date on which the election is filed and cannot be more than
12 months after the date on which the election is filed. Reg.
§ 301.7701-3(c)(1)(iii).
b.
If the entity is not eligible to make an election on the date specified
on Form 8832, the Service will treat the filing date as the effective
date of the election, provided the election complies with the checkthe-box regulations at that time. See I.L.M. 200238025 (June 14,
2002) (where entity was not properly characterized as a business
entity under local law on the specified date, the effective date was
the date the Form 8832 was filed).
c.
See Section IV.B., below, for the timing of the transactions
deemed to occur upon an elective classification change.
The Service has authority under Reg. § 301.9100 to grant an extension of
time to make an election. Typically the Service grants such extensions
only in response to a private letter ruling request (for which a user fee
must be paid) when the taxpayer establishes that it has acted in good faith
and the grant of relief will not prejudice the interests of the government.
a.
In Rev. Proc. 2002-15, 2002-1 C.B. 490, the Service provided a
simplified method for newly formed entities to request relief for
the late filing of their initial classification election under Reg.
§ 301.7701-3. Relief is requested by filing Form 8832 within six
months of the original due date for the initial classification election
(i.e., within six months and 75 days of the entity’s formation). An
entity is eligible for relief if (i) the entity failed to obtain its desired
classification as of the date of its formation because Form 8832
was not timely filed, (ii) the due date for the entity’s initial tax
-8return has not passed, and (iii) the entity had reasonable cause for
its failure to make a timely election.
(i)
Subsequently, Rev. Proc. 2002-59, 2002-2 C.B. 615,
extended the time for requesting relief from six months to
the unextended due date of the entity’s federal tax return
for the year of the entity’s formation.
(ii)
In Rev. Proc. 2009-41, 2009 I.R.B. 439, which superseded
Rev. Proc. 2002-59, the Service extended late entity
classification relief to both initial classification elections
and changes in entity classification elections. Rev. Proc.
2009-41 also extended the time for filing late entity
classification elections to within 3 years and 75 days of the
requested effective date of the eligible entity’s
classification. Entities that satisfy the requirements set out
in Rev. Proc. 2009-41 must follow the prescribed
procedures for obtaining relief for a late entity
classification election.
(iii)
An entity not eligible for relief under these revenue
procedures or denied relief by the Service may apply for a
private letter ruling requesting relief.
b.
The Service issued guidance to provide relief in the case of
elections filed by S corporations. Under Reg. § 301.77013(c)(1)(v)(C), if an entity files an S corporation election but fails to
file Form 8832, the entity will be deemed to have filed an election
to be treated as a corporation. If the S corporation election is not
timely filed, the Service provided a simplified method to request
relief for the late filing of both elections. Rev. Proc. 2004-48,
2004-2 C.B. 172; Rev. Proc. 2007-62, 2007-2 C.B. 786.
c.
In Rev. Proc. 2010-32, 2010-32 I.R.B. 320, the Service issued
guidance to address taxpayer concerns about the validity of
elections made by foreign eligible entities to be classified as a
partnership or disregarded entity in cases of uncertainty regarding
the number of owners of the entity on the effective date of the
election. The revenue procedure assists foreign eligible entities
from defaulting into corporate status under the check-the-box
regulations when the number of owners for federal tax purposes is
uncertain. The revenue procedure applies to certain qualified
entities (as defined in the revenue procedure) and is in lieu of the
letter ruling process ordinarily used to obtain relief for an
erroneous entity classification election.
-9D.
E.
Waiting Period
1.
Under the check-the-box regulations an eligible entity that has exercised
its right to elect its tax classification may not elect a different tax
classification for a period of 60 months (the “60-month waiting period”).
2.
An election by a newly formed eligible entity that is effective on the date
of formation is not considered an elective change; thus, the 60-month
waiting period is not triggered. See Reg. § 301.7701-3(c)(1)(iv).
3.
Rescission of Election – It may be possible to rescind an election and thus
not trigger a waiting period. However, such a rescission must occur
before the end of the taxable year. See P.L.R. 200952036 (Sept. 23, 2009)
(permitting rescission of a partnership’s conversion to a corporation by
converting the corporation into an LLC taxed as a partnership); P.L.R.
200843001 (July 2, 2008) (permitting rescission of the sale of a portion of
a disregarded entity’s ownership interests to prevent an automatic
classification change from a disregarded entity to a partnership); P.L.R.
200613027 (Dec. 16, 2005) (permitting rescission of conversion of LLC
taxed as a partnership into a corporation where reason for conversion, i.e.,
a planned IPO, failed).
Applicability of Check-the-Box Regulations to Elections by Foreign Entities
1.
On January 16, 1998, the Service issued Notice 98-11, 1998-1 C.B. 433, to
prevent the use of “hybrid branches” to avoid subpart F. The Service
announced that it would issue regulations to treat such branches as
separate corporations for purposes of subpart F.
a.
Hybrid branches are entities that are fiscally transparent for U.S.
tax purposes, but not under the law of the country of incorporation.
b.
Interest Stripping Example – The Notice identified the following
type of transaction as one that was inconsistent with the policies of
subpart F. CFC1 owns all of the stock of CFC2, and both are
incorporated in Country A. CFC1 also has a branch (BR1) in
Country B. The tax laws of Country A and B classify CFC1,
CFC2, and BR1 as separate, non-fiscally transparent entities.
CFC2 earns non-subpart F income and uses its assets in a trade or
business in Country A. BR1 transfers money to CFC1, which both
Country A and Country B recognize as a loan.
(i)
CFC2 is able to deduct the interest under Country A law.
Country B imposes little or no tax on BR1’s receipt of
interest income.
(ii)
For U.S. tax purposes, the loan is treated as made by CFC1
to CFC2 and the interest as being paid by CFC2 to CFC1.
- 10 Thus, the same country exception in section 954(c)(3)
applies to exclude the interest from subpart F income.
6
2.
On March 23, 1998, the Service and Treasury issued temporary
regulations implementing Notice 98-11. The temporary regulations
treated hybrid branch payments that met the following conditions as
subpart F income: (i) the payment reduces the foreign tax of the payor;
(ii) the payment would have been foreign personal holding company
income if made between separate CFCs; and (iii) there is a disparity
between the effective rate of tax on the payment in the hands of the payee
and the hypothetical rate of tax that would have been applied if the income
had been taxed to the payor.
3.
On June 19, 1998, the Service issued Notice 98-35, 1998-2 C.B. 34, in
which it announced that it was withdrawing the temporary regulations and
issuing them as proposed regulations with certain transitional relief. The
stated purpose of this action was to allow Congress an appropriate period
to address the policy issues raised by the regulations and to permit
Treasury to further study the issues. The temporary regulations were
formally removed on July 12, 1999, effective March 23, 1998. T.D. 8827
(July 12, 1999).
4.
On November 29, 1999, the Service issued proposed regulations that
would have invalidated an election by an eligible foreign entity to be
treated as a disregarded entity in certain circumstances. Prop. Reg.
§ 301.7701-3(h). The proposed regulations were intended to shut down
so-called check-and-sell transactions designed to avoid subpart F.6 The
proposed regulations would have treated a foreign entity as a corporation
if it had been involved in an “extraordinary transaction” within the period
beginning one day before and ending 12 months after the effective date of
that foreign entity’s change in classification to a disregarded entity, and
that foreign entity was classified as a corporation at any time within the
12-month period prior to the extraordinary transaction. Prop. Reg.
§ 301.7701-3(h)(1).
5.
The Service announced the withdrawal of these proposed regulations on
June 25, 2003 in Notice 2003-46, 2003-2 C.B. 53. The Service formally
withdrew Prop. Reg. § 301.7701-3(h) effective October 22, 2003. See
Announcement 2003-78, 2003-2 C.B. 73. The remaining portions of the
Because subpart F income excludes sales of property used in a trade or business (section
954(c)(1)(B)(iii); Reg. § 1.954-2(e)(3)), but not sales of stock, taxpayers can avoid subpart F
income by checking the box on a lower-tier subsidiary immediately before that entity is sold by a
controlled foreign corporation.
- 11 proposed regulations were finalized without substantial change. See T.D.
9093, 2003-2 C.B. 1156.7
7
a.
Notice 2003-46 indicated that the approach in the proposed
regulations was widely criticized as overly broad and potentially
damaging to the increased certainty promoted by the entity
classification regulations issued in 1996. The Notice also indicated
the Service and Treasury remain concerned about cases in which a
taxpayer, seeking to dispose of an entity, makes an election to
disregard it merely to alter the tax consequences of the disposition.
The Notice stated the Service would continue to pursue the
application of other principles of existing law (such as the
substance over form doctrine) to determine the proper tax
consequences in such cases.
b.
Notice 2003-46 also indicated the Service and Treasury are
examining the potential use of the entity classification regulations
to achieve results inconsistent with the policies and rules of
particular Code provisions or of U.S. tax treaties. The Notice
stated the examination would focus on ensuring that the
substantive rule of particular Code provisions and U.S. tax treaties
reach appropriate results notwithstanding changes in entity
classification. This is consistent with the Service’s historic
approach. The Service has previously attempted to police the use
of disregarded entities in the foreign context through subpart F and
other substantive Code provisions—it has never proposed
invalidating an entity classification election. See, e.g., Notice 9811, 1998-1 C.B. 433; Notice 98-35, 1998-2 C.B. 34; Prop. Reg.
§ 1.954-9; I.T.A. 199937038 (June 28, 1999).
The remaining portions of the final regulations include a rule that terminates the
grandfathered status of foreign per se entities when there has been a 50-percent change of
ownership of such entity. Reg. § 301.7701-2(d)(2)(i)(D). In addition, the final regulations
provide two rules that relate to the application of the 60-month rule. The 60-month rule provides
that if the classification of a foreign eligible entity that was previously relevant for federal tax
purposes ceases to be relevant for 60 months and then becomes relevant again, the entity’s
classification will be determined under the default rules of Reg. § 301.7701-3(b)(2). The two
rules provided by the final regulations are: (i) the classification of a foreign eligible entity that
files an entity classification election is deemed relevant on the effective date of the election for
purposes of the 60-month rule; and (ii) the classification of a foreign eligible entity whose
classification has never been relevant for federal tax purposes will initially be determined
pursuant to the default classification rules at the time the classification of the entity first becomes
relevant. Reg. § 301.7701-3(d).
- 12 6.
The Service challenged a check-and-sell transaction under principles of
existing law and lost. Dover Corp. v. Commissioner, 122 T.C. 324
(2004).
a.
In Dover, Dover U.K. Holdings (“Dover UK”) sold the stock of its
subsidiary, Hammond & Champness Ltd. (“H&C”). Dover UK
and H&C were controlled foreign corporations of the taxpayer;
thus, the sale would give rise to subpart F income to the taxpayer.
H&C requested an extension of time, pursuant to Reg. § 301.91001(c), to file a retroactive election to be a disregarded entity, which
the Service reluctantly granted. The parties agreed that the checkthe-box election resulted in a deemed section 332 liquidation of
H&C. The question before the court was whether, in the section
332 liquidation, the parent succeeded to the business history of the
liquidated subsidiary so that the assets qualified as used in the
parent’s trade or business and, therefore, qualified for the subpart F
exemption.
b.
The Tax Court considered two competing lines of authority—Rev.
Rul. 75-223, 1975-1 C.B. 109, which concluded in the context of
the partial liquidation provisions that after a section 332
liquidation, the parent is viewed as if it always operated the
business of the subsidiary, and Acro Mfg. Co. v. Commissioner, 39
T.C. 377 (1962), which concluded that the character of a liquidated
subsidiary’s assets does not automatically carry over to the parent
where the parent held the assets for only a transitory period. The
court concluded that the Service, by reason of its published
revenue ruling, had conceded that H&C’s business history carried
over to Dover UK by reason of the deemed liquidation.
7.
In its report on simplification, the Joint Committee Staff called for the
elimination of the disregarded entity election for foreign entities. See
Joint Committee on Taxation, Options to Improve Tax Compliance and
Reform Tax Expenditures, JCS-02-05, Jan. 27, 2005, Doc 2005-1714,
2005 TNT 18-18.
8.
Nonetheless, in 2006, Congress codified the anti-Notice 98-11 sentiment
in 954(c)(6) effective for tax years of foreign corporations beginning after
December 31, 2005, and for tax years of U.S. shareholders with or within
which such tax years of foreign corporations. P.L. 109-222, § 103(b)(1).
a.
That section provides a look-through rule in which subpart F
foreign personal holding company income generally does not
include dividends, interest, rents, and royalties received or accrued
from a related CFC. Thus, section 954(c)(6) permits a CFC to pay
its active earnings into a tax haven without triggering subpart F
- 13 income, without regard to whether it has checked the box to be
disregarded.
b.
9.
10.
III.
This statute originally expired at the end of 2011, but was extended
to December 31, 2013.
President Obama’s FY 2010 budget included proposed changes to the
check-the-box rules in relation to foreign entities. The proposals would
not repeal the regulations in their entirety, but would prevent the use of
disregarded entities when they are established in a different jurisdiction
than their owner. In those situations the entity would be treated as a
corporation. See Treasury Provides Details on Check-the-Box Reforms,
2009 TNT 89-4 (describing the explanation in the Treasury Department’s
green book).
a.
“Except in cases of U.S. tax avoidance,” the proposal would
generally not apply to a first-tier foreign eligible entity whollyowned by a U.S. person.
b.
In the interest stripping example above, BR1 would be respected as
a corporation. Thus, the loan from BR1 to CFC2 would be
respected as such, and the same country exception in section
954(c)(3) would not apply to exclude the interest from subpart F
income.
c.
The Obama Administration proposal would reverse 954(c)(6) and
not only reinstate Notice 98-11 but go beyond it by treating the
disregarded entities as corporations for all purposes and not just
subpart F.
The above proposals were not included in President Obama’s FY 2011
budget, but the Administration says that it is still looking at the underlying
issues that are achieved by changing the check-the-box rules for foreign
entities. See Obama Administration Still Vigilant on Check-the-Box,
Treasury Official Says, 2010 TNT 56-2.
WHAT IS A DISREGARDED ENTITY?
A.
In General
1.
Whether an organization is an entity separate from its owners for federal
tax purposes is a matter of federal tax law and does not depend on whether
the organization is recognized as an entity under local law. Reg.
§ 301.7701-1(a)(1).
2.
The assets and liabilities of a disregarded entity are treated as owned, and
its activities are treated as actually performed, by its owner. If the owner
is a corporation, the activities of the disregarded entity are treated as if
- 14 they were conducted by a division or a branch of the corporation. Reg.
§ 301.7701-2(a).
3.
4.
In analyzing issues regarding the use of disregarded entities in corporate
transactions, it may be helpful to look to the treatment of similar situations
in which corporations have been disregarded.
a.
Qualified REIT Subsidiaries – Under section 856(i)(1), a wholly
owned subsidiary of a real estate investment trust (i.e., a qualified
REIT subsidiary) is disregarded as an entity separate from its
owner, and all of its assets, liabilities, and items of income,
deduction, and credit are treated as assets, liabilities, and items of
its owner.
b.
Qualified S Corporation Subsidiaries (“QSubs”) – Similarly, under
section 1361(b)(3)(A), a wholly owned subsidiary of an S
corporation is not treated as a separate corporation, and all of its
assets, liabilities, and items of income, deduction, and credit are
treated as those of its owner.
c.
Finally, the existence of corporate entities may be ignored through
the application of the step-transaction doctrine, such as the case
where a transitory subsidiary is ignored.
Even though the assets and liabilities of a single-member LLC are treated
as owned by the LLC for state law purposes, they are treated as owned by
the LLC’s owner for federal tax purposes.
a.
For example, in P.L.R. 199947001 (Dec. 7, 1998), a partnership
owned all of the interests in a single-member LLC. The Service
ruled that if the partnership made a section 754 election, the
adjustment under section 743(b) would be made to all of the
partnership’s assets, including those of its single-member LLC.
b.
In P.L.R. 200143012 (July 25, 2001), X, an S corporation, owned
all of the stock of Sub, a qualified S corporation subsidiary. Sub
owned directly and through single-member LLCs interests in
several limited partnerships that operated commercial real estate—
Sub held limited partnership interests directly and held general
partnership interests through the LLCs. The Service ruled that for
purposes of section 1362(d)(3), X would be treated as holding the
general partnership interests directly, and the rents received by the
partnerships would thus not be treated as passive investment
income. Cf. P.L.R. 200218033 (Feb. 5, 2002) (ruling that rents
from properties owned directly and through a multi-member LLC
treated as a partnership were not passive investment income under
section 1362(d)(3) where X provided various operational services
- 15 to the properties, and solicited new tenants and negotiated leases
for the properties).
5.
c.
In P.L.R. 200316003 (Dec. 20, 2002), C, a limited partnership,
owned all of the interests of B, a single-member LLC, and B
owned all of the interests of A, a single-member LLC. A owned a
synthetic fuel facility. The Service concluded that because A and
B are disregarded entities, C was deemed to own the facility and
therefore C was entitled to the section 29 credit for the production
of qualified fuel.
d.
In P.L.R. 200522006 (Mar. 4, 2005), a UK corporation owned a
US corporation through a disregarded entity. The disregarded
entity distributed the US corporation to the UK parent and, within
12 months, the US corporation made a dividend distribution to the
UK parent. The Service ruled that the 12-month stock ownership
requirement for exclusion of the dividend under the US-UK Treaty
was satisfied, because the UK parent was treated as owning the US
company during the time it was held by the disregarded entity.
e.
In P.L.R. 200005023 (Nov. 9, 1999), Foreign Parent formed
FSub2, a disregarded entity, which in turn formed Newco, a
disregarded entity. Newco purchased S2, a second-tier subsidiary
of Foreign Parent from FS1, a first-tier subsidiary of Foreign
Parent. The Service ruled that Foreign Parent would be treated as
the purchaser of S2’s stock; therefore, the acquisition was not an
acquisition of stock by a related corporation within the meaning of
section 304.
f.
In GLAM 2012-001 (Feb. 9, 2012), the Service concluded that, for
Federal tax purposes, the owner of a disregarded entity could not
split its ownership interest into separate classes of interests and
allocate income, loss, deduction, credit, or basis among those
classes, even if state law may have allowed different classes of
interests.
However, the Service has, at least in a few instances, “regarded” a
disregarded entity.
a.
For example, the Service looked to the rights and obligations of the
debtor and creditor under state law to determine whether a
modification of a debt instrument resulted in a taxable exchange
under Reg. § 1.1001-3. P.L.R. 201010015 (Nov. 5, 2009); P.L.R.
200709013 (Nov. 22, 2006); P.L.R. 200630002 (Apr. 24, 2006);
P.L.R. 200315001 (Sept. 19, 2002).
- 16 -
b.
(i)
In P.L.R. 200315001 (Sept. 19, 2002), the Parent group
restructured with Parent becoming a wholly owned
subsidiary of New Parent. Parent then converted to a
single-member LLC, LLC1. Parent achieved this
conversion by filing a certificate, not by merging into a
new legal entity.
(ii)
The Service determined that under the applicable State A
law, the conversion of Parent into LLC1 would not affect
the legal rights or obligations between debt holders and
Parent because, as a matter of State A law, LLC1 remains
the same legal entity as Parent. The Service therefore
determined that the conversion of Parent into LLC1 did not
result in a modification of the debt held by the debt holders.
(iii)
The Service reached the same conclusion under similar
facts in P.L.R. 200630002.
(iv)
If the tax fiction had been respected so that the LLC is
disregarded for all federal tax purposes, New Parent would
become the obligor on any debt of Parent, and because only
the assets of LLC can be reached by the creditors of LLC,
such debt would become nonrecourse debt of New Parent.
See Reg. § 1.465-27(b)(6), Ex. 6; see also Section X.A.,
below.
The Service also “regarded” a disregarded entity in applying the
small partnership exception to the TEFRA unified partnership
audit and litigation procedures under section 6231(a)(1)(B). Rev.
Rul. 2004-88, 2004-2 C.B. 165.
(i)
In Rev. Rul. 2004-88, P was a limited partnership, the sole
general partner of which was LLC, a disregarded entity
owned by individual A. A and the four limited partners
were individuals who were not nonresident aliens. The
TEFRA procedures do not apply to a small partnership,
which is defined as a partnership in which there are 10 or
fewer partners, each of whom is an individual other than a
nonresident alien, an estate of a deceased partner, or a C
corporation. Section 6231(a)(1)(B). However, the small
partnership exception does not apply if any partner is a
“pass-thru partner,” which includes a partnership, estate,
trust, S corporation, nominee or other similar person
through other persons hold an interest in the partnership.
Section 6213(a)(9); Reg. § 301.6231(a)(1)-1(a)(2).
- 17 (ii)
The Service concluded that although LLC was disregarded
for federal tax purposes, it, and not A, was the partner
under state law. Therefore, LLC was a pass-thru partner,
and the small partnership exception did not apply. The
Service further concluded that as the general partner under
state law, only LLC, and not A, was eligible to be
designated as the tax matters partner (“TMP”).
(iii)
In emailed advice dated February 4, 2008, the Service
advised that if the TMP becomes a disregarded entity, its
owner does not become the TMP, but rather the disregarded
entity remains the TMP unless it is dissolved. See Service
Addresses Tax Matter Partner Status in Context of
Disregarded Entity, 2009 TNT 32-12.
c.
The Service has “regarded” disregarded entities for purposes of
reporting, paying, and collecting employment taxes and certain
excise taxes to alleviate certain administrative difficulties. See
Treas. Reg. § 301.7701-2(c)(2)(iv) & (v); These regulations
became final on August 16, 2007, and reverse the Service’s earlier
position in Notice 99-6, 1999-1 C.B. 321, for wages paid on or
after January 1, 2009. The Service has also issued regulations to
clarify that a single-owner eligible entity that is regarded as a
separate entity for certain employment and excise tax purposes is
treated as a corporation. See Treas. Reg. § 301.77012(c)(2)(iv)(B), T.D. 9553, 76 Fed.Reg. 66181-83 (Oct. 31, 2011).
The regulations are discussed in conjunction with employment
issues below. See Section X.F., below. Temp. Treas. Reg. §
301.7701-2T(e)(9)(i) provides for separate treatment of
disregarded entities for the indoor tanning services excise tax in
section 5000B.
d.
The Service regards a disregarded entity for purposes of
determining whether a conduit financing arrangement exists. See
Treas. Reg. § 1.881-3(a)(2)(i)(C) (effective for payments made on
or after December 9, 2011).
e.
In C.C.A. 200929001 (July 17, 2009), the Service held that section
6621(d) does not permit interest netting among a parent company
and its disregarded LLC subsidiaries for interest arising from years
prior to a check-the-box election or conversion. The Service
determined that the LLC’s election or conversion did not make the
LLC and its parent company the same taxpayer under section
6621(d) for the purpose of netting interest rates on underpayments
and overpayments from the prior years. The Service relied on the
fact that, during the tax periods generating the underpayments and
- 18 overpayments for which netting was requested, the entities
involved filed separate tax returns using separate EINs.
f.
In the QSub context, the Service has issued regulations treating
QSub banks as separate entities to which the special rules
applicable to banks continue to apply. Reg. § 1.1361-4(a)(3). See
Vainisi v. Commissioner, 599 F.3d 567 (7th Cir. 2010) (noting
that, under Reg. § 1.1361-4(a)(3), special financial institution rules
apply separately to a bank that also constituted a QSub, but
concluding that special bank rule regarding the deductibility of
interest on debt used to purchase qualified tax-exempt
obligations—section 291(a)(3)—was inapplicable to such bank
under the language of Section 1363(b)(4) since it had not been a C
corporation for the prior 3 taxable years), acquiesced in result only,
AOD 2010-006. In addition, QSubs are treated separately for
excise taxes under Treas. Reg. § 1.1361-4(a)(8). See also Temp
Treas. Reg. § 1.1361-4T(a)(8)(iii)(B) (providing for separate
treatment of QSubs for the indoor tanning services excise tax in
section 5000B).
g.
The Tax Court has also “regarded” a disregarded entity for
purposes of gift tax valuation. In Pierre v. Commissioner, 133
T.C. 24 (2009), the Tax Court held that, although the check-thebox regulations govern how a single-member LLC is taxed for
federal tax purposes, the check-the-box regulations do not apply to
disregard the LLC in determining how a donor must be treated for
gift tax purposes on a transfer of an ownership interest in the LLC.
h.
(i)
The taxpayer had transferred cash and securities to a singlemember LLC, and then granted interests in the LLC to
trusts established for the taxpayer’s son and granddaughter.
The taxpayer used a discounted value for gift tax purposes
for the LLC interests given to the trusts. The Service
argued that, because the LLC was a disregarded entity
under the check-the-box regulations, the transfer should
have been treated as a transfer of the underlying assets, and
no valuation discounts should have applied.
(ii)
In siding with the taxpayer, the Tax Court concluded that
the check-the-box regulations should not be applied to
define the property interest transferred, as state law defined
the rights and interests transferred by a donor for valuation
purposes under the gift tax regime. Because the LLC was a
valid state entity, its form was respected in the transfer.
Under proposed regulations implementing the Affordable Care
Act, a disregarded entity will be regarded for purposes of an
- 19 assessable payment under section 4980H and for purposes of
reporting under section 6056. These requirements are imposed on
the disregarded entity, and not the owner of the disregarded entity.
Prop. Treas. Reg. § 301.7701-2(c)(2)(v)(A)(5). This is also true
for Qsubs. Prop. Treas. Reg. § 1.1361-4(a)(8)(i)(E).
B.
6.
Similarly, the owner is treated as conducting the activities of the LLC for
federal tax purposes. Thus, for example, if the owner of a single-member
LLC is a tax-exempt entity, the activities of the LLC will be considered
conducted by the owner for purposes of determining the owner’s exempt
status and for purposes of applying the unrelated trade or business
provisions of sections 511-513. See P.L.R. 200606047 (Nov. 14, 2005);
P.L.R. 200538027 (Jun. 27, 2005); P.L.R. 200510030 (Dec. 17, 2004);
P.L.R. 200124022 (Mar. 13, 2001). Similarly, under Notice 2012-52, the
IRS stated that if all other requirements of section 170 are met, it will treat
a contribution to a domestic single-member LLC that is wholly owned and
controlled by a U.S.501(c)(3) organization as a charitable contribution
made directly to a branch of the charity.
7.
Transactions between disregarded entities and their owners, and
transactions between commonly owned disregarded entities should be
treated as interdivisional transactions and, thus, ignored for federal tax
purposes. See Examples 1-3, below.
8.
Transactions between disregarded entities and third parties, however,
should generally be treated as having occurred between the owner of the
disregarded entity and the third party.
Determination of Single Owner
1.
The preamble to the check-the-box regulations provides that the
determination of whether an entity has a single owner is based on the
underlying facts and circumstances. Preamble to Reg. § 301.7701, 61 Fed.
Reg. 66,584, 66,585 (1996).
a.
The Service’s ruling position under the prior entity classification
rules was that members had to meet a one-percent ownership
threshold in order to be considered as lacking certain corporate
characteristics. Rev. Proc. 95-10, §§ 4.02-4.05, 1995-1 C.B. 501.
No such threshold appears in the check-the-box regulations. Thus,
these ruling guidelines are apparently no longer relevant.
b.
The Service has issued some rulings addressing what constitutes an
owner for purposes of the check-the-box regulations, applying a
facts-and-circumstances analysis. See P.L.R. 200201024 (Oct. 5,
2001); P.L.R. 199911033 (Dec. 18, 1998); P.L.R. 199914006
(Dec. 23, 1998); I.L.M. 200501001 (Sept. 21, 2004).
- 20 -
2.
(i)
In I.L.M. 200501001, the Service stated that credible
evidence that one member of an LLC reported all of the
income and expenses from the LLC’s business and
represents that he is the sole owner of the LLC would be
sufficient to consider the LLC a single-member entity,
unless there is credible evidence to the contrary.
(ii)
In P.L.R. 199911033, a trust and a corporation wholly
owned by the trust held interests in an LLC. The structure
was used to achieve bankruptcy-remote status for the LLC,
and provided no economic rights to the corporation. The
LLC agreement provided that all LLC decisions would be
made by the trust, except that the corporation had certain
limited veto powers (e.g., the LLC could not file for
bankruptcy without the corporation’s approval). In
addition, all profits and losses were to be allocated to the
trust, and all distributions were to be made only to the trust.
The Service ruled that the trust and the corporation did not
enter an agreement to operate a business and share profits
and losses under general partnership principles.
Accordingly, the LLC was treated as a disregarded entity
wholly owned by the trust. See also P.L.R. 200201024.
(iii)
In P.L.R. 19914006, the Service ruled that an LLC interest
held by a corporation’s wholly owned subsidiary provided
the subsidiary with no economic management rights and,
therefore, the subsidiary would not be treated as a second
member.
(iv)
However, the Service declined to rule on the issue in a
similar situation. See P.L.R. 200109018 (Nov. 29, 2000)
(declining to rule whether a partnership’s stock ownership
in an S corporation should be disregarded as a nominee
interest, instead ruling that the S corporation’s termination
was inadvertent); see also P.L.R. 9716007 (Jan. 8, 1997).
General legal principles, such as whether an entity is respected as a
separate entity under Moline Properties, Inc. v. Commissioner, 319 U.S.
436 (1943), also apply in determining the number of owners. For
example, in Robucci v. Commissioner, T.C. Memo. 2011-19, the taxpayer
restructured his sole proprietorship into an LLC owned 95% by him and
5% by a newly formed corporation solely owned by the taxpayer. The
taxpayer also formed a corporation to act as a management company. The
Tax Court held that both corporations were hollow corporate shells not
formed for business activity and thus would be disregarded under Moline
Properties. As a result, the taxpayer’s LLC had a single owner and was a
disregarded entity.
- 21 3.
C.
In Rev. Proc. 2002-69, 2002-2 C.B. 831, the Service provided guidance on
the classification of entities solely owned by a husband and wife as
community property. The revenue procedure provides that the Service
will respect a taxpayer’s treatment of these entities as either disregarded
entities or partnerships. Note, however, that the revenue procedure deals
only with the issue of classification. It does not provide guidance on
which spouse should include amounts in income. State community
property rules, as supplemented by federal tax rules dealing with
community property issues, would govern that issue. See Sheryl Stratton,
Treasury Officials Clarify Reach of Recent Corporate Guidance, 2002 Tax
Notes Today 219-2 (Nov. 12, 2002).
Assessment and Collection Issues
Because disregarded entities are regarded for state law purposes, it has presented
unique issues for the Service relating to the assessment and collection of taxes.
These issues are analyzed in I.L.M. 200235023 (June 28, 2002).
1.
Liability for Tax
a.
b.
Classified as Corporation
(i)
If a single or multi-member LLC elects to be taxed as a
corporation, it is liable for any income or employment
taxes.
(ii)
However, the Service can assert the trust fund penalty
against a member of the LLC who qualifies as a responsible
person under section 6672.
Classified as Partnership
(i)
If a multi-member LLC is taxed as a partnership, the
income tax liability arising from the LLC’s activities flows
through to its members.
(ii)
The LLC is liable for any employment taxes. However,
unlike the typical partnership situation where general
partners are liable for the employment tax under state law
as they are for any other liabilities of the partnership, state
law exempts LLC members from liability for an LLC’s
debts. Thus, the Service cannot assert employment tax
liabilities against members of an LLC taxed as a
partnership. Rev. Rul. 2004-41, 2004-1 C.B. 845.
(iii)
A disregarded entity may, however, be liable for taxes
during a period prior to becoming disregarded or because it
is the successor of a taxable entity. The Service and
- 22 Treasury have issued regulations to clarify that in such
cases, the disregarded entity will be treated as a separate
entity for purposes of assessment, lien and levy, consent to
extend the statute of limitations, and refunds and credits.
Reg. § 301.7701-2(c)(2)(iii), T.D. 9183, 70 Fed. Reg. 922022 (Feb. 24, 2005).
c.
2.
Classified as Disregarded Entity
(i)
If a single-member LLC is disregarded, the initial rule was
that the single member owner was the taxpayer and was
liable for income and employment taxes. See Notice 99-6,
1999-1 C.B. 321 (providing that the owner is the employer
for employment tax purposes, even though it may allow the
LLC to separately calculate, report, and pay the
employment tax obligations). However, Reg. § 301.77012(c)(2)(iv) changed the rule for wages paid on or after
January 1, 2009, respecting the disregarded entity as the
employer. See Section X.F.2., below, for a discussion of
employment taxes.
(ii)
Nonetheless, the Service takes the position that an
employment tax assessment in the name and EIN of the
LLC is, in substance, an assessment of the owner’s liability,
although the owner’s name, if known, should be added to
the assessment.
Collection of Tax
a.
A notice of federal tax lien (“NFTL”) should be filed against the
single member owner, since the owner and not the LLC is liable
for the tax. However, the Service takes the position that the NFTL
need not precisely identify the taxpayer if it substantially complies
with the notice requirement.
b.
Assuming a valid assessment and notice and demand upon the
owner, does the owner’s property include the assets of the LLC?
(i)
The Service has concluded that it does not, because under
state law the owner has no interest in the LLC’s property.
Thus, the Service cannot levy on the LLC’s assets to satisfy
the owner’s tax liability. See also I.L.M. 200840001 (Aug.
2008); I.L.M. 200338012 (Sept. 19, 2003); I.L.M.
199930013 (Apr. 18, 1999). The Service can, however,
levy on the member’s ownership interest in the LLC or on
the owner’s share of LLC profits. See I.L.R. 200835030
(Jul. 18, 2008).
- 23 (ii)
Further, the Service could assert state law theories, such as
piercing the corporate veil or nominee or transferee
liability, to reach the LLC’s assets. But see I.L.M.
200840001 (Aug. 2008) (successor liability does not apply
because the single member has no interest in the LLC’s
assets); Kay Co LLC v. United States, No. 2:10-cv-00410
(S.D.W.V. 2011) (District Court grants temporary
restraining order against the IRS in a challenge of
transferee liability; Court also denies IRS motion to dismiss
individual plaintiffs because the members of the LLC have
an interest in the property at issue).
- 24 D.
Examples
1.
Transactions Between Disregarded Entities and Their Owners
a.
Example 1 – Contribution to Disregarded Entity
P
Property
LLC Interests
LLC
(i)
Facts: Corporation P contributes property to a newly
formed, wholly owned LLC. LLC does not elect to be
taxed as an association.
(ii)
Tax Consequences: Because LLC is disregarded as an
entity separate from P, LLC is treated as a division of P.
As a result, P’s contribution will be treated as an
interdivisional transaction, which is ignored for federal tax
purposes. Thus, the contribution is tax free, because no
sale or exchange of property has occurred for purposes of
section 1001. See, e.g., P.L.R. 200228008 (Apr. 4, 2002)
(ruling that a transfer of the interests in a single-member
LLC by an S corporation to its QSub is disregarded).
(iii)
Because the transfer is disregarded, any election that P has
made will not terminate. For example, in P.L.R.
200423016 (Feb. 24, 2004), the Service ruled that the
taxpayer’s election to defer prepaid subscription income
under section 455 did not terminate upon the taxpayer’s
transfer of its assets and liabilities to a disregarded entity.
- 25 b.
Example 2 – Distribution From Disregarded Entity
P
Appreciated
Property
100%
LLC
(i)
Facts: P owns all of the membership interests in LLC,
which does not elect to be taxed as an association. LLC
makes a distribution of appreciated property to P.
(ii)
Tax Consequences: Because LLC is treated as a division of
P, the distribution will be treated as an interdivisional
transaction, which is ignored for federal tax purposes.
Thus, similar to the contribution in the example above, the
distribution will not result in the recognition of gain or loss
to either LLC or P.
(iii)
This presents a planning opportunity to avoid the
application of section 311(b). If a corporate subsidiary of P
wanted to distribute an appreciated asset to P, it could
convert into a single-member LLC (which would be treated
as a tax-free section 332 liquidation) and distribute the
asset tax free. See, e.g., P.L.R. 200944011 (July 24, 2009);
P.L.R. 200035031 (June 6, 2000).
- 26 Example 3 – Debt Between a Disregarded Entity and its Owner
c.
P
LLC Note
$
100%
LLC
Facts: P owns all of the membership interests in LLC,
which does not elect to be taxed as an association. LLC
borrows money from P, issuing its note to P in exchange.
(ii)
Tax Consequences: Because LLC is treated as a division of
P, there is no separate debtor and creditor and the debt is
ignored. Thus, if LLC does not repay the debt, P could not
claim a bad debt deduction. See P.L.R. 200814026 (Dec.
17, 2007). See Section X.A.3., below for the treatment of
debt where the entity becomes disregarded or regarded.
Example 4 – Transactions Between Commonly Owned
Disregarded Entities
d.
A
(i)
B
(1)
X Stock
A
Z
Z
X
(2)
1% X Stock
B
100%
99%
1% X
Stock
W
X
W
(3)
Merger
Y
1%
Y
- 27 -
(i)
Facts: A and B own all of the stock of X. A and B
contribute their X stock to Z, a newly formed state
partnership that elects to be taxed as an association. Z
contributes 1 percent of its X stock to W, a newly formed
LLC, and X merges into a limited partnership, Y, under
state law. Neither W nor Y elects to be taxed as an
association.
(ii)
Tax Consequences: These are similar to the facts of P.L.R.
200201005 (Sept. 27, 2001). The taxpayer represented that
the series of transactions would qualify as a section
368(a)(1)(F) reorganization (see Section VI.E., below), and
the Service ruled that both the transfer of X stock to W and
the merger of X into Y would be disregarded for federal tax
purposes. Because W is treated as a division of Z, the
transfer of one percent of the X stock to W is treated as an
interdivisional transaction, which is ignored for federal tax
purposes. Further, Y, which is owned one percent by W
and 99 percent by Z, will be disregarded for federal tax
purposes. Thus, X’s merger into Y will also be ignored,
because at the end of the series of transactions, the assets of
X continue to be owned by Z for federal tax purposes.
(iii)
Because transactions between commonly owned
disregarded entities are ignored, they would not be subject
to the arm’s-length standard of section 482. See G.C.M.
36,015 (Sept. 27, 1974) (concluding that section 482 may
not be used to make allocations between divisions of a
single corporation but that section 863 could be used to
prevent distortion of the taxpayer’s foreign source income).
- 28 2.
Corporate Structures Involving Disregarded Entities
a.
Example 5 – Multiple Disregarded Entities
P
100%
100%
LLC-1
LLC-2
50%
50%
LLC-3
(i)
Facts: Corporation P is the sole member of LLC-1 and
LLC-2, both of which do not elect to be taxed as
associations. LLC-1 and LLC-2 form LLC-3, with each
taking a 50-percent membership interest.
(ii)
Tax Consequences: LLC-1 and LLC-2 are disregarded as
entities separate from P. Thus, P is treated as owning the
assets of LLC-1 and LLC-2, including the interests in LLC3, directly. As a result, LLC-3 should not be treated as a
partnership, because it has only one member (P). Instead,
the assets of LLC-3 should likewise be treated as owned
directly by P. P.L.R. 200513001 (Dec. 9, 2004); See also
Rev. Rul. 2004-77, 2004-2 C.B. 119 (ruling that an entity
cannot be classified as a partnership if it has two members
under local law and one of those members is disregarded as
separate from the other for federal tax purposes); P.L.R.
199915030 (Jan. 12, 1999) (same); P.L.R 200102037 (Oct.
12, 2000) (ruling that an individual was treated as owning
all of the assets of a single-member LLC that was wholly
owned by the individual’s grantor trust).
(iii)
Assume instead that P is an S corporation, and LLC-1 and
LLC-2 are corporations that are treated as QSubs, each of
which owns a 50-percent interest in an LLC. In P.L.R.
- 29 9732030 (May 14, 1997), the Service ruled that, on these
facts, the LLC was treated as owned directly by P and, thus,
disregarded as an entity separate from P. Thus, the federal
tax results are the same whether LLC-1 and LLC-2 are
organized as LLCs or QSubs. Cf. Reg. § 1.1361-2(d), Exs.
1 & 2.
b.
Example 6 – Preservation of S Corporation Status
A
A
Trust
Trust
S-Corp Stock
LLC
LLC Interests
LLC
S-Corp
S-Corp
(i)
Facts: Individual A and Trust are qualified shareholders of
S Corp. Trust forms LLC, and transfers its S Corp stock to
LLC in exchange for LLC interests. LLC does not elect to
be taxed as an association.
(ii)
Tax Consequences: These are the facts of P.L.R. 9745017
(Aug. 8, 1997) and P.L.R. 200303032 (Oct. 8, 2002), in
which the Service ruled that because LLC is disregarded
for federal tax purposes, the transfer of S Corp shares to
LLC does not terminate S Corp’s election. See also P.L.R.
200816002 (Jan. 14, 2008) (ruling that a transfer of S
corporation stock owned by an individual to an LLC owned
by the individual did not terminate S corporation status);
P.L.R. 200439027 (May 7, 2004) (ruling that the transfer of
S corporation stock by an individual to a partnership owned
by that individual, his grantor trust, and an LLC owned by
the individual and another grantor trust did not terminate S
corporation status); P.L.R. 200107025 (Nov. 17, 2000)
(ruling that a transfer of S corporation stock to a limited
partnership owned by the individual shareholder and his
- 30 single-member LLC did not terminate S corporation
status); P.L.R. 200008015 (Nov. 18, 1999) (same).
IV.
TREATMENT OF CLASSIFICATION CHANGES
A.
In General
1.
B.
There are essentially three ways in which to accomplish a classification
change: (i) An elective classification change, wherein the entity simply
checks the box to change its classification; (ii) an automatic classification
change, wherein an entity’s default classification changes as a result of a
change in the number of owners; and (iii) an actual conversion, wherein an
entity merges into or liquidates and forms a new entity that has the desired
classification.
a.
An automatic classification change occurs when there is a change
in the number of owners of an entity that precludes its current
classification. For example, an entity can no longer be treated as
disregarded if the number of owners increases above one.
Similarly, a partnership can no longer be classified as such if the
number of partners decreases to one. The Service has provided
further guidance on the tax consequences of such automatic
classification changes. See Rev. Rul. 99-5, 1999-1 C.B. 434; Rev.
Rul. 99-6, 1999-1 C.B. 432 (both discussed below).
b.
Waiting Period - The regulations provide that an automatic
classification change is not treated as an elective change, so the 60month waiting period is unaffected by an automatic classification
change. Reg. § 301.7701-3(f)(3). Thus, if an entity is formed on
April 1, 1998, and an automatic classification change occurs on
April 30, 1998, the entity may elect a different classification at any
time, because the entity has not made a prior election for purposes
of the 60-month waiting period.
Timing
1.
A change of classification election is treated as occurring at the start of the
day for which the election is effective. Any transactions that are deemed
to occur as the result of the change in classification are treated as
occurring as of the close of the day before the election becomes effective.
Reg. § 301.7701-3(g)(3).
a.
Because the tax impact of the deemed transactions may have
different tax consequences depending upon the circumstances, care
- 31 must be taken in choosing the effective date of the change in
classification.8
b.
8
The timing of an elective classification change may also affect who
must sign the Form 8832 if the entity is sold immediately before
the election.
(i)
In general, either the members of the electing entity or an
authorized officer or manager of the entity must sign the
Form 8832. Reg. § 301.7701-3(c)(2)(i).
(ii)
However, for changes in classification of an entity, each
person who was an owner on the date that any transactions
are deemed to occur, and who is not an owner at the time
the election is filed, must also sign the election. Reg.
§ 301.7701-3(c)(2)(iii). Similarly, for retroactive elections,
each person who was an owner between the date the
election is to be effective and the date the election is filed,
and who is not an owner at the time the election is filed,
must also sign the election. Reg. § 301.7701-3(c)(2)(ii).
(iii)
Thus, if a purchaser of an eligible entity wants to avoid
obtaining the seller’s signature on the Form 8832, it should
elect to change the classification effective two days after
the acquisition so that the deemed transactions are deemed
to occur the day after the acquisition, when the seller no
longer owns the entity. See P.L.R. 200251006 (Sept. 6,
2002) (granting section 9100 relief and allowing a taxpayer
who made a section 338 election and an a check-the-box
election with respect to an acquisition to amend Form 8832
because the original election was made effective on
acquisition date rather than the day after and therefore was
not valid as a result of the failure to obtain sellers’
signatures).
For example, assume the deemed transactions triggered by the change in classification
cause a consolidated group of corporations to recognize gain. If the group has an expiring NOL,
it would be to the benefit of the group to have the election, which triggers the recognition of
gain, take effect no later than the first day of the taxable year after the NOL expires. Thus,
because the deemed transactions are treated as occurring immediately before the close of the day
before the election is effective, the gain triggered by the deemed transactions could be offset by
the expiring NOL.
- 32 2.
The timing of the classification election conflicts with the timing of the
deemed transactions where a section 338 election is made. See Preamble
to Reg. § 301.7701, 64 Fed. Reg. 66,580, 66,581 (1999).
a.
As a result, the regulations provide that a corporation’s
classification election cannot be effective before the day after the
acquisition date of the target corporation. In addition, the
transactions that are deemed to occur as a result of the
classification election will be treated as occurring immediately
after the deemed asset purchase by the new target corporation
under section 338. Reg. § 301.7701-3(g)(3)(ii).
b.
Thus, the timing rule for section 338 elections avoids the problem
identified above with having to obtain the signature of the seller on
the Form 8821.
3.
Tiered Entities – When classification elections for a series of tiered
entities are effective on the same date, the eligible entities may specify the
order of the elections. If no order is specified, then the transactions are
treated as occurring first for the highest tier entity’s classification change
and then for each next highest tier entity’s classification change. Reg.
§ 301.7701-3(g)(3)(iii).
4.
Overlap Between Elective and Automatic or Actual Classification
Changes
a.
If an elective classification change is effective at the same time as
an automatic classification change resulting from a change in the
number of owners, the deemed transactions from the elective
change preempt the transactions that would result from the
automatic classification change. Reg. § 301.7701-3(f)(2).
b.
Similarly, the Service has ruled that an elective classification
change that is effective at the same time as an actual conversion
will govern the entity’s classification. See P.L.R. 200109019
(Nov. 29, 2000) (ruling that a corporation that converted into an
LLC under state law and filed an election to be classified as an
association effective on the date of conversion will not be
classified as an entity other than a corporation).
- 33 C.
Treatment of Elective Classification Changes9
1.
2.
In General
a.
The preamble to the final regulations amending the check-the-box
regulations notes that elective classification changes are
transactions without actual form. The regulations provide that only
one transaction form will be applied to each type of elective
conversion, thus rejecting commentators’ recommendations that
taxpayers be allowed to choose which form to apply to an elective
classification change. Preamble to Reg. § 301.7701, 64 Fed. Reg.
at 66,581.
b.
The regulations treat an elective change in classification as
triggering a series of deemed transactions, which differ depending
upon the reclassification that takes place. The tax treatment of a
change in classification is determined under all relevant provisions
of the Code and general principles of tax law, including the steptransaction doctrine. Reg. § 301.7701-3(g)(2). This provision is
intended to ensure that the tax consequences of an elective change
will be identical to the consequences that would have occurred if
the taxpayer had actually taken the steps described in the
regulations. See Preamble to Prop. Reg. § 301.7701, 62 Fed. Reg.
55,768, 55,769 (1997).
An Association Elects to be Classified as a Partnership
a.
b.
Deemed Transactions - If an eligible entity classified as an
association elects to be classified as a partnership, the following
transactions will be deemed to occur. Reg. § 301.7701-3(g)(1)(ii).
(i)
First, the association is deemed to distribute all of its assets
to its shareholders in liquidation.
(ii)
Second, the shareholders are deemed to contribute the
assets to a newly formed partnership.
Tax Consequences
(i)
9
The distributing corporation recognizes gain on the
distribution of its assets to its shareholders. The
corporation’s gain is equal to the difference between the
fair market value of the distributed assets and the
For purposes of this outline, unless otherwise specified, assume all corporations
involved are solvent for all purposes.
- 34 corporation’s adjusted basis in those assets. Section 336(a).
The character of the gain depends on the character of the
assets deemed distributed. The shareholders recognize gain
on the distribution equal to the difference between the fair
market value of the assets (less the amount of liabilities
assumed) and the basis in their stock. Section 331. Under
section 334(a), the shareholders take a fair market value
basis in the assets distributed.
(ii)
Under section 331, the shareholders are treated as
purchasing the assets received in the liquidating
distribution; thus, the shareholders’ holding periods for the
assets deemed distributed in the liquidation begin on the
date of distribution.
(iii)
If the corporation is treated as liquidating into an “80percent distributee” within the meaning of section 337(c),
neither the liquidating corporation nor its parent
corporation will recognize gain as a result of the liquidating
distribution. Sections 332 and 337. If section 332 applies
to the liquidation, the parent corporation will take a
carryover basis and a tacked holding period in the assets
acquired in the liquidating distribution. Sections 334(b)(1);
1223(2). Under section 331, minority shareholders of the
liquidating corporation will recognize gain on the
distribution.
(iv)
Neither the shareholders nor the newly formed partnership
recognizes gain on the transfer of the assets to the
partnership in exchange for interests in the partnership.
Section 721. Under sections 722 and 752, the transferring
partners take a substituted basis in their partnership
interests equal to their bases in the assets, less the amount
of liabilities assumed by the partnership, increased by the
partners’ shares of overall partnership liabilities. The
partnership takes a carryover basis in the contributed assets,
increased by the amount of gain recognized by the
contributing partner under section 721(b). Section 723.
Note that if the deemed liquidation is taxable, then the
partnership takes a fair market value basis in the assets.
(v)
Under section 1223(1), the partners’ holding periods for
their partnership interests include their holding period for
the property contributed. Under section 1223(2), the
partnership’s holding period for the contributed assets
includes the partners’ holding periods for those assets.
- 35 c.
3.
Plan of Liquidation – One of the requirements of section 332 is the
adoption of a plan of liquidation. However, formally adopting
such a plan is inconsistent with the elective regime of the checkthe-box regulations, which allows a local law entity to remain in
existence and liquidate only for federal tax purposes. Preamble to
Prop. Reg. § 301.7701-3(g)(2)(ii), 66 Fed. Reg. 3959, 3959 (2001);
Preamble to Reg. § 301.7701-3(g)(2)(ii), 66 Fed. Reg. 64,911,
64,912 (2001). However, the regulations provide that, in the case
of elective classification changes, a plan of liquidation is deemed
adopted immediately before the deemed liquidation, unless a
formal plan that contemplates the elective change in classification
is adopted on an earlier date. Reg. § 301.7701-3(g)(2)(ii).
A Partnership Elects to be Taxed as an Association
a.
Deemed Transactions - If an eligible entity classified as a
partnership elects to be classified as an association, the following
transactions are deemed to occur. Reg. § 301.7701-3(g)(1)(i).
(i)
First, the partnership is deemed to contribute its assets to a
newly formed corporation (“Newco”) in exchange for all of
the outstanding stock of Newco.
(ii)
Second, the partnership is deemed to distribute the stock of
Newco to its partners in complete liquidation.
(iii)
The preamble to Prop. Reg. § 301.7701 states that although
the deemed transactions are deemed to occur pursuant to an
election to change the classification of an entity under the
check-the-box rules, taxpayers may still employ other
transactions to actually convert a partnership to a
corporation, and the form of the transaction chosen will be
respected. 62 Fed. Reg. at 55,769. Specifically, the
preamble provides that the regulations do not affect the
holdings in Rev. Rul. 84-111, 1984-2 C.B. 88, which dealt
with three differing methods of converting a partnership to
a corporation. In Rev. Rul. 84-111, the Service stated that
the form chosen to convert a partnership to a corporation
would be respected for tax purposes.
(iv)
However, the Service has ruled that if a partnership
converts into a corporation in accordance with a state law
formless conversion statute, Rev. Rul. 84-111 does not
apply, and the transaction will be treated in the same
manner as an election to be taxed as an association. Rev.
Rul. 2004-59, 2004-1 C.B. 1050.
- 36 b.
4.
Tax Consequences
(i)
The partnership generally will not recognize gain or loss on
the contribution of its assets to Newco in exchange for
Newco stock. Section 351. Under section 362(a), Newco’s
basis in the assets received from the partnership equals the
partnership’s basis in those assets immediately before their
contribution.
(ii)
The partnership takes a substituted basis in the Newco
stock equal to the partnership’s basis in the contributed
assets, reduced by the liabilities assumed by Newco.
Section 358. Newco’s assumption of partnership liabilities
is treated as a payment of money to the partnership under
section 358(d). If the amount of liabilities exceeds the
partnership’s basis for the assets contributed, the
partnership must recognize gain equal to the amount by
which the liabilities exceed the partnership’s basis in its
assets. See section 357(c). An assumption of partnership
liabilities by Newco will decrease each partner’s basis in
the partnership interest by the amount of liabilities included
in the partner’s basis. Section 752.
(iii)
Upon the distribution of the Newco stock to the partners,
the partnership terminates under section 708(b)(1)(A).
Under section 732(b), the basis of the Newco stock
distributed to the partners in liquidation of their partnership
interest is, with respect to each partner, equal to the
partner’s adjusted basis in the partnership interest.
(iv)
If an unincorporated entity that was taxed as a partnership
becomes a corporation for tax purposes, either through the
check-the-box regulations or through a state formless
conversion statute, it is eligible to elect to be taxed as an S
corporation effective its first taxable year. Rev. Rul. 200915, 2009-21 I.R.B. (May 7, 2009).
An Association Elects to be a Disregarded Entity
a.
Deemed Transactions - Generally, an eligible entity classified as an
association, which has a single owner, may elect to be classified as
a disregarded entity. If such an election is made, the association is
deemed to distribute all of its assets to its shareholder in a
liquidating distribution. Reg. § 301.7701-3(g)(1)(iii). Thereafter,
the owner is deemed to own the distributed assets directly.
The deemed liquidation is treated the same for tax purposes as an
- 37 actual liquidation. See Dover Corp. v. Commissioner, 122 T.C.
324 (2004) (holding that a deemed liquidation resulting from a
check-the-box election should be treated as an actual liquidation;
therefore, parent was viewed as selling assets used in its trade or
business for purposes of determining whether gain from the sale
constituted subpart F income); Rev. Rul. 2003-125, 2003-2 C.B.
1243 (treating a check-the-box election as an identifiable event for
purposes of supporting a worthless security deduction under
section 165(g)(3); reversing the result in F.S.A. 200226004 (March
7, 2002)).
b.
5.
Tax Consequences
(i)
The association recognizes gain on the distribution of any
appreciated assets. Section 336(a). The shareholder
receiving the liquidating distribution recognizes gain equal
to the difference between the shareholder’s basis in its
stock and the sum of any money and the fair market value
of any property received in the distribution. Section 331.
(ii)
If section 331 is applicable, the shareholder is treated as
purchasing the assets of the liquidating corporation, and
thus, under section 334(a), will take a fair market basis in
the assets. Because the shareholder is deemed to purchase
the assets, the shareholder’s holding period for the assets
begins on the date of distribution.
(iii)
If the shareholder is an 80-percent distributee, neither the
liquidating corporation nor its corporate shareholder will
recognize gain as a result of the liquidating distribution.
Sections 332 and 337. If section 332 applies to the
liquidation, the shareholder takes a carryover basis and a
tacked holding period in the assets acquired in the
liquidating distribution. Sections 334(b)(1); 1223(2).
Under section 381, the parent corporation will succeed to
the liquidating subsidiary’s enumerated tax attributes.
A Disregarded Entity Elects to be Classified as an Association
a.
Deemed Transactions - If an eligible entity that is disregarded as
an entity separate from its owner elects to be classified as an
association, the owner of the eligible entity is deemed to contribute
all of the assets and liabilities of the entity to a newly formed
corporation (“Newco”) in exchange for the stock of Newco. Reg.
§ 301.7701-3(g)(1)(iv).
- 38 b.
6.
Tax Consequences
(i)
Generally, under section 351, neither the owner of the
disregarded entity nor Newco will recognize gain or loss on
the deemed contribution. However, under section 357(c), if
the liabilities assumed by Newco exceed the transferor’s
basis in the assets, then the transferor must recognize gain
equal to the excess of the liabilities over the transferor’s
basis.
(ii)
Under section 362(a), Newco’s basis in the assets received
equals the transferor’s basis in those assets immediately
before their contribution. Under section 358, the transferor
takes a substituted basis in Newco stock it is deemed to
receive, reduced by any liabilities assumed by Newco.
(iii)
Under section 1223(l), the transferor’s holding period for
Newco stock includes its holding period for the assets
transferred. Under section 1223(2), Newco’s holding
period for the contributed assets includes the transferor’s
holding period for those assets.
Legal Effect of Deemed Transactions
a.
The government views the check-the-box regulations as “merely a
mechanic to allow taxpayers to achieve a result without moving
assets that could otherwise be achieved by moving assets.” Sheryl
Stratton, Treasury Officials Clarify Reach of Recent Corporate
Guidance, 2002 Tax Notes Today 219-2 (Nov. 13, 2002) (quoting
Jeffrey Paravano, Senior Advisor to the Assistant Secretary for Tax
Policy).
b.
Thus, for example, the government takes the position that a
business purpose is required for a deemed section 351 transaction
resulting from an election to be taxed as a corporation, just as there
is for an actual section 351 transaction. See Estate of Kluener v.
Commissioner, 154 F.3d 630 (6th Cir. 1998); Caruth v. United
States, 688 F. Supp. 1129 (N.D. Tex. 1987), aff’d, 865 F.2d 644
(5th Cir. 1989). But see Dover Corp. v. Commissioner, 122 T.C.
324, n.19 (2004) (stating that “[n]or do the check-the-box
regulations require that the taxpayer have a business purpose for
such an election or, indeed, for any election under those
regulations. Such elections are specifically authorized ‘for federal
tax purposes’”).
(i)
Note, however, that Dover involved a deemed section 332
liquidation, which, unlike section 351, has generally not
- 39 been held to require a business purpose. See, e.g., Rev.
Rul. 2003-125 (deemed section 332 liquidation to obtain
worthless stock deduction); Rev. Rul. 75-521, 1975-2 C.B.
120 (permitting purchase of stock to achieve requisite
ownership percentage to engage in section 332 liquidation);
see also Granite Trust Co. v. United States, 238 F.2d 670
(1st Cir. 1956) (permitting sale of stock to avoid section
332 treatment).
(ii)
D.
Nonetheless, an election under the check-the-box
regulations only applies for tax purposes – there would
never seem to be a non-tax business purpose for such an
election. Thus, the government’s position seems
unreasonable.
c.
Query whether the Service would apply the codified economic
substance doctrine to a check-the-box election. See section
7701(o).
d.
Similarly, tax-free treatment may not be available if the electing
entity is insolvent. See Section IV.F., below.
Treatment of Automatic Classification Changes
1.
Partnership to a Disregarded Entity – Rev. Rul. 99-6
a.
An eligible entity classified as a partnership will automatically
become a disregarded entity as of the date the entity has a single
owner (assuming it is still treated as an entity under local law).
Reg. § 301.7701-3(f)(2). This automatic classification change will
not be treated as a change in classification election and will not
trigger a new 60-month waiting period. Reg. § 301.7701-3(f)(3).
b.
Under Rev. Rul. 99-6, 1999-C.B. 432, the tax consequences are
determined differently with respect to the buyer and the seller.
Assume, for example, an LLC is owned equally by A and B, and B
purchases A’s entire interest in the LLC. See Examples 55 and 56,
below.
(i)
The partnership is treated as terminating under
708(b)(1)(A).
(ii)
For purposes of determining the tax consequences to A, A
is treated as selling his partnership interest to B. A thus
recognizes gain or loss on the sale of such interest under
section 741.
- 40 -
c.
(iii)
For purposes of determining the tax consequences to B, the
LLC is deemed to make a liquidating distribution of all of
its assets to A and B, and following the distribution, B is
treated as acquiring the assets deemed distributed to A. See
McCauslen v. Commissioner, 45 T.C. 588 (1966); Rev.
Rul. 67-65, 1976-1 C.B. 168; see also Rev. Rul. 84-111,
1984-2 CB 88. The ruling does not address whether the
partnership anti-mixing bowl rules apply with respect to B
(iv)
Under these rules, if a partner contributes built-in gain or
built-in loss property and such property is distributed to
another partner within 7 years, the contributing partner
recognizes any remaining built-in gain or built-in loss as if
the partnership sold the property for its fair market value at
the time of the distribution. Section 704(c)(1)(B).
(v)
Conversely, if a partner contributes built-in gain property
and that partner receives other property from the
partnership within 7 years, then that partner recognizes gain
equal to the lesser of (i) net pre-contribution gain (which in
the remaining built in gain at the time of the distribution) or
(ii) the excess of the fair market value of the distributed
property over the adjusted basis of its partnership interest
immediately before the distribution. Section 737.
(a)
B’s basis in the assets attributable to A’s one-half
interest is equal to the purchase price paid for A’s
partnership interest. Section 1012.
(b)
B’s holding period for these assets begins on the
day after the date of the sale. See Rev. Rul. 66-7,
1966-1 C.B. 188.
(c)
B must recognize gain or loss on the assets received
in the deemed liquidating distribution to the extent
required by section 731(a). B’s basis in these assets
is determined under section 732(b), and B’s holding
period includes the LLC’s holding period for such
assets. Section 735(b).
Treasury and the Service have solicited comments with respect to
whether and how “the principles of Revenue Ruling 99-6” should
apply when, under similar facts as Rev. Rul. 99-6, B acquires A’s
entire interest in the LLC in a tax-free reorganization (rather than
B purchasing A’s entire interest in the LLC in a taxable sale
transaction) or A merges into the LLC. See Preamble, T.D. 9243
(Jan. 23, 2006). See Section VI.A., below.
- 41 2.
Disregarded Entity to a Partnership – Rev. Rul. 99-5
a.
An eligible entity that is disregarded as an entity separate from its
owner will automatically be classified as a partnership as of the
date the entity has more than one owner. Reg. § 301.7701-3(f)(2).
This automatic classification change will not be treated as a change
in classification election and will not trigger a new 60-month
waiting period. Reg. § 301.7701-3(f)(3).
b.
Under Rev. Rul. 99-5, 1999-1 C.B. 434, the tax consequences
depend on whether the automatic classification change is a result
of the acquisition of an interest in the LLC from the existing owner
or from the LLC. Assume, for example, that A owns all of the
interests in an LLC, and B acquires a 50-percent interest in the
LLC.
(i)
If B acquires the LLC interest from A, then A is treated as
selling a proportionate amount of the LLC’s assets to B,
and A and B are then treated as contributing the assets to a
newly formed partnership. See Examples 15 and 16,
below.
(a)
A recognizes gain or loss on such sale under section
1001.
(b)
Neither A nor B recognizes gain or loss as a result
of the deemed contribution of assets to the
partnership. Section 721(a).
(c)
Under section 722, B’s basis in his partnership
interest equals the amount paid for the LLC interest.
A’s basis in his partnership interest is equal to his
basis in its share of the LLC assets.
(d)
Under section 723, the partnership’s basis of the
property received is the adjusted basis of that
property in A and B’s hands immediately after the
deemed sale.
(e)
Under section 1223(1), A’s holding period for the
partnership interest includes the holding period of
the assets deemed contributed. B’s holding period
begins on the day following the deemed sale of
LLC assets. Under section 1223(2), the
partnership’s holding period for the assets deemed
transferred includes A and B’s holding periods for
such assets.
- 42 (ii)
3.
If B acquires the LLC interest directly from the LLC for
cash, B is treated as contributing cash to a partnership in
exchange for a partnership interest. A is treated as
contributing all of the assets of the LLC to the partnership
in exchange for a partnership interest. See P.L.R.
200934013 (May 20, 2009).
(a)
Under section 721(a), no gain or loss is recognized
by A or B.
(b)
Under section 722, B’s basis in his partnership
interest is equal to the amount of cash contributed.
A’s basis in his partnership interest is equal to his
basis in the assets of the LLC.
(c)
Under section 723, the partnership’s basis of the
property contributed by A is equal to the adjusted
basis of that property in A’s hands. The basis of the
property contributed by B is equal to the cash
contributed.
(d)
Under section 1223(1), A’s holding period for the
partnership interest includes the holding period of
the assets deemed contributed. B’s holding period
for the partnership interest begins on the day
following the contribution of money to the LLC.
Under section 1223(2), the partnership’s holding
period for the assets deemed transferred to it
includes A’s holding period.
Conversion of Ineligible Entity into an Eligible Entity
a.
The check-the-box regulations provide for default classifications
for eligible entities that do not file an election. Reg. § 301.77013(b)(1).
(i)
A domestic eligible entity with two or more owners is
treated as a partnership.
(ii)
A domestic eligible entity with one owner is treated as a
disregarded entity.
b.
Thus, the conversion of an ineligible entity to an eligible entity
should immediately trigger the default rules if no election is filed.
c.
The regulations do not, however, specifically provide for the form
of such a conversion they way they do for elective classification
changes.
- 43 -
4.
(i)
This has created some confusion. For example, the Federal
Circuit has held that where a corporation converted into an
LLC, it continued to exist for federal tax purposes and,
therefore, had standing to file a tax refund claim. The court
reasoned that the taxpayer could not rely on Reg.
§ 301.7701-3(g)(1)(iii), which provides for a deemed
liquidation when an association elects to be treated as a
disregarded entity, because the corporation was not an
“eligible entity classified as an association.” BrowningFerris Indus., Inc. v. United States, 274 Fed. Appx. 904
(Fed. Cir. 2008).
(ii)
This holding takes an overly narrow view of the check-thebox regulations. The default rules clearly treat the
converted entity as a disregarded entity—they just do not
expressly provide the tax transactions to get there.
(iii)
Note, however, that the holding favored the Service by
preventing the taxpayer from dismissing a suit and
engaging in what the Service perceived as forum shopping.
See Browning-Ferris Indus., Inc. v. United States, 75 Fed.
Cl. 591 (2007).
(iv)
Nonetheless, the Service clearly intended to provide form
to classification changes in the check-the-box regulations.
See Preamble to Prop. Reg. § 301.7701, 62 Fed. Reg.
55,768, 55,769 (1997). This intent most likely included
changes from ineligible to eligible entities under the default
rules. The Service should amend the regulations to make
this clear.
Overlap between Automatic and Elective Classification Changes
a.
If an elective classification change is effective at the same time as
an automatic classification change, the deemed transactions
resulting from the elective change preempt the transactions that
would result from the automatic classification change. Reg.
§ 301.7701-3(f)(2).
b.
The regulations contain an example of the overlap case. Reg.
§ 301.7701-3(f)(4), Ex.1. Assume that A owns a disregarded
entity. On January 1, 1998, B purchases a 50-percent interest in
the entity from A. A and B elect to have the entity classified as an
association effective January 1, 1998.
- 44 -
c.
E.
(i)
Upon A’s sale of a 50-percent interest in the entity to B, the
disregarded entity would automatically be classified as a
partnership.
(ii)
However, the regulations provide that the elective change
in classification preempts the automatic classification
change.
(a)
Thus, A would be treated as contributing all of the
assets and liabilities of the disregarded entity to a
newly formed association in exchange for stock of
the association immediately before the close of
December 31, 1997. Reg. § 301.7701-3(g)(1)(iv),
(g)(3)(i).
(b)
A would then be treated as selling 50 percent of the
stock to B on January 1, 1998.
(c)
Because A does not retain control of the association
under section 351, A’s contribution would be a
taxable event.
(iii)
A would thus take a fair market value basis in the stock of
the association, and the association would take a fair
market value basis in the assets contributed by A.
Section 1012.
(iv)
A will have no additional gain upon the sale of stock to B.
B will have a cost basis in the stock purchased from A.
This rule also appears to apply where the automatic classification
change occurs by reason of an ineligible entity converting into an
eligible entity. In P.L.R. 200109019 (Nov. 29, 2000), a
corporation converted into an LLC and filed a timely election to be
treated as an association taxable as a corporation effective on the
date of the conversion. The Service ruled that the conversion
would not cause the entity to be classified as other than a
corporation.
Treatment of Actual Conversions of An Existing Entity Into An LLC
There are a number of different ways to convert an existing entity into an LLC.
Despite the similarity in end result, the manner in which an entity is converted
may result in different federal and state tax consequences.10 In addition to the tax
10
State tax issues are discussed below in section XI of this outline.
- 45 consequences, the method of conversion may impact other considerations that are
important to the owners of the entity. For example, one method of converting a
corporation to an LLC may expose the shareholders to the liabilities of the
corporation, while another method may not. Thus, careful consideration should
be exercised in choosing the method of converting an entity to an LLC. In
addition to converting the legal form of an entity into an LLC, it is possible to
elect a different tax classification for an entity under the check-the-box
regulations, as discussed above.
1.
Converting Existing Corporations Into LLCs
a.
Liquidation Followed by Contribution of Assets – An existing
corporation could convert into an LLC classified as either a
partnership or a disregarded entity by distributing its assets and
liabilities to its shareholders in complete liquidation and having the
shareholders contribute such assets to a newly formed LLC. As
discussed above, this is the same series of transactions that is
deemed to occur upon an elective change in classification from an
association to either a partnership or disregarded entity. Reg.
§ 301.7701-3(g)(1)(i), (iii). Accordingly, the tax consequences are
the same as those discussed in Section IV.C.2. & 4., above, in
connection with elective classification changes.
(i)
However, actually undertaking the transactions requires
two separate transfers of the assets. If state transfer taxes
are imposed on the asset transfers, undertaking an actual
conversion will result in the imposition of the transfer tax
twice, initially on the distribution to the shareholders and
again on the transfer of assets to the LLC. In addition, an
actual conversion exposes the shareholders to the liabilities
of the corporation. The successive imposition of state
transfer taxes and the shareholder exposure to the
corporation’s liabilities may be eliminated through the use
of a “cause to be directed” transaction or through the use of
one of the methods set forth below.
(ii)
As illustrated by the examples below, a corporation can
obtain different consequences by undertaking an actual
conversion that differs from what the regulations deem
upon an elective change in classification.
- 46 b.
Example 7 - Corporate Contribution of Assets to an LLC
Classified as Either a Partnership or a Disregarded Entity Followed
by Corporate Liquidation
STEP 1:
STEP 2:
A
B
50%
A
50%
P
B
LLC
Interests
LLC
Interests
P
LLC
Interests
Assets
LLC
LLC
(i)
Facts: Individuals A and B each own 50 percent of the
outstanding stock of P. P contributes all of its assets and
liabilities to a newly formed LLC in exchange for
membership interests in LLC. Following the contribution,
P distributes the LLC membership interests to A and B in
complete liquidation.
(ii)
Tax Consequences: Because LLC is a disregarded entity, P
is treated as owning LLC’s assets directly. Thus, when P
distributes its membership interest in LLC to A and B, P
should be viewed as distributing its interest in LLC’s assets
to A and B. A and B are then deemed to contribute these
assets to a newly formed partnership. Accordingly, the tax
consequences are the same as those discussed in Section
IV.C.2. & 4., above, in connection with elective
classification changes, where the liquidation precedes the
formation of the LLC. See P.L.R. 200734003 (May 15,
2007) (reaching same conclusion where trust contributed its
assets to an LLC and then terminated, distributing the LLC
interests to the beneficiaries).
(iii)
Nontax Considerations - Unlike the method of conversion
involving a liquidation followed by a contribution,
- 47 however, this approach results in a single imposition of any
applicable transfer taxes. In addition, this method should
shield the shareholders of the corporation from the
corporation’s liabilities by encapsulating the liabilities in
LLC.
c.
Example 8 - Formation of LLC by the Corporation and its
Shareholders Followed by Liquidation of Corporation
STEP 2:
STEP 1:
A
B
50%
50%
$1.00
P
LLC
Int.
P’s
LLC
Int.
$1.00
LLC
Interests
Assets
LLC
A
B
P
LLC
Int.
LLC
(i)
Facts: P and its shareholders, A and B, form a new LLC. P
contributes all of its assets to LLC, and LLC assumes all of
P’s liabilities. A and B each contribute one dollar to LLC
in exchange for an interest in LLC. Immediately thereafter,
P distributes all of its LLC interests to A and B in complete
liquidation.
(ii)
Tax Consequences:
(a)
Neither the transferors nor the newly formed LLC
recognize gain on the contribution of assets to LLC
in exchange for membership interests. Section 721.
Under sections 722 and 752, each transferor takes a
substituted basis in the membership interests equal
to the transferor’s basis in the contributed assets,
less the amount of liabilities assumed by LLC,
increased by the transferor’s share of LLC’s
liabilities. LLC takes a carryover basis in the
contributed assets, increased by the amount of gain
P’s
LLC
Int.
- 48 recognized by the contributing partner under section
721(b). Section 723. Under section 1223(2),
LLC’s holding period for the contributed assets
includes P’s holding period for those assets.
This treatment differs from that in subsections a.
and b., above. Because LLC is formed before the
corporation is liquidated, LLC does not end up with
a fair market value basis in its assets (absent a
section 754 election). Further, LLC receives a
tacked holding period, rather than a holding period
that begins on the date of the liquidation.
(b)
Under section 336(a), P must recognize gain on the
distribution of the membership interests in LLC in
liquidation. P’s gain is equal to the difference
between its basis and the fair market value of the
LLC interests at the time of the distribution.
Generally, the character of P’s gain is capital as
opposed to ordinary. However, to the extent the
partnership interest represents section 751 assets,
the sale of the partnership interest will trigger
ordinary income. See section 751(a). Contrast this
with the treatment in subsections a. and b., above,
where the character of the gain depended on the
character of the underlying assets.
(c)
Under section 331, A and B must recognize gain on
the distribution of the membership interests in LLC.
The gain is equal to the difference between the basis
in their P stock and the fair market value of the LLC
membership interests received from P.
(d)
Under section 331, A and B are treated as
purchasing the assets received in the liquidating
distribution, thus, their holding period for the
distributed LLC membership interests begins on the
date of distribution. Under section 334(a), A and B
take a fair market value basis in the LLC
membership interests distributed.
(e)
P is treated as selling its interest in LLC to A and B
in exchange for A and B’s P stock. Assuming P
held membership interests representing more than
50 percent of the profits and capital interest in LLC,
the distribution in liquidation will trigger a
termination of LLC under section 708(b)(1)(B).
- 49 See section 761(e). Under Reg. § 1.708-1(b)(1)(iv),
a partnership that is deemed to terminate under
section 708(b)(1)(B) is deemed to transfer all its
assets to a new partnership in exchange for interests
in the new partnership. Immediately after the
deemed contribution, the partnership is deemed to
distribute the interests in the new partnership to its
partners in liquidation.
d.
i.)
Under section 721, neither the old partnership nor the new
partnership will recognize gain on the deemed transfer of
assets. Under section 723, the new partnership takes a
basis in the contributed property equal to the terminating
partnership’s basis in the assets immediately before their
contribution. If the partnership has a section 754 election
in effect for the terminating year, the basis increase
resulting from the operation of section 743(b) will be
reflected in the new partnership’s basis for the contributed
assets. Under Reg. § 1.704-3(a)(3)(i), the contributed
property will be treated as section 704(c) property only to
the extent it was characterized as section 704(c) property in
the hands of the terminating partnership.
ii.)
Under section 732(b), the basis of the new partnership
interests distributed to the partners of the terminating
partnership is, with respect to each partner, equal to the
adjusted basis of the partner’s interest in the partnership,
which in this case is equal to fair market value.
(iii)
Nontax Considerations – As with Example 7, above, this
approach results in a single imposition of any applicable
transfer taxes. In addition, this method should shield the
shareholders of the corporation from the corporation’s
liabilities by encapsulating the liabilities in LLC.
Example 9 - Merger of Corporation Into Multi-Member LLC
P
100%
100%
S-1
S-2
Merger
LLC
- 50 -
(i)
Facts: P owns all of the stock of S-1 and S-2. P and S-2
form an LLC, with each initially taking a 50-percent
membership interest. S-1 is merged into LLC in a state
statutory merger. Pursuant to the merger, all of S-1’s assets
and liabilities are transferred to LLC, and S-1’s separate
corporate existence ceases. Following the merger, P owns
90 percent of the membership interests in LLC, and S-2
owns the remaining 10 percent.
(ii)
Tax Consequences:
(a)
In P.L.R. 9404021 (Nov. 1, 1993), the Service
treated the statutory merger of a wholly owned
subsidiary into a two-member LLC as a
contribution of assets by the subsidiary in exchange
for membership interests in the LLC, followed by
the liquidation of the subsidiary. Pursuant to the
deemed liquidation, the parent corporation was
deemed to receive membership interests in the LLC.
(b)
Under section 332, P does not recognize any gain or
loss as a result of the liquidating distribution.
Under section 337, S-1 does not recognize any gain
or loss as a result of the liquidating distribution. P
takes a carryover basis and a tacked holding period
in the LLC interests received in the section 332
liquidation. Sections 334(b)(1); 1223(2).
(c)
Note, however, that if S-1 does not have an 80percent owner, the deemed liquidation will be
taxable under section 331. See P.L.R. 200214016
(Dec. 21, 2001). Thus, if S-1 has a built-in loss, this
transaction might permit recognition of such loss.
(d)
Neither S-1 nor the newly formed LLC recognizes
gain on the deemed transfer of assets to LLC in
exchange for membership interests. Section 721.
Under sections 722 and 752, S-1 takes a substituted
basis in the membership interests it is deemed to
receive equal to its basis in the transferred assets
(less the amount of liabilities assumed by LLC),
increased by S-1’s share of LLC’s liabilities. LLC
takes a carryover basis in the contributed assets,
increased by the amount of gain recognized by the
contributing partner under section 721(b). Section
- 51 723. Under section 1223(2), LLC’s holding period
for the contributed assets includes S-1’s holding
period for those assets.
(e)
When S-1 liquidates, it transfers all of its
membership interest in LLC to P. Because S-1 held
50 percent or more of the profits and capital
interests in LLC at the time of the liquidation, the
distribution will result in the termination of LLC
under section 708(b)(1)(B). See section 761(e).
Under Reg. § 1.708-1(b)(1)(iv), a partnership that is
deemed to terminate under section 708(b)(1)(B) is
deemed to transfer all of its assets to a new
partnership in exchange for interests in the new
partnership. Immediately after the deemed
contribution, the partnership is deemed to distribute
the interests in the new partnership to its partners in
liquidation.
i.)
Under section 721, neither the old partnership nor the new
partnership will recognize gain on the deemed transfer of
assets. Under section 723, the new partnership takes a
basis in the contributed property equal to the terminating
partnership’s basis in the assets immediately before their
contribution. If the partnership has a section 754 election
in effect for the terminating year, any basis increase
resulting from the operation of section 743(b) will be
reflected in the new partnership’s basis for the contributed
assets. However, in this situation, because P takes a
carryover basis in the LLC membership interest it receives
when S-1 liquidates, section 743(b) will not produce any
increase in LLC’s basis in its assets. Under Reg. § 1.7043(a)(3)(i), the contributed property will be treated as
section 704(c) property only to the extent it was
characterized as section 704(c) property in the hands of the
terminating partnership.
ii.)
Under section 732(b), the basis of the new partnership
interests distributed to P and S-2 equal their adjusted bases
in the terminating partnership.
(f)
The tax consequences of this example are thus like
the ones in Example 8, above.
- 52 e.
Example 10 - Merger of Corporation Into Single-Member LLC
A
100%
100%
P
LLC
Merger
(i)
Facts: Individual A owns all of the stock of P Corporation
and all of the membership interests in LLC. LLC does not
elect to be taxed as an association. P is merged into LLC
pursuant to Delaware General Corporation Law § 264
(which permits the merger or consolidation of a Delaware
corporation with an LLC). Pursuant to the merger, all of
P’s assets and liabilities are transferred to LLC, and P’s
separate corporate existence ceases.
(ii)
Tax Consequences:
(a)
As set forth above, the default rule provides that a
single-member LLC will be disregarded as an entity
separate from its owner. As such, the merger of a
corporation, with a single owner, into a singlemember LLC, owned by the same person, should be
viewed as a liquidation of the corporation. See,
e.g., P.L.R. 200949031 (Aug. 24, 2009) (merger of
taxable REIT subsidiary into single-member
disregarded LLC treated as complete liquidation of
subsidiary under section 331); P.L.R. 200104003
(Aug. 3, 2000); P.L.R. 200129024 (Apr. 20, 2001);
P.L.R. 9822037 (Feb. 27, 1998); see also Reg.
§ 301.7701-3(g)(1)(iii) (an association electing to
be a disregarded entity is treated as distributing all
of its assets and liabilities to its owner in complete
liquidation).
- 53 (b)
Because the shareholder of P is not a corporation or
an entity classified as an association, the liquidation
is a taxable event to both the liquidating corporation
and its shareholder. Sections 336(a) and 331.
(c)
Under section 331, A is treated as purchasing the
assets received in the liquidating distribution. Thus,
A’s holding period for the distributed LLC
membership interests begins on the date of
distribution. Under section 1012, A has a basis in
the distributed LLC membership interests equal to
the fair market value of such interests.
(d)
P may hold assets that are not easily transferable
(e.g., a partnership interest the transfer of which
requires permission from the other partner). In such
cases, an actual merger may be impractical.
However, certain states permit the conversion of an
entity into an LLC merely by filing articles or a
certificate of conversion, thus avoiding an actual
transfer of assets. See, e.g., Del. Code § 18-214;
Ga. Code § 14-11-212. Certain other states permit
such conversions only with respect to general and
limited partnerships. See, e.g., D.C. Code § 291013; Va. Code § 13.1-1010.1.
(e)
Note that the tax consequences of an actual
conversion into a disregarded entity are the same as
those of the deemed liquidation that would occur if
P had simply elected to be a disregarded entity.
See, e.g., P.L.R. 201041029 (July 14, 2010)
(conversion of subsidiary into an LLC treated as a
section 332 liquidation); Reg. § 301.77013(g)(1)(iii) (election of eligible entity taxed as an
association to be classified as a disregarded entity is
treated as a distribution of the association’s assets
and liabilities in complete liquidation).
- 54 f.
Example 11 – Merger of Wholly Owned Subsidiary Into SingleMember LLC
X
100%
100%
P
LLC
Merger
(i)
Facts: Corporation X owns all of the stock of P
Corporation and all of the membership interests of LLC.
LLC does not elect to be taxed as an association. P is
merged into LLC in a statutory merger.
(ii)
Tax Consequences:
(a)
i.)
As set forth above, the default rule provides that a
single-member LLC will be disregarded as an entity
separate from its owner. As such, the merger of a
corporation into a single-member LLC owned by
the same person could be viewed as a liquidation of
the corporation. See, e.g., P.L.R. 200104003 (Aug.
3, 2000); P.L.R. 200129024 (Apr. 20, 2001); P.L.R.
9822037 (Feb. 27, 1998); see also Reg. § 301.77013(g)(1)(iii) (an association electing to be a
disregarded entity is treated as distributing all of its
assets and liabilities to its owner in complete
liquidation).
Under section 332, X does not recognize any gain or loss
when P liquidates. Under section 337(a), P will not
recognize gain or loss as a result of the liquidating
distribution to X. X takes a transferred basis and a tacked
holding period in the assets received in the section 332
liquidation. Sections 334(b)(1); 1223(2).
- 55 (b)
As discussed below in Section VI.A., Reg. § 1.3682(b)(1) permits certain mergers of target
corporations into single-member LLCs to qualify as
A reorganizations. Thus, the merger in this
example should constitute an upstream A
reorganization. However, where a transaction
qualifies as both an upstream A reorganization and
a section 332 liquidation, section 332 takes
precedence. See Reg. § 1.332-2(d), (e).
(c)
P may be permitted in some states to convert into an
LLC simply by filing articles or a certificate of
conversion. Similar to a check-the-box election,
this avoids an actual transfer of assets. See, e.g.,
Del. Code § 18-214; Ga. Code § 14-11-212.
However, as discussed below in Section VI.A.,
Treasury and the Service take the position that
neither a conversion nor a check-the-box election
qualifies as an A reorganization. See Preamble to
Reg. § 1.368-2, 71 Fed. Reg. 4259.
(d)
Similar results may be obtained by merging
upstream or downstream into a disregarded entity
rather than cross-chain.
i.)
For example, in P.L.R. 200725002 (Mar. 15, 2007), P
owned S1, which owned S2. S1 converted into a singlemember LLC, which was treated as a section 332
liquidation. S2 then merged upstream into S1 (now a
disregarded entity). The Service ruled that the upstream
merger was a section 332 liquidation into P. Cf. P.L.R.
200727001 (Mar. 27, 2007) (upstream merger of Target
into a disregarded entity owned by Acquiring, followed by
a drop of some of Target’s assets qualified as an upstream
A reorganization followed by a section 368(a)(2)(C) drop
(citing Rev. Rul. 69-617, 1969-2 C.B. 57).
ii.)
In P.L.R. 200701018 (Sept. 27, 2006), Parent owned all of
the stock of Holding, which in turn, owned all of the
interests in LLC, a disregarded entity. The Service ruled
that a merger of Holding downstream into LLC qualified as
a section 332 liquidation. See also P.L.R. 200930025 (Apr.
22, 2009).
iii.)
In P.L.R. 200910028 (Dec. 3, 2008), Parent owned more
than 80 percent of the stock of T, which wholly owned
Acquiring. Acquiring formed LLC, a disregarded entity.
- 56 The Service ruled that a merger of T into LLC qualified as
a section 368(a)(2)(A) reorganization and would be treated
as if T merged downstream into A.
2.
Converting Existing Partnerships Into LLCs Classified as Partnerships
a.
In General
As with the conversion of corporations, there may be a number of
ways to accomplish, under state law, a conversion of an existing
partnership into an LLC that is classified as a partnership.
Regardless of the method of conversion, however, the transaction
is simply treated as a partnership-to-partnership conversion, which
generally has no impact for federal tax purposes. See Rev. Rul.
95-37, 1995-1 C.B. 130.
b.
Example 12 – Partnership-to-LLC Conversion
A
B
GP
LLC
Merger
(i)
Facts: A and B each own a 50-percent interest in GP. A
and B wish to convert GP into an LLC that is still classified
as a partnership for federal tax purposes, so A and B form
LLC, with each taking a 50-percent membership interest in
the LLC. A and B then cause GP to merge into LLC.
(ii)
Tax Consequences:
(a)
In Rev. Rul. 95-37, the Service held that the
conversion of an existing domestic partnership into
a domestic LLC classified as a partnership will not
- 57 result in the recognition of gain to the LLC, the
existing partnership, or its partners. Rev. Rul. 9537 incorporated the holdings of Rev. Rul. 84-52,
1984-1 C.B. 157, in which the Service held that the
conversion of a general partnership to a limited
partnership was not a taxable event.
F.
(b)
Under the Service’s approach, the LLC is deemed
to be a continuation of the old partnership. As long
as the business activity of the partnership is
continued, the partnership will not be treated as
terminating under section 708(b). Moreover, the
LLC will maintain the partnership’s taxable year,
the partnership’s basis in its assets, and the
partnership’s taxpayer identification number. See
Rev. Rul. 95-37 and Rev. Rul. 84-52.
(c)
Each partner’s basis in the partnership interest will
remain the same as long as the partner’s share of the
entity’s liabilities remains the same.11 See Rev.
Rul. 95-37 and Rev. Rul. 84-52. Under section
1223(1), there will be no change in the holding
period of any partner’s total interest in the
partnership. Thus, if a partner held both general
and limited partnership interests, the holding period
for the LLC interests received in the exchange will
not be bifurcated to reflect timing differences as to
when the differing partnership interests were
acquired.
Solvency of Electing or Converting Entity
1.
In General
If a partner’s share of partnership liabilities does not change, there will be no change in
the adjusted basis of the partner’s interest in the partnership. If a partner’s share of partnership
liabilities changes and causes a deemed contribution of money to the partnership by the partner
under section 752(a), then the adjusted basis of such partner’s interest will be increased under
section 722 by the amount of the deemed contribution. If the partner’s share of partnership
liabilities changes and causes a deemed distribution of money by the partnership to the partner
under section 752(b), then the basis of such partner’s interest will be reduced under section 733
(but not below zero) by the amount of the deemed distribution, and gain will be recognized by
the partner under section 731 to the extent the deemed distribution exceeds the adjusted basis of
the partner’s interest in the partnership.
11
- 58 a.
b.
2.
As discussed above, the tax treatment of a change in classification
is determined under all relevant provisions of the Code and general
principles of tax law.
(i)
As a result, the deemed liquidation in the case of a
conversion of a parent corporation’s 80-percent subsidiary
into a disregarded entity must satisfy the requirements of
section 332 in order to be tax free.
(ii)
Likewise, the deemed incorporation in the case of a
conversion of a disregarded entity into an association must
satisfy the requirements of section 351 in order to be tax
free.
On March 10, 2005, Treasury and the Service issued proposed
regulations governing the treatment of nonrecognition transactions
involving insolvent companies. 70 Fed. Reg. 11,903 (Mar. 10,
2005). The proposed regulations adopt a uniform “net value”
requirement applicable to section 351 contributions, section 332
liquidations, and reorganizations under section 368. In general, the
proposed regulations establish that property with a net value must
be exchanged in these transactions (or distributed in the case of a
section 332 liquidation). Thus, under the proposed regulations, a
deemed section 332 liquidation or 351 incorporation of an
insolvent entity would not qualify as tax free. These proposed
regulations are discussed further in an article published in The Tax
Executive. See Mark J. Silverman, Lisa M. Zarlenga, and Gregory
N. Kidder, Assessing the Value of the Proposed “No Net Value”
Regulations, 57 TAX EXECUTIVE 270 (May 2005).
Deemed Liquidation of Insolvent Entity – As discussed above, if an entity
taxed as an association elects to be taxed as, or converts into, a
disregarded entity or a partnership the entity is deemed to liquidate. In
addressing the tax consequences of the various scenarios presented, we
have assumed that the entities were solvent. However, if the liquidating
entity is insolvent, some of the tax consequences detailed above will not
apply.
a.
Where the actual or deemed liquidation involves the liquidation of
a subsidiary into an 80% distributee, any liquidating distribution is
normally tax free to both the liquidating corporation and the parent
corporation. However, if the controlled subsidiary is insolvent at
the time of liquidation, section 332 will not apply, and the
subsidiary will recognize gain or loss under section 1001.
(i)
Reg. § 1.332-2(b) states that section 332 applies “only to
those cases in which the recipient corporation receives at
- 59 least partial payment for the stock which it owns in the
liquidating corporation.” As a result, it has long been held
that the liquidation of an insolvent subsidiary does not
qualify as a section 332 liquidation. See, e.g., H.G. Hill
Stores, Inc. v. Commissioner, 44 B.T.A. 1182 (1941); Rev.
Rul. 59-296, 1959-2 C.B. 87.
(ii)
The same rule applies where there is no actual distribution,
but the effect of the transaction is a deemed liquidation.
See Rev. Rul. 2003-125 (applying partial payment rule to
deemed liquidation as a result of check-the-box election
with respect to an insolvent subsidiary); see also P.L.R.
9610030 (Dec. 12, 1995); P.L.R. 9425024 (Mar. 25, 1994).
(iii)
The proposed no net value regulations confirm this result.
Prop. Reg. § 1.332-2(b).
b.
Because section 332 does not apply, the parent corporation will not
succeed to the liquidating corporation’s tax attributes under section
381.
c.
Even if the liquidation does not involve a controlled subsidiary, but
rather involves individual shareholders, it has been held that
section 331 does not apply to the liquidation of an insolvent
corporation. See Braddock Land Co. v. Commissioner, 75 T.C.
324 (1980); Jordan v. Commissioner, 11 T.C. 914 (1948).
d.
Nonetheless, the parent corporation should be entitled to a
worthless stock deduction under section 165(g), subject to any
limitations that may be imposed by the consolidated return
regulations. See, e.g., Reg. § 1.1502-36.
(i)
However, to claim a worthless stock deduction, the stock
must have no liquidating value and there must not be a
reasonable hope or expectation that it will become valuable
at some future time. Such hope or expectation may be
foreclosed by the happening of some identifiable event,
such as the bankruptcy or liquidation of the corporation.
Morton v. Commissioner, 38 B.T.A. 1270, 1278-79 (1938);
see also Rev. Rul. 2003-125; P.L.R. 200710004 (Dec. 5,
2006).
(ii)
The Service had previously noted in F.S.A. 200226004
(June 28, 2002) that continuation of the business as a
partnership or a disregarded entity following a deemed
liquidation may undermine the treatment of the deemed
liquidation as an identifiable event evidencing
- 60 worthlessness. However, it reversed this position in Rev.
Rul. 2003-125 with respect to a single member LLC treated
as a disregarded entity, and in the proposed no net value
regulations. See Prop. Reg. § 1.332-2(e), Ex. 2.
e.
In a generic legal advice memorandum (GLAM) the IRS provided
additional guidance regarding the application of these rules to an
insolvent foreign corporation’s election to convert to a partnership.
GLAM 2011-003 (August 18, 2011).
(i)
Facts: X is a US corporation with a 100 percent ownership
of Y, a foreign corporation. X also owns 80 percent of Z, a
foreign corporation, and Y owns the remaining 20 percent
interest in Z. X’s adjusted basis in its Z stock is $100, and
Y’s adjusted basis is $30. Z has assets of $100 and
liabilities of $110. Z elects to change its classification from
a corporation to a partnership under Treas. Reg. §
301.7701-3(c)(1)(i). In Situation 1, the liabilities of Z are
owed to X; in Situation 2, the liabilities of Z are owed to U,
an unrelated foreign corporation.
(ii)
Under both Situation 1 and Situation 2, the Service
determined that X and Y were entitled to a worthless stock
deduction under section 165(g) equal to their adjusted basis
in the stock as a result of the deemed liquidation of the
insolvent entity that occurred with the change in
classification. This result is similar to that of Rev. Rul.
2003-125.
(iii)
However, the GLAM differs from Rev. Rul. 2003-125 in
determining that the creditor cannot claim a section 166
bad debt deduction. Rather, the liabilities of Z are deemed
to be contributed to the new partnership in a transaction
that is not a significant modification of the liabilities for
section 1001 purposes. In contrast, Rev. Rul. 2003-125
indicates that the foreign subsidiary’s creditors, including
its parent corporation, may be entitled to a section 166 bad
debt deduction.
(iv)
The GLAM also provides guidance on the basis of each
partner’s interest in the new partnership.
(a)
As described earlier, in the conversion from an
association to a partnership, Z is deemed to
distribute its assets and liabilities to X and Y in
liquidation. Because Z is insolvent, sections 331
and 332 are inapplicable, and the basis of the assets
- 61 is determined under section 1012 (i.e., the cost of
the assets). Therefore, in Situations 1 and 2, X is
deemed to assume liabilities of $88 in the deemed
liquidation of Z (80% of $110), thus X is deemed to
receive assets with a basis of $88, and Y is deemed
to assume liabilities of $22 (20% of $110), thus Y is
deemed to receive assets with a basis of $22.
(b)
In Situations 1 and 2, X and Y are then treated as
contributing assets and liabilities, pro rata, to the
newly formed partnership. Under section 752(c), the
amount of the liabilities treated as assumed by the
partnership is limited to the FMV of the assets at the
time of the deemed contribution ($100).
Accordingly, X is deemed to contribute assets with
a basis to X of $88 and liabilities of $80, and Y is
deemed to contribute assets with a basis to Y of $22
and liabilities of $20. Under section 721, no gain or
loss is recognized to the partnership or X and Y on
the deemed contribution. Under section 723, the
partnership's basis in the assets deemed contributed
is $110 (the AB of the assets to X and Y). Cf. Prop.
Treas. Reg. § 1.351-1(a)(1)(iii)(A) and (B), which
would require a surrender and receipt of net value,
respectively, in a section 351 transaction.
(c)
The GLAM takes the position that section 721
applies regardless of whether net value is
transferred, contrary to the principles in the
proposed no-net value regulations. See Preamble to
Proposed No Net Value Regulations (“The IRS and
the Treasury Department recognize that the
principles in the proposed rules under section 351
may be applied by analogy to other Code sections
that are somewhat parallel in scope and effect, such
as section 721 . . . .”).
(d)
In Situation 1, X’s basis in its partnership interest is
$108 and Y’s basis in its partnership interest is $2.
The partnership is deemed to assume $100 of the
liabilities contributed by X and Y ($80 and $20,
respectively), but because X bears the economic
risk of loss for the liability, X's share of the liability
is increased by $100. X's basis in its partnership
interest is $108 (adjusted basis in assets deemed
contributed ($88) under section 722 increased by
the deemed contribution of money ($20) under
- 62 section 752(a)), and Y's basis in its partnership
interest is $2 (adjusted basis in assets deemed
contributed ($22) under section 722 decreased by a
deemed distribution of $20 under section 752(b)).
(e)
3.
In Situation 2, X’s basis in its partnership interest is
$88 and Y’s basis in its partnership interest is $22.
Because no partner bears the economic risk of loss
with respect to the liabilities contributed to the
partnership, the liability contributed is nonrecourse.
There is no net change in the partners' share of
liabilities and, thus, no net deemed contributions or
distributions under section 752(a) and (b)
(partnership assumes $100 of liabilities deemed
contributed by X and Y ($80 and $20, respectively),
and X and Y's share of the liability increases by $80
and $20, respectively). X's basis in its partnership
interest is $88 (adjusted basis in assets deemed
contributed ($88) under section 722) and Y's basis
in its partnership interest is $22 (adjusted basis in
assets deemed contributed ($22) under section 722).
Deemed Incorporation of Insolvent Entity – As discussed above, if a
disregarded entity elects to be taxed as, or converts into, an association,
the owner of the disregarded entity is deemed to transfer the assets of the
entity to a newly formed corporation in a section 351 exchange.
a.
Section 351(a) provides that no gain or loss will be recognized if
property is transferred to a corporation by one or more persons
solely in exchange for stock of such corporation and, immediately
after the exchange, such person or persons are in control of the
corporation.
(i)
There are two ways in which insolvency may implicate the
requirements of section 351: (i) the transfer of overencumbered property may not constitute “property;” or
(ii) if stock of an insolvent corporation is received, it may
not satisfy the “solely in exchange for stock” requirement.
(ii)
Current law is unclear as to whether a contribution of overencumbered property to an insolvent corporation qualifies
for nonrecognition treatment as a section 351 transaction.
See Rosen v. Commissioner, 62 T.C. 11 (1974) (holding
that section 357(c) applied where the taxpayer transferred
the assets and liabilities of an insolvent sole proprietorship
to a newly formed corporation; see also Focht v.
Commissioner, 68 T.C. 223 (1977); G.C.M. 33,915 (Aug.
- 63 26, 1968). But see DeFelice v. Commissioner, 386 F.2d
704 (10th Cir. 1967) (rejecting the taxpayer’s argument that
section 357(c) did not apply, because he was insolvent; the
court found that the taxpayer failed to prove he was
insolvent); Meyer v. United States, 121 F. Supp. 898 (Ct.
Cl. 1954) (holding in dicta that the transfer of worthless
property in exchange for stock did not meet the exchange
requirement of the predecessor of section 351).
(iii)
b.
The proposed no net value regulations adopt the latter
position and provide that stock will not be treated as issued
for property if either (i) the fair market value of the
transferred property does not exceed the sum of the amount
of liabilities of the transferor that are assumed by the
transferee in connection with the transfer and the amount of
money and fair market value of any other property received
by the transferor in connection with the transfer (i.e., the
transferor does not transfer net value), or (ii) the fair market
value of the assets of the transferee does not exceed the
amount of its liabilities immediately after the transfer (i.e.,
the transferee is insolvent). Prop. Reg. § 1.351-1(a)(1)(iii).
If section 351 does not apply, the deemed transfer would
presumably be either a taxable exchange or a taxable 301
distribution to the owner.
- 64 V.
SALE OF A SINGLE-MEMBER LLC
A.
Sale of All of the Membership Interests
1.
Example 13 – Sale of All of the Membership Interests to a Single Buyer
Sale of 100% LLC
Interests
P
X
Cash
100%
LLC
a.
Facts: Corporation P owns all of the outstanding interests in LLC.
LLC does not elect to be classified as a association (i.e., it is
treated as a disregarded entity). P sells all of the outstanding
membership interests in LLC to X, an unrelated party.
b.
Tax Consequences:
(i)
LLC is disregarded as an entity separate from P. As a
result, P is not treated as owning “interests” in LLC for
federal tax purposes, but rather is treated as owning LLC’s
assets directly. Thus, the sale of all of the interests in LLC,
a disregarded entity, to a single buyer should be treated as a
sale of assets by P. Under section 1001, P should recognize
gain or loss on the sale, the character of which will depend
on the nature of the assets sold. See Rev. Rul. 99-5, 1999-1
C.B. 434.
(ii)
It is not likely that P would be able to change this result by
converting LLC into an association taxed as a corporation
immediately prior to the sale of the LLC interests to X.
Informal discussions with the Service have indicated that it
would likely apply step-transaction principles to treat P’s
- 65 sale of the LLC interests as the sale of the LLC’s assets.
See Rev. Rul. 70-140, 1970-1 C.B. 73.
c.
2.
Treatment of Buyer
(i)
Because LLC will be owned by a single buyer, X, it will
remain a disregarded entity in X’s hands. See Reg.
§ 301.7701-3(b)(1)(ii). Accordingly, X should be treated
as purchasing the assets of LLC directly from P.
(ii)
What if LLC elects to be taxed as an association
immediately after the purchase? If a disregarded entity
elects to be treated as an association, the owner is treated as
contributing all of the assets and liabilities of the
disregarded entity to a newly formed association in
exchange for stock of the association. Reg. § 301.77013(g)(1)(iv). Thus, X should be treated as contributing the
assets of LLC to a newly formed association in a tax-free
section 351 exchange.
Example 14 – Sale of All of the Membership Interests Through a Cash
Merger
P
X
100%
Merger
LLC
a.
S
Facts: P owns all of the membership interests of LLC, which is
treated as a disregarded entity for tax purposes. X wants to acquire
LLC. X forms a transitory subsidiary, S. S merges into LLC in a
reverse subsidiary cash merger, with LLC surviving (pursuant to a
- 66 state statute permitting such mergers). P exchanges LLC interests
for cash from X.
b.
B.
Tax Consequences: The transitory existence of S will be
disregarded. See Rev. Rul. 73-427, 1973-2 C.B. 301. Thus, the
result should be the same as in Example 13, above. Because LLC
is disregarded as an entity separate from P, P is treated as owning
LLC’s assets directly. Because the sole consideration for the
merger is cash, the merger should be treated as the sale of LLC’s
assets by P, and P should recognize gain or loss under section
1001. Moreover, because LLC, the surviving entity, will be owned
by a single buyer, X, it will remain a disregarded entity in X’s
hands (unless LLC elects to be taxed as an association). Reg.
§ 301.7701-3(b)(ii). Accordingly, X should be treated as
purchasing the assets of LLC.
Sale of Less Than All of the Membership Interests
1.
Example 15 – Sale of Less Than All of the Membership Interests
50% of LLC
P
X
Cash
100%
LLC
a.
Facts: P owns all of the outstanding interests in LLC, which is
treated as a disregarded entity for tax purposes. P sells 50 percent
of the outstanding membership interests in LLC to X, an unrelated
party.
b.
Tax Consequences: LLC is disregarded as an entity separate from
P, and is treated as owning LLC’s assets directly. Thus, the sale of
50 percent of the interests in LLC to a single buyer is treated as a
- 67 sale of 50 percent of the LLC assets by P. P recognizes gain or
loss under section 1001, with the character of such gain or loss
depending on the character of the assets sold. See Rev. Rul. 99-5,
1999-1 C.B. 434.
c.
Deemed Change In Classification: Immediately after the sale,
LLC has two owners and, thus, it will be treated as a partnership
under the default rules of the check-the-box regulations. Reg.
§ 301.7701-3(b)(1)(i). Under Rev. Rul. 99-5, X is treated as
having purchased assets from P and contributed the assets (with
their stepped-up basis) to a newly formed partnership under section
721. The other 50 percent of the assets, which are deemed
contributed by P would not receive a stepped-up basis; instead,
LLC would take a carryover basis in those assets. Note that under
section 704(c), the built-in gain with respect to the assets
contributed by P will be allocated to P.
If, however, P and X elected to treat LLC as an association
effective the same date as the sale, the deemed transactions
resulting from the elective change would preempt the transactions
that would result from the automatic classification change. Reg.
§ 301.7701-3(f)(2). Thus, P would be treated as contributing all of
the assets and liabilities of LLC to a newly formed association in
exchange for stock of the association immediately before the close
of the effective date of the election. Reg. § 301.7701-3(g)(1)(iv),
(g)(3)(i). P would then be treated as selling 50 percent of the stock
to X on the effective date of the election. Because P does not
retain control of the association under section 351, P’s contribution
would be a taxable event. See Reg. § 301.7701-3(f)(4), Ex.1.
If P and X rescind the sale within the same tax year, LLC will be
treated as continuing to be a disregarded entity for the entire
period, and the rescission will not be treated as a liquidation of the
partnership. See P.L.R. 200843001 (July 2, 2008).
d.
Section 197 Anti-Churning Rules: Assume that a portion of the
assets held by LLC consisted of goodwill, which was not
amortizable under pre-section 197 law. Would LLC be permitted
to amortize its goodwill after the sale?
(i)
In general, section 197 amortization deductions may not be
taken for an asset, which was not amortizable under presection 197 law, if it is acquired after August 10, 1993, and
either (i) the taxpayer or a related person held or used the
asset on or after July 25, 1991; (ii) nominal ownership of
the intangible changes, but the user of the intangible does
not; or (iii) the taxpayer grants the former owner the right
- 68 to use the asset. See Section 197(f)(1)(A). In addition,
under section 197(f)(2), in certain nonrecognition
transactions (including section 721 transfers), the transferee
is treated as the transferor for purposes of applying section
197.
(ii)
In the example above, P was treated as owning LLC’s
goodwill directly, prior to the sale of 50 percent of LLC.
Because P’s deemed contribution of 50 percent of the
goodwill was pursuant to section 721, LLC takes a
carryover basis in the goodwill (presumably zero), which
will not be amortizable by LLC. Because X’s half of the
goodwill was held by P, who is related to LLC under
section 197(f)(9)(C) during the prohibited time period, the
anti-churning rules will apply to X’s transfer of its 50percent interest. Therefore, LLC’s entire basis in its
goodwill is nonamortizable. See Reg. § 1.197-2(k), Ex.18.
(iii)
What if P sold more than 80 percent of the LLC
membership interests to X? In that case, P is not related to
the newly formed partnership within the meaning of section
197(f)(9)(C). Thus, the anti-churning rules should not
apply. However, under Reg. § 1.197-2(h)(6)(ii), the time
for testing relationships in the case of a series of related
transactions is immediately before the earliest transaction
and immediately after the last transaction. Query whether
P is considered related to the newly formed partnership
under this rule, because it was an entity not separate from
LLC immediately before the initial acquisition by X.
(iv)
There is a special partnership rule for purposes of
determining whether the anti-churning rules apply with
respect to any increase in basis of partnership property
under section 732(d), 734(b), or 743(b). In such cases, the
determinations are to be made at the partner level, and each
partner is to be treated as having owned or used such
partner’s proportionate share of the partnership property.
Section 197(f)(9)(F); Reg. § 1.197-2(h)(12). Thus, if a
purchaser acquires an interest in an existing partnership
from an unrelated seller, the purchaser will be entitled to
amortize its share of any step up in basis of the partnership
intangibles.
(v)
Assume that, in the example above, LLC was already
classified as a partnership for tax purposes (e.g., P
contributed the assets of LLC to a newly formed
partnership in exchange for partnership interests, and, at the
- 69 same time, another party contributed property to the newly
formed partnership in exchange for nominal partnership
interests), and LLC had a section 754 election in effect. If
P then sold 50 percent of its partnership interest to X, X’s
proportionate share of any basis step-up under section 743
should be amortizable.
2.
Example 16 – Initial Public Offering of LLC Interests
50% LLC
Interests
Public
P
Cash
100%
LLC
a.
Facts: P owns all of the outstanding interests in LLC, which is
treated as a disregarded entity for tax purposes. P sells 50 percent
of its LLC membership interests to the public in an initial public
offering (“IPO”).
b.
Tax Consequences: Because LLC is disregarded as an entity
separate from P, P is treated as owning LLC’s assets directly.
Thus, the sale of 50 percent of the interests in LLC to the public in
an IPO should be treated as a sale of 50 percent of the LLC assets
by P. See Rev. Rul. 99-5, 1999-1 C.B. 434.
c.
Deemed Change in Classification
(i)
Immediately after the IPO, LLC has more than one owner.
Thus, under the default rules of the check-the-box
regulations, LLC will be treated as a partnership. Reg.
§ 301.7701-3(b)(ii). Upon the deemed reclassification as a
partnership, the public should be treated as having
purchased assets from P and contributed the assets (with
- 70 their stepped-up basis) to a newly formed partnership under
section 721. The other 50 percent of the assets, which
would be deemed contributed by P, would not receive a
stepped-up basis; LLC would take a carryover basis in
those assets. See Rev. Rul. 99-5, 1999-1 C.B. 434.
(ii)
However, because the partnership interests are publicly
traded, the partnership should immediately be reclassified
as a corporation under section 7704 (unless the partnership
is engaged in passive activities, e.g., real estate). Under
section 7704(f), the partnership is treated as having (i)
transferred all of its assets to a newly formed corporation in
exchange for stock of the corporation pursuant to section
351, and (ii) distributed such stock to its partners in
liquidation of their interests. These deemed transfers are
treated as occurring as of the first day that the partnership is
treated as a corporation.
(iii)
Because the deemed incorporation occurs at the same time
that the entity is treated as a partnership, these transactions
may be stepped together. See Reg. § 301.7701-3(g)(2)
(providing that the step-transaction doctrine applies to
elective changes in an entity’s classification). The
application of the step-transaction doctrine could yield one
of two results:
(a)
P is viewed as selling half of the LLC’s assets to the
public, followed by the transfer by P and the public
of all of the assets to a newly formed corporation in
a section 351 exchange.
(b)
Alternatively, the transaction may be viewed as if P
transferred all of the LLC’s assets to a newly
formed corporation in exchange for stock, and then
sold half of the stock to the public. In this case, the
sale of half of the stock immediately after the
transfer of the assets to the corporation would
presumably disqualify the transaction under section
351. Informal discussions with the Service have
indicated that it would not likely view this
transaction as a sale of assets to the public under the
principles of Rev. Rul. 70-140, 1970-1 C.B. 73; see
also Reg. § 1.1361-5(b)(3), Ex. 1. But cf. Section
1361(b)(3)(C)(ii).
- 71 VI.
REORGANIZATIONS INVOLVING SINGLE-MEMBER LLCs
A.
A Reorganizations Involving Single-Member LLCs
1.
Definition - Section 368(a)(1)(A) provides that the term “reorganization”
includes “a statutory merger or consolidation.” Prior to the regulations
described below, the section 368 regulations defined an A reorganization
as a “merger or consolidation effected pursuant to the corporation laws of
the United States or a State or Territory or the District of Columbia.” Old
Reg. § 1.368-2(b)(1) (emphasis added).
2.
History of Regulations:
a.
Old Proposed Regulations – On May 16, 2000, the Service issued
proposed regulations under section 368 in which it took the
position that the merger of a target corporation (T) into a
disregarded entity wholly owned by another corporation (P) could
not qualify as an A reorganization. Old Prop. Reg. § 1.3682(b)(1), 65 Fed. Reg. 31,115 (2000).
(i)
The Service reasoned that the owner of the disregarded
entity, P, the only potential party to the reorganization, is
not a party to the state law merger transaction. Preamble to
Old Prop. Reg. § 1.368-2(b)(1), 65 Fed. Reg. at 31,116. P
and T have combined their assets and liabilities only under
the federal tax law regarding disregarded entities—not
under state merger law. Id. There does not appear to be
any policy reason requiring this result.
(ii)
The old proposed regulations also took the position that the
merger of a disregarded entity owned by P into T could not
qualify as an A reorganization because it was a divisive
reorganization that did not satisfy the requirements of
section 355. Preamble to Old Prop. Reg. § 1.368-2(b)(1),
65 Fed. Reg. at 31,116.
(iii)
The old proposed regulations deleted the reference to
“corporation” laws in the prior regulations, which
conformed to the Service’s long-standing position that a
merger may qualify as an A reorganization even if it is
pursuant to laws other than the corporation law of the state
(e.g., National Banking Act, see Rev. Rul. 84-104, 1984-2
C.B. 94). Preamble to Old Prop. Reg. § 1.368-2(b)(1), 65
Fed. Reg. at 31,116.
(iv)
The proposed regulations also deleted the reference to
“Territory” to be consistent with the definition of domestic
- 72 under section 7701(a)(4) (which was amended in 1976).
Id.
b.
Old Temporary Regulations – On November 14, 2001, the Service
withdrew the old proposed regulations and issued new proposed
regulations, which permitted certain statutory mergers involving
disregarded entities to qualify as A reorganizations. Old Prop.
Reg. § 1.368-2(b)(1)(ii). On January 23, 2003, these proposed
regulations were issued as temporary regulations with certain
modifications.
(i)
The temporary regulations provided a general definition of
“statutory merger” and “consolidation,” so they applied to
mergers of corporations as well as disregarded entities.
The temporary regulations simply looked at whether the
transaction effected pursuant to state law is a statutory
merger or consolidation, which is required for a valid A
reorganization. The statutory merger or consolidation still
must have satisfied the other requirements for a tax-free A
reorganization (e.g., continuity of interest and continuity of
business enterprise).
(ii)
The temporary regulations defined a statutory merger or
consolidation as a transaction effected pursuant to the laws
of the United States or a State or the District of Columbia
in which the following events occur pursuant to the
operation of such laws (Old Temp. Reg. § 1.3682T(b)(1)(ii)):
(iii)
(a)
All of the assets (other than those distributed in the
transaction) and liabilities (except to the extent
satisfied or discharged in the transaction) of each
member of one or more combining units (each a
transferor unit) become the assets and liabilities of
one or more members of one other combining unit
(the transferee unit); and
(b)
The combining entity of each transferor unit ceases
its separate legal existence for all purposes.
Like the old proposed regulations, the old temporary
regulations also took the position that the merger of a
disregarded entity owned by P into T could not qualify as
an A reorganization because it was a divisive
reorganization. T.D. 9038; 68 Fed. Reg. 3384-3388.
- 73 -
c.
(iv)
The definition of statutory merger or consolidation in the
temporary regulations was intended to comport with
principles under the law prior to the temporary regulations.
See Preamble to Old Prop. Reg. § 1.368-2(b)(1), 66 Fed.
Reg. at 57,401 (citing Cortland Specialty Co. v.
Commissioner, 60 F.2d 937 (2d Cir. 1932); Rev. Rul. 20005, 2000-1 C.B. 436).
(v)
Limitation to domestic entities –For purposes of the
temporary regulations, the following entities must have
been domestic: (i) the combining entity of the transferor
unit; (ii) the combining entity of the transferee unit; (iii)
any disregarded entity of the transferee unit that receives
assets in the merger; and (iv) any entity between the
combining entity of the transferee unit and the disregarded
entity receiving the assets. Old Temp. Reg. § 1.3682T(b)(1)(iii).
(a)
However, a disregarded entity of the transferor unit
that became a disregarded entity of the transferee
unit did not need to be domestic.
(b)
The reason for the carve-out was that mergers
involving foreign entities were the subject of a
separate guidance project.
Proposed Regulations Would Permit Foreign Mergers
(i)
This guidance project resulted in the issuance of proposed
regulations on January 5, 2005 (which were finalized in
2006, see below), that proposed to expand the temporary
regulations not only to apply to mergers involving foreign
entities but also to include certain mergers effected
pursuant to the laws of a foreign country or a United States
territory in addition to the laws of the United States, a
State, or the District of Columbia. For a more detailed
discussion of these proposed regulations, see Mark J.
Silverman, Lisa M. Zarlenga, and John J. Giles, New
Regulations Would Permit Cross-Border “A”
Reorganizations for the First Time in 70 Years, 57 TAX
EXECUTIVE 58 (Jan.-Feb. 2005).
(ii)
The proposed regulations accomplish the expansion to
foreign mergers by changing the language “a transaction
effected pursuant to the laws of the United States or a State
or the District of Columbia” to “a transaction effected
pursuant to the statute or statutes necessary to effect the
- 74 merger or consolidation.” Compare Old Temp. Reg.
§ 1.368-2T(b)(1)(ii) with Old Prop. Reg. § 1.368-2(b)(ii).
(a)
3.
The preamble stated that the phrase “statute or
statutes” is not intended to prevent transactions
effected pursuant to legislation from qualifying as
mergers or consolidations where such legislation is
supplemented by administrative or case law.
Preamble to Old Prop. Reg. § 1.368-2(b)(1), 70 Fed.
Reg. at 746.
(iii)
The proposed regulations would have removed Old Temp.
Reg. § 1.368-2T(b)(1)(iii), which required that the abovelisted entities be domestic, from the temporary regulations.
(iv)
Concurrently with the proposed regulations, the Service
issued proposed regulations under sections 358, 367, and
884 to address, among other issues, the collateral
consequences of cross-border corporate reorganizations.
d.
Final Regulations - On January 23, 2006, the Service issued final
regulations that adopted the temporary and proposed regulations
with certain modifications. See T.D. 9242.
e.
Amendment to Final Regulations - On April 25, 2006, the Service
amended the final regulations to provide transitional relief for
certain transactions initiated before January 23, 2006. See T.D.
9259, 71 Fed. Reg. 23,855.
General Definition of Statutory Merger or Consolidation
a.
Definition – The final regulations define a statutory merger or
consolidation as “a transaction effected pursuant to the statute or
statutes necessary to effect the merger or consolidation, in which
transaction, as a result of such statute or statutes, the following
events occur simultaneously at the effective time of the transaction
(Reg. § 1.368-2(b)(1)(ii)):
(i)
All of the assets (other than those distributed in the
transaction) and liabilities (except to the extent such
liabilities are satisfied or discharged in the transaction or
are nonrecourse liabilities to which assets distributed in the
transaction are subject) of each member of one or more
combining units (each a transferor unit) become the assets
and liabilities of one or more members of one other
combining unit (the transferee unit) [the “all of the assets”
requirement]; and
- 75 (a)
b.
The underlined language was added by the final
regulations. The change was not discussed in the
preamble—it was apparently to correct an oversight
in the earlier regulations.
(ii)
The combining entity of each transferor unit ceases its
separate legal existence for all purposes; provided,
however, that this requirement will be satisfied even if,
under applicable law, after the effective time of the
transaction, the combining entity of the transferor unit (or
its officers, directors, or agents) may act or be acted
against, or a member of the transferee unit (or its officers,
directors, or agents) may act or be acted against in the name
of the combining entity of the transferor unit, provided that
such actions relate to assets or obligations of the combining
entity of the transferor unit that arose, or relate to activities
engaged in by such entity, prior to the effective time of the
transaction and such actions are not inconsistent with the
requirements of paragraph (b)(1)(ii)(A) of this section
[which is the all of the assets requirement]” [the “ceasing
separate legal existence” requirement].
(iii)
Note that the other requirements applicable generally to
reorganizations (e.g., continuity of interest and continuity
of business enterprise) must also be satisfied to qualify as
an A reorganization.
New Terms – The definition of statutory merger or consolidation
introduces a number of new terms.
(i)
Combining entity – Business entity that is a corporation (as
defined in Reg. § 301.7701-2(b)) that is not a disregarded
entity. Reg. § 1.368-2(b)(1)(i)(B).
(ii)
Combining unit – Comprised solely of a combining entity
and all disregarded entities, if any, owned by the combining
entity. Reg. § 1.368-2(b)(1)(i)(C).
(iii)
Transferor unit – Combining unit that is transferring assets
and liabilities pursuant to state law.
(iv)
Transferee unit – Combining unit that receives the assets
and liabilities pursuant to state law.
- 76 c.
Example 17 – Merger Into LLC (Base Case)
P
T
Merger
100%
P Voting
Stock
LLC
(i)
Facts: P forms a wholly owned LLC. LLC is treated as a
disregarded entity. T merges into LLC pursuant to a state
statutory merger, with the T shareholders receiving P
voting stock.
(ii)
Tax Consequences: Under the final regulations, this
transaction would qualify as a statutory merger for
purposes of section 368(a)(1)(A). Thus, as long as the
other requirements for a tax-free A reorganization are
satisfied, the fact that T merged into a disregarded entity
will not affect its qualification as a tax-free A
reorganization. See P.L.R. 200944011 (July 24, 2009);
P.L.R. 200930025 (Apr. 22, 2009)
(a)
In this example, T is a combining entity, a
combining unit, and the transferor unit; P is a
combining entity; P and LLC constitute a
combining unit and the transferee unit.
(b)
Because all of the assets and liabilities of T become
the assets and liabilities of one or more members of
the transferee unit (here, LLC), and T goes out of
existence, both requirements of the regulatory test
are satisfied and the transaction qualifies as a
statutory merger. See Reg. § 1.368-2(b)(1)(iii),
Ex. 2. Under old proposed regulations, the merger
- 77 would not have qualified as a statutory merger,
because the transferee entity is not a corporation
that can be a party to the reorganization within the
meaning of section 368(b).
(c)
Note that the Service had been willing to issue
favorable A reorganization rulings under similar
facts even before the second set of proposed
regulations were made temporary. See P.L.R.
200250023 (Sept. 4, 2002); P.L.R. 200236005 (May
23, 2002).
(d)
This result is consistent with the approach of the
check-the-box regulations. The LLC is disregarded
for all federal tax purposes, and P ends up with T’s
assets pursuant to a merger under the Delaware
corporation laws. The substance of the transaction
is a merger of T into P.
(e)
This treatment is also consistent with pre-check-thebox authorities.
i.)
In P.L.R. 9411035 (Dec. 20, 1993), Parent owned all of the
common stock and some of the preferred stock of Sub.
Parent and Sub qualified as REITs. Parent formed Newco
as a qualified REIT subsidiary. Parent caused Sub to
merge into Newco under a plan of liquidation. The Service
ruled that the merger of a corporation into a qualified REIT
subsidiary, which is disregarded, is treated as a merger
directly into the parent of the qualified REIT subsidiary.
See also P.L.R. 9512020 (Dec. 29, 1994); P.L.R. 8903074
(Oct. 26, 1988).
ii.)
In King Enterprises, Inc. v. United States, 418 F.2d 511
(Ct. Cl. 1969), Minute Maid acquired all of Tenco’s stock
in exchange for cash, notes, and Minute Maid stock.
Approximately three months later, Minute Maid approved a
plan to merge Tenco and three other subsidiaries into
Minute Maid. The court held that the transfer of the Tenco
stock to Minute Maid, followed by the merger of Tenco
into Minute Maid, were steps in a unified transaction to
merge Tenco into Minute Maid, which qualified as an A
reorganization. See also Rev. Rul. 2001-46, 2001-2 C.B.
321.
iii.)
Similarly, in P.L.R. 9539018 (June 30, 1995), Acquiring
formed Acquiring Sub, which was merged into Target in a
- 78 triangular merger that qualified as a reorganization under
section 368(a)(2)(E). Target then merged into Acquiring.
The Service ruled that the two mergers would be treated as
if Acquiring had directly acquired the Target assets in
exchange for Acquiring stock through a statutory merger
under section 368(a)(1)(A).
iv.)
Similar conclusions have been reached in the C
reorganization context. See Rev. Rul. 72-405, 1972-2 C.B.
217.
(f)
4.
What if T could not otherwise merge into P under
state law (e.g., T is a bank and P is a bank holding
company)? Because the disregarded entity is
viewed as the survivor of the state law merger under
the final regulations, the status of P should not
matter. See Rev. Rul. 74-297, 1974-1 C.B. 84
(concluding that a merger of a domestic corporation
into the wholly owned domestic subsidiary of a
foreign corporation in exchange for stock of the
foreign corporation qualifies as a tax-free forward
triangular merger under section 368(a)(2)(D)).
All of the Assets Requirement
a.
Not Substantially All – The requirement that all of the assets of the
transferor unit be transferred was not intended to impose a
“substantially all” requirement on A reorganizations. Rather, it
was intended to ensure that divisive transactions did not qualify as
A reorganizations. Preamble to Old Prop. Reg. § 1.368-2(b)(1), 66
Fed. Reg. at 57,401; Preamble to Old Temp. Reg. § 1.3682T(b)(1), 68 Fed. Reg. 3384, 3385 (2003).
(i)
Thus, if the merger in Example 17 were immediately
preceded by a distribution by T of half of its assets to its
shareholders, it should still qualify as a statutory merger
(assuming the continuity of business enterprise requirement
is satisfied). This is true even though the substantially all
requirement applicable to certain other types of
reorganizations would not be satisfied. Reg. § 1.3682(b)(1)(iii), Ex. 8; Preamble to Old Temp. Reg. § 1.3682T(b)(1), 68 Fed. Reg. at 3385.
(ii)
As a result, the use of disregarded entities achieves the
same result as a forward triangular merger but without
- 79 having to comply with the substantially all requirement of
section 368(a)(2)(D).12
(iii)
b.
A disregarded entity cannot be used in the same way to
achieve the effect of a reverse triangular merger under
section 368(a)(2)(E),13 because, as discussed further below,
the transaction is divisive and does not qualify as a
statutory merger under section 368(a)(1)(A). Nonetheless,
it might be possible to achieve the effect of a reverse
triangular merger by applying the pre-check-the-box
authorities described above. For example, P could form a
corporate subsidiary, S, and S could merge into T.
Immediately thereafter, T could merge into P or into a
single-member LLC owned by P. The transaction should
be treated as a straight merger of T into P. See P.L.R.
9539018. Such two-step acquisitions are further discussed
below.
Disregarded Entities in Transferor Unit – A disregarded entity of
the transferor unit need not transfer its assets to the combining
entity of the transferee unit, but rather may remain a disregarded
entity without violating the all of the assets requirement. Reg.
§ 1.368-2(b)(1)(iii), Ex. 2; Preamble to Old Temp. Reg. § 1.3682T(b)(1), 68 Fed. Reg. at 3385. This is because the transferee is
deemed to own the assets of the disregarded entity.
(i)
Thus, if T in Example 17 owned a disregarded entity, that
disregarded entity could either transfer its assets to LLC or
remain a disregarded entity of LLC—either way, LLC is
treated as owning all of the assets of T’s disregarded entity.
(ii)
Similarly, if P owned all of the interests in LLC-1, which,
in turn, owned all of the interests in a second-tier LLC,
12
Section 368(a)(2)(D) provides that an A reorganization is not disqualified where
substantially all of the properties of the target corporation are acquired in exchange for stock of
a corporation in control of the acquiring corporation, if no stock of the acquiring corporation is
used in the transaction, and the transaction would have qualified under section 368(a)(1)(A) had
the merger been into the controlling corporation.
13
Section 368(a)(2)(E) provides that an A reorganization is not disqualified where stock
of the corporation controlling the merged corporation is used in the transaction, if the surviving
corporation holds substantially all of its and the merged corporation’s properties, and former
shareholders of the surviving corporation surrendered control of the surviving corporation in
exchange for stock of the corporation controlling the merged corporation.
- 80 LLC-2, both of which are disregarded entities, and T
merged into LLC-2, the conclusion should not change.
(a)
Under the final regulations, a combining unit is
comprised of a combining entity and all disregarded
entities owned by the combining entity. In this
variation, P (a combining entity) and LLC-1 and
LLC-2 are a combining unit and the transferee unit.
(b)
The final regulations require that all of the assets
and liabilities of the transferor unit become the
assets and liabilities of one or more members of the
transferee unit. Because T’s assets and liabilities
become those of LLC-2, the merger should be
treated as a statutory merger.
Example 18 – Sprinkling of Assets Among Transferee Unit
c.
P
T
100%
100%
LLC2
LLC1
P Voting Stock and
cash
Merger
100%
LLC3
(i)
Facts: P owns all of the interests of LLC-1 and LLC-2, and
T owns all of the interests of LLC-3. T merges into LLC-1,
and LLC-3 merges into LLC-2.
(ii)
Tax Consequences: The transaction qualifies as a tax-free
A reorganization. The final regulations require that all of
the assets and liabilities of the transferor unit become the
assets and liabilities of one or more members of the
transferee unit. T is deemed to own all of the assets of
LLC-3; because all of T’s assets and liabilities become
those of LLC-1 and LLC-2, the merger should be treated as
a statutory merger. See Reg. § 1.368-2(b)(1)(iii), Ex. 2.
- 81 -
5.
(iii)
The result is the same if LLC-3 also merges into LLC-1 or
if LLC-3 remains a disregarded entity of LLC-1.
(iv)
This example illustrates the flexibility of these regulations.
As long as all of the assets and liabilities of the transferor
unit are transferred to the transferee unit, they may be
sprinkled among different disregarded entities within the
transferee unit.
Ceasing Separate Legal Existence Requirement - As discussed above, the
combining entity of each transferor unit must cease its separate legal
existence for all purposes, except that the regulations permit the entity to
remain in existence for certain limited purposes (e.g., legal actions) as
long as such actions relate to assets or obligations that arose, or relate to
activities engaged in by such entity, prior to the effective time of the
transaction.
a.
Subsidiary or Disregarded Entity Owned by T
(i)
Assume the same facts as Example 17, except that T owns
all of the stock of corporation T1 at the time of the merger,
and T1 does not go out of existence as a result of the
merger.
(a)
(ii)
b.
The final regulations require that each member of
the transferor unit transfer all of its assets and
liabilities and that the combining entity of the
transferor unit go out of existence. Although T1
meets the definition of a combining entity and a
combining unit, it is not a transferor unit because it
is not transferring assets and liabilities pursuant to
the state law merger. Thus, T1 is not required to
transfer all of its assets and liabilities and go out of
existence for the merger of T into LLC to qualify as
a statutory merger.
Similarly, if T1 were a disregarded entity, it is not required
to transfer all of its assets and liabilities and go out of
existence.
State Law Conversion or Check-the-Box Election
(i)
As discussed in Section IV.C.4., above, if a corporation
elects to be a disregarded entity, it is treated as a liquidation
of the corporation. However, the merger of a wholly
owned subsidiary into a disregarded entity owned by the
parent should be treated as an upstream A reorganization
under the final regulations (subject to section 332 treatment
- 82 under Reg. § 1.332-2(d), (e)). See Example 10. Because a
check-the-box election and a merger into a disregarded
entity of the parent lead to the same result, the question
arises as to whether a check-the-box election likewise
should be treated as an A reorganization.
(ii)
c.
(a)
The final regulations take the position that checking
the box to treat a corporation as a disregarded entity
does not qualify as a statutory merger or
consolidation since the converted entity continues to
exist in derogation of Reg. § 1.368-2(b)(1)(ii)(B)
(the “ceasing the separate legal existence”
requirement).
(b)
In addition, the check-the-box election violates the
“transfer all of the assets” requirement since there is
no action under state law that effects the transfer of
assets in a check-the-box election. See Preamble to
Reg. § 1.368-2, 71 Fed. Reg. 4259.
Similarly states permit a corporation to convert into an
LLC by simply filing a form. However, the final
regulations take the position that a state law conversion of a
corporation into an LLC that is disregarded for federal
income tax purposes does not qualify as a statutory merger
or consolidation since the converted entity continues to
exist in derogation of Reg. § 1.368-2(b)(1)(ii)(B) (the
ceasing the separate legal existence requirement). See
Preamble to Reg. § 1.368-2, 71 Fed. Reg. 4259.
Consolidations and Amalgamations
(i)
In General - A state law consolidation or a foreign law
amalgamation of two corporations will qualify as a
statutory merger or consolidation, even if effected pursuant
to a law that provides that the consolidating or
amalgamating corporations continue in the resulting
corporation. As the preamble to the final regulations
explains, although a consolidation or amalgamation may
cause the resulting corporation to be treated as a
continuation of the consolidating or amalgamating
corporations, “the separate legal existence of the
consolidating or amalgamating entities does in fact cease.”
(Emphasis added.) Preamble to Reg. § 1.368-2, 71 Fed.
Reg. 4259, 4260.
(ii)
Example 19 – Consolidation
- 83 -
P
T
Consolidation
Y
(a)
Facts: Under state law, P and T consolidate.
Pursuant to state law, the following events occur
simultaneously: (i) all of the assets and liabilities of
P and T become the assets and liabilities of Y, an
entity that is created in the transaction, and (ii) the
existence of P and T continues in Y. In the
consolidation, the P and T shareholders exchange
their P and T stock for Y stock.
(b)
Tax Consequences: The transaction qualifies as a
statutory merger or consolidation under the final
regulations. Although under state law the legal
existence of P and T continues in Y, the preamble to
the final regulations clarifies that P and T’s separate
legal existence does in fact cease. Accordingly,
Reg. § 1.368-2(b)(1)(ii)(B) is satisfied. See Reg.
§ 1.368-2(b)(1)(iii), Ex. 12.
- 84 (iii)
Amalgamations
(a)
Horizontal – A horizontal amalgamation is the
foreign analog to state law consolidations. Thus,
the result in Example 19 would be the same if P and
T presumably were foreign entities amalgamating
into Y pursuant to foreign law. See Reg. § 1.3682(b)(1)(iii), Ex. 14.
(b)
Upstream – What if a parent and subsidiary
amalgamate? Presumably, such a transaction would
qualify as an A reorganization under the final
regulations; however, section 332 would trump
section 368(a)(1)(A). See Reg. § 1.332-2(d) and
(e).
(c)
Example 20 – Forward Triangular Amalgamation
P
P Voting
Stock
T
S
Amalgamation
U
P Voting
Stock
i.)
Facts: T and U are entities organized under foreign law
and are classified as corporations for federal income tax
purposes. T and U amalgamate. Under the foreign law, all
of the assets and liabilities of T and U become the assets
and liabilities of S, an entity that was created in the
transaction and is wholly owned by P immediately after the
transaction, and T and U’s separate legal existence ceases.
In the transaction, shareholders of T and U exchange their
shares in T and U for shares in P.
ii.)
Tax Consequences:
- 85 -
iii.)
Even though P does not control the
acquiring corporation, S,
immediately before the transaction, it
does control S immediately after the
transaction.
b)
As stated in the preamble to the final
regulations, the Service and Treasury
do not believe that section
368(a)(2)(D) requires the corporation
the stock of which is used in a
triangular consolidation or
amalgamation to control the
acquiring corporation immediately
prior to the transaction and that such
corporation’s control of the acquiring
corporation immediately after the
transaction is sufficient to satisfy that
requirement in section 368(a)(2)(D).
See Reg. § 1.368-2(b)(1)(iii), Ex. 14;
Preamble to Reg. § 1.368-2, 71 Fed.
Reg. 4259, 4261.
c)
This is consistent with the final
regulations’ approach of testing the
transferee unit immediately after the
transaction.
What are the results if T is a wholly-owned subsidiary of P
prior to the amalgamation – is the amalgamation tested as a
forward triangular merger or as a D reorganization?
(d)
6.
a)
The preamble to the final regulations notes that one
commentator questioned whether an amalgamation
should be treated as an F reorganization with
respect to one entity followed by an A
reorganization by the other. See 71 F.R. 42764294. Treasury and the Service are considering this
suggestion in the context of their F reorganization
project. Presumably, the reason for the suggestion
is to designate a surviving entity and permit the
carryback of NOLs. However, it is not clear which
entity would be considered the surviving entity.
Definition and Existence of Transferee and Transferor Units
- 86 a.
Example 21 – Merger into Disregarded Entity Owned by
Partnership
P
T
P Voting Stock
and cash
100%
Merger
LLC
b.
(i)
Facts: P is classified as a partnership for tax purposes, T is
a domestic corporation, and LLC is a domestic limited
liability company. LLC is wholly owned by P. LLC is
treated as a disregarded entity. T merges into LLC under
state statutory merger law with the T shareholders receiving
consideration of 50% P voting stock and 50% cash.
(ii)
Tax Consequences: Because only a corporation can qualify
as a combining entity, the merger would not qualify as a
statutory merger under the final regulations. See Reg.
§ 1.368-2(b)(1)(iii), Ex. 5. T would be a combining entity,
a combining unit, and the transferor unit. However, there is
no combining entity, combining unit, or transferee unit on
the other side.
Timing for Testing of Transferee/Transferor Units
(i)
General Rule - The final regulations clarify that the
existence and composition of a transferee unit is not tested
immediately prior to the transaction but, instead, is only
tested immediately after the transaction.
- 87 (ii)
Example 22 – Merger into LLC in Exchange for LLC
Interests
A
P
100%
A
P
LLC
Interests
T
LLC
LLC
(P-Ship)
Merger
(a)
Facts: P forms a wholly owned LLC. LLC is
treated as a disregarded entity. T merges into LLC
pursuant to a state statutory merger, with the T
shareholders receiving LLC interests.
(b)
Tax Consequences: Under the final regulations, this
transaction would not qualify as a statutory merger
for purposes of section 368(a)(1)(A). See Reg.
§ 1.368-2(b)(1)(iii), Ex. 7.
i.)
In this example, immediately before the merger, T is a
combining entity, a combining unit, and the transferor unit;
P is a combining entity; P and LLC constitute a combining
unit and the transferee unit.
ii.)
However, immediately after the merger, LLC is a
partnership. Therefore, it cannot be a combining entity,
combining unit, or transferee unit. Although P is a
combining entity and a combining unit, it is not a transferee
unit, because it did not receive T’s assets and liabilities.
Because T’s assets and liabilities do not become the assets
and liabilities of one or more members of a transferee unit,
the transaction does not qualify as a statutory merger.
- 88 (c)
What if LLC elects to be taxed as a corporation
effective on the date of the merger?
i.)
The final regulations focus on the status of the entities
immediately after the merger. See Reg. § 1.3682(b)(1)(iii), Ex. 7. Thus, T should be treated as merging
into a C corporation in a qualifying A reorganization.
Assuming the transaction satisfies all of the other
requirements for a tax-free A reorganization, the
transaction should be tax free to T and A.
ii.)
Upon the election to be taxed as a corporation, P is deemed
to contribute all of the assets and liabilities of LLC to a
newly formed corporation in exchange for stock of the new
corporation. Reg. § 301.7701-3(g)(1)(iv).
iii.)
If P does not control LLC immediately after the deemed
contribution, is P taxed on the transaction? For purposes of
testing whether the section 351 control requirement is
satisfied, T should be treated as a co-transferor. See Rev.
Rul. 76-123, 1976-1 C.B. 94; Rev. Rul. 68-357, 1968-2
C.B. 144; see also Reg. § 1.1361-5(b)(3), Ex. 3. But see
Rev. Rul. 68-349, 1968-2 C.B. 143 (denying section 351
treatment where the corporation was formed for the sole
purpose of enabling the shareholder to transfer appreciated
assets without recognition of gain).
- 89 (iii)
Example 23 – Merger of Corporate Partner into Partnership
T
P
50% 50%
P
Merger
P stock and
cash
X
(P-ship)
100%
X
(DE)
(a)
Facts: P and T, both corporations, together own all
of the membership interests in X, a limited liability
company that is treated as a partnership. Under
State W law, T merges into X. Pursuant to such
law, the following events occur simultaneously: all
of the assets and liabilities of T become the assets
and liabilities of X, and T ceases its separate legal
existence for all purposes. In the merger, the
shareholders of T exchange their T stock for
consideration consisting of 50% P stock and 50%
cash. As a result of the merger, X becomes an
entity that is disregarded as an entity separate from
P.
(b)
Tax Consequences: Under the final regulations, the
transaction qualifies as a statutory merger or
consolidation because all of the assets and liabilities
of T, the combining entity and sole member of the
transferor unit, become the assets and liabilities of
one or more members of the transferee unit that is
comprised of P, the combining entity of the
transferee unit, and X, a disregard entity the assets
of which P is treated as owning for tax purposes
immediately after the transaction, and T ceases its
separate legal existence for all purposes. See Reg.
§ 1.368-2(b)(1)(iii), Ex. 11.
- 90 (c)
i.)
As discussed in the preamble to the final regulations,
Treasury and the Service believed that this transaction
should qualify as an A reorganization, so the final
regulations clarify that the composition of the transferee
unit is not tested immediately before the transaction, but is
only tested immediately after the transaction. Preamble to
Reg. § 1.368-2, 71 Fed. Reg. 4259.
(d)
i.)
Example 22 illustrated that the transferee unit is
tested immediately after the merger. The question
presented in this example is whether it is also tested
immediately before the merger. If it is, then this
transaction would not qualify as an A
reorganization, because X is a partnership
immediately before and cannot be a member of the
combining unit.
Note that in the transaction X terminates as a
partnership under section 708(b)(1)(A). This raises
some interesting questions as to whether the
subchapter K rules or the principles of Rev. Rul. 996 should apply. The preamble requests comments
on these issues. Preamble to Reg. § 1.368-2, 71
Fed. Reg. 4259, 4260. There appear to be three
ways to treat the transaction under subchapters C
and K:
The principles of Rev. Rul. 99-6, if applied, would
bifurcate the transaction. As discussed above, the facts of
Rev. Rul. 99-6 were similar in that T sold its interest in X
to P. As to T, the Rev. Rul. treated it as a sale of a
partnership interest. But as to P, the Rev. Rul. treated X as
having made a liquidating distribution of all of its assets to
T and P, and following the distribution, P was treated as
acquiring the assets deemed distributed to T in the
liquidation.
a)
The ruling noted that P would have
to recognize gain or loss under
731(a) on the deemed liquidating
distribution. Query whether the antimixing bowl rules of sections
704(c)(1)(B) and 737 apply to P.
b)
Thus, it seems that application of
Rev. Rul. 99-6 would result in
respecting T’s merger into X as to T,
- 91 but deeming a liquidating
distribution and tax-free transfer of
assets by T in exchange for P stock
as to P. Thus, the assets of X will
take a basis equal to the basis in T
and P’s interests in X.
ii.)
If subchapter K principles were to apply before subchapter
C, there would appear to be a liquidation of the partnership
as to both P and T. Then T would transfer all of its assets
and liabilities and the assets and liabilities received in the
liquidation of X to a disregarded entity owned by P in
exchange for P stock in a tax-free reorganization. Thus, T
is potentially subject to tax under section 731, which seems
contrary to the tax-free nature of the transaction.
iii.)
Finally, if subchapter C principles were to apply before
subchapter K, there would appear to be a transfer of T’s
assets, including its partnership interest in X, to P. Then, X
would liquidate into P as the 100% partner. This approach
preserves tax-free treatment to T and results in a carryover
basis in T’s assets, including its partnership interest. This
approach was the one suggested by the ABA Tax Section.
ABA Members Comment on Final Regs Defining Statutory
Merger or Consolidation, 2007 TNT 113-21 (Jun. 11,
2007).
iv.)
Note that the same issue arises if T merges into P instead of
into X, because P is also left holding X as a disregarded
entity in that case.
- 92 7.
Example 24 – Upstream Merger
P
2
50% T
Assets
100%
1
T
LLC
S
Merger
a.
Facts - P owns all of the stock of T and S and all of the interests in
LLC, which is treated as a disregarded entity. T merges into LLC
and immediately thereafter, P contributes half of T’s assets to S.
b.
Tax Consequences – Because LLC is disregarded, T is treated as
transferring all of its assets to P by merger in a transaction that is
treated as an upstream A reorganization. The subsequent drop of
half of T’s assets to S should not prevent the reorganization from
qualifying under section 368(a)(1)(A). Section 368(a)(2)(C). See
Rev. Rul. 69-617, 1969-2 C.B. 57; P.L.R. 200832001 (Aug. 8,
2008); P.L.R. 200727001 (July 6, 2007); P.L.R. 200532011 (Aug.
12, 2005).
(i)
Assume that, instead of merging into LLC, T files the form
under state law to be treated as a disregarded entity or
checks the box to be a disregarded entity. As discussed
above, the final regulations take the position that such
actions do not qualify as statutory mergers. However, the
deemed transfer of assets to P should be treated as an
upstream C reorganization followed by a section
368(a)(2)(C) drop. See Treas. Reg. § 1.368-2(d)(4); P.L.R.
200952032 (Sept. 24, 2009) (conversion of S into a singlemember LLC, followed by a transfer of certain assets to a
brother-sister subsidiary and a conversion of S back into a
corporation, treated as an upstream C reorganization
followed by two separate 351 transactions).
- 93 (ii)
8.
If P contributes a small portion of T’s assets (probably less
than 20 percent) to S, the deemed transfer of T’s assets to P
should be respected as a liquidation under section 332
liquidation, and the contribution of T’s assets should
qualify under section 351. See Rev. Proc. 2011-3,
§ 4.01(22), 2011-1 I.R.B. 111 (Dec. 31, 2010) (limiting norule position in reincorporation cases to situations where
transferee corporation is “alter ego” of liquidating
corporation) & Informal Comments of IRS Chief Counsel
(Corporate) Representatives; Cf. Telephone Answering
Service Co. v Commissioner, 63 T.C. 423 (1974), aff’d
without published opinion, 546 F.2d 423 (4th Cir. 1976).
Two-Step Acquisitions of Target Corporation
a.
STEP TWO
Example 25 – Merger Into LLC Followed by Merger Upstream
into P
P
T
P Voting Stock
and cash
Merger
STEP ONE
Merger
LLC
(i)
Facts - P and T are domestic corporations and LLC is a
domestic limited liability company. LLC is wholly owned
by P. LLC is treated as a disregard entity. T merges into
LLC under state statutory merger law, with the T
shareholders receiving 50% P voting stock and 50% cash.
Immediately after the merger, LLC merges into P as part of
a plan that included the first merger.
(ii)
Tax Consequences – Because LLC is disregarded, the
principles of Rev. Rul. 72-405, 1972-2 C.B. 217 (holding
- 94 that a forward triangular merger of a target corporation into
a newly formed controlled corporation of parent, followed
by the liquidation of the controlled corporation into the
parent is tested as a C reorganization rather than a section
368(a)(2)(D) reorganization), should not be applied to
prevent the merger of T into LLC from qualifying as an A
reorganization. See Preamble to Old Reg. § 1.3682T(b)(1).
b.
P
100%
Example 26 – Acquisition of T Stock Followed by Alternative
Transfers to P
P
T Stock
T SHs
50% P Stock
50% Cash
T
LLC
LLC
T
(i)
Facts – P owns all of the interests in LLC, a domestic LLC
that is disregarded for federal tax purposes. T’s
shareholders transfer their T stock to P in exchange for
50% P stock and 50% cash. Immediately after the
acquisition, T engages in one of the following alternative
transactions: (i) T merges into P; (ii) T merges into LLC
owned by P; (iii) T files a form in Delaware to become an
LLC; (iv) T checks the box to be treated as a disregarded
entity; (v) T liquidates into P; (vi) T dissolves.
(ii)
Tax Consequences - First, assume T merges upstream into
P. These are similar to the facts of King Enterprises, 418 F.
2d 511 (Ct. Cl. 1969) in which the court integrated the two
steps and treated the transaction as a single A
reorganization of T into P. In Rev. Rul. 2001-46, the
Service reiterated that the step transaction doctrine would
- 95 apply where the integrated steps result in a tax-free
reorganization.
(a)
Now assume that in the second step, T merges into
an LLC owned by P instead of directly into P. As
discussed above, T’s merger qualifies as an A
reorganization under the final regulations, so it
should be treated the same as an upstream merger,
and the transaction should be stepped together.
(b)
Now, assume that in the second step T files the
form under state law to be treated as a disregarded
entity or checks the box to be a disregarded entity.
As discussed above, the final regulations take the
position that such actions do not qualify as statutory
mergers; therefore, the transactions would not be
stepped together as an A reorganization but rather
would be tested as a C reorganization (which would
not qualify here because of the boot) or treated as
separate transactions.
(c)
Now, assume that in the second step, T liquidates
into P in a section 332 liquidation. If the steps are
integrated, it is treated as a taxable asset acquisition
(it would not be a C reorganization under Rev. Rul.
67-274, 1967-2 C.B. 141, because of the boot).
However, in Rev. Rul. 90-95, 1990-2 C.B. 67, the
Service ruled that section 338 is the exclusive
means to achieve a cost basis under these
circumstances, so the step-transaction doctrine is
turned off where the integrated steps would be
treated as a taxable asset acquisition resulting in a
cost basis. Instead, the separate steps are respected
as a qualified stock purchase followed by a section
332 liquidation.
(d)
Finally, assume that T dissolves under state law.
Under state law, the ownership of T’s assets does
not automatically vest in P upon dissolution.
i.)
Recall that the requirement of the final regulations is that
“as a result of the operation of such statue,” all of the assets
and liabilities transfer and the transferor ceases its separate
legal existence.
ii.)
The final regulations provide that this example does not
qualify as an A reorganization because P does not acquire
- 96 the assets as a result of T’s filing the certificate of
dissolution but only acquires the assets upon T’s later
transfer of assets to P.
iii.)
9.
Therefore, the transactions would not be stepped together
as an A reorganization but would be tested as a C
reorganization (which does not qualify here) or treated as
separate transactions.
Example 27 – Forward Triangular Merger
P
T
Merger
S
P Voting
Stock
LLC
a.
Facts: P’s wholly owned subsidiary, S, forms a single-member
LLC, which is disregarded for federal tax purposes. T merges
directly into LLC, and the former shareholders of T receive solely
P voting stock.
b.
Tax Consequences: LLC is disregarded as an entity separate from
S; thus, S is treated as acquiring substantially all of T’s assets and
liabilities in the merger. Because S is using P stock as
consideration, the transaction should qualify as a triangular merger
under section 368(a)(1)(A) and (a)(2)(D). See Reg. § 1.3682(b)(1)(iii), Ex. 4.
(i)
If S had formed a wholly owned C corporation, instead of
an LLC, the transaction would not qualify as a tax-free
reorganization, because neither section 368(a)(2)(D) nor
section 368(a)(1)(C) permits the use of grandparent stock
- 97 as consideration in the reorganization. Thus, disregarded
entities can be used to avoid this limitation.
10.
Divisive Mergers Involving LLCs
a.
Example 28 - LLC Merger Into Corporation
T
P
100%
Merger
LLC
(i)
Facts: T owns all of the interests of LLC. LLC is treated
as a disregarded entity. LLC operates a business, which P
wants to acquire. LLC merges into P pursuant to a state
statutory merger.
(ii)
Tax Consequences: This transaction does not qualify as a
statutory merger under the final regulations. See Reg.
§ 1.368-2(b)(1)(iii), Ex. 6.
(a)
T is a combining entity; T and LLC constitute a
combining unit and the transferor unit; P is a
combining entity, the combining unit, and the
transferee unit.
(b)
Because not all of the assets and liabilities of the
transferor unit become assets and liabilities of the
transferee unit, and the combining entity of the
transferor unit does not cease to exist, the
transaction does not qualify as a statutory merger.
See Reg. § 1.368-2(b)(1)(ii)(A), (B).
- 98 (c)
b.
This result is consistent with the authorities. The
substance of this transaction is the transfer by T of
part of its assets to P in exchange for P stock.
i.)
In Cortland Specialty Co. v. Commissioner, 60 F.2d 937,
939 (2d Cir. 1932), cert. denied, 288 U.S. 599 (1933), the
court stated, “A merger ordinarily is an absorption by one
corporation of the properties and franchises of another
whose stock it has acquired. The merged corporation
ceases to exist and the merging corporation alone
survives.” In this example, T does not cease to exist.
ii.)
In addition, the Service has ruled that certain transactions
that are structured as state law mergers, but in reality are
divisive transactions cannot qualify as tax-free
reorganizations without satisfying the requirements of
section 355. Rev. Rul. 2000-5, 2000-1 C.B. 436. In this
example, T’s assets and liabilities are being divided
between T and P without satisfying the requirements of
section 355.
Example 29 – Merger of Corporation into Multiple LLCs
P Voting
Stock
P
100%
LLC-1
A
100%
LLC-2
Merge
r
T
Merge
r
(i)
Facts: P owns all of the interests of LLC-1 and LLC-2,
both of which are treated as disregarded entities. Pursuant
to a state statutory merger, T transfers all of its assets and
liabilities to LLC-1 and LLC-2; a portion are transferred
- 99 directly to LLC-1 and a portion are transferred directly to
LLC-2.
(ii)
11.
Tax Consequences: This transaction should qualify as a
statutory merger under the final regulations.
(a)
T is a combining entity, a combining unit, and the
transferor unit; P is a combining entity; P, LLC-1,
and LLC-2 constitute the combining unit and the
transferee unit.
(b)
Because all of the assets and liabilities of the
transferor unit (T) become assets and liabilities of
one or more members of the transferee unit, and the
combining entity of the transferor unit (T) ceases to
exist, the transaction qualifies as a statutory merger.
See Reg. § 1.368-2(b)(1)(ii)(A), (B).
Application of the Final Regulations in the Context of Foreign Entities
a.
Since 1935, the term “statutory merger or consolidation” has been
defined to exclude mergers under foreign law. The final
regulations reverse this longstanding interpretation – an
interpretation for which there was no strong policy support.
(i)
The preamble to the old proposed regulations noted that
there was no indication in the legislative history of the 1934
changes to the definition of reorganization that Congress
intended to exclude transactions effected under foreign law.
Although the Service continues to believe that the
limitation in the regulations to domestic laws is reasonable,
the Service nonetheless believes that changes in the
purposes of the statute and in both domestic and foreign
law since 1935 warrant a reexamination of the definition.
The preamble notes that many foreign jurisdictions now
have merger or consolidation statutes that operate in
material respects like those of the states – that is, assets and
liabilities transfer by operation of law – and that
transactions effected pursuant to such statutes should be
treated as reorganizations if they otherwise satisfy the
functional criteria applicable to domestic transactions.
Preamble to Old Prop. Reg. § 1.368-2(b)(1), 70 Fed. Reg.
746, 746 (2005).
- 100 b.
Example 30 – Transaction Effected Pursuant to Foreign Law
Merge
r
T
P
P
Stock
US
LLC
(a)
Facts: P and T are entities organized under foreign
laws. P owns a wholly owned domestic LLC, US
LLC. T merges into P pursuant to foreign law, with
the T shareholders receiving P stock. Under foreign
law the following are deemed to occur
simultaneously: (i) all of the assets and liabilities of
T become the assets and liabilities of P, and (ii) T’s
separate legal existence ceases.
(b)
Tax Consequences: Under the final regulations, this
transaction would qualify as a statutory merger for
purposes of section 368(a)(1)(A). See Reg.
§ 1.368-2(b)(1)(iii), Ex. 13.
- 101 Example 31 – Merger with Foreign Entity
c.
P
US
P voting stock and cash
LLC1
US
T
Foreign
LLC2
Foreign
Merger
(i)
Facts: P owns 100% of the outstanding units of LLC-1 and
LLC-2. Both LLCs are treated as disregarded entities for
federal tax purposes. LLC-2 and T are entities organized
under the laws of Country Q. Pursuant to Country Q law, T
merges with and into LLC-2 with T shareholders
exchanging their T stock for 50% P voting stock and 50%
cash.
(ii)
Tax Consequences: This transaction should qualify as an A
reorganization under Reg. § 1.368-2(b)(1)(ii).
(a)
The final regulations removed Old Temp. Reg.
§ 1.368-2T(b)(1)(iii), which required that the
following entities be domestic, from the temporary
regulations: (i) the combining entity of the
transferor unit; (ii) the combining entity of the
transferee unit; (iii) any disregarded entity of the
transferee unit that receives assets in the merger;
and (iv) any entity between the combining entity of
the transferee unit and the disregarded entity
receiving the assets. Old Temp. Reg. § 1.3682T(b)(1)(iii).
(b)
Therefore, T may merge into a foreign disregarded
entity of P.
- 102 d.
Example 32 – Drop and Check vs. Check and Drop
P
US
CFC1
Foreign
CFC1 stock
NewCFC
Foreign
CFC1
Foreign
CTB Election
(i)
Facts: P owns 100% of the stock of CFC1. P forms
NewCFC as a corporation, contributes the stock of CFC1,
and checks the box to treat CFC1 as a disregarded entity.
(ii)
Tax Consequences: Depending on the effective date of the
check-the-box election, the transaction may be viewed as
an upstream C reorganization or a sideways D or F
reorganization.
(a)
A check-the-box election is effective on the date
specified (or on the date filed if no date is
specified). See Reg. § 301.77013(c)(1)(iii). Any
transactions that are deemed to occur as a result of a
change in classification are treated as occurring
immediately before the close of the day before the
election is effective. See Reg. § 301.7701-3(g)(3).
(b)
If the check-the-box election is effective prior to, or
on the same day as, the contribution of CFC1 stock,
then the transaction should be viewed as a
- 103 liquidation followed by a contribution of CFC1’s
assets to NewCFC.
i.)
The Service takes the position that a liquidation followed
by a reincorporation does not qualify as a section 332
liquidation. See, e.g., Rev. Rul. 69-617, 1969-2 C.B. 57;
Rev. Rul. 76-429, 1976-2 C.B. 97.
ii.)
However, the transaction could qualify as an upstream C
reorganization followed by a drop of assets to a subsidiary.
See Section 368(a)(2)(C); Reg. § 1.368-2(k).
(c)
If the check-the-box election is effective one day
after the contribution of CFC1 stock, then the
transaction should be viewed as a contribution
followed by a liquidation. Such a transaction is
treated as a cross-chain reorganization rather than
an upstream reorganization. See, e.g., Rev. Rul.
2004-83, 2004-2 C.B. 157 (treating a sale of stock
followed by a liquidation as a D reorganization);
Rev. Rul. 67-274, 1967-2 C.B. 141 (treating a drop
of stock followed by a liquidation as a C
reorganization). Because NewCFC is newly
formed, the transaction is likely to be treated as an F
reorganization. See Rev. Rul. 87-27, 1987-1 CB
134.
(d)
Thus, the timing of the check-the-box election is
critical to whether the transaction will be treated as
an upstream or cross-chain reorganization, which
can have other consequences. For example, stock
basis goes away in an upstream reorganization, but
it carries over in a cross-chain reorganization. In
addition, section 367 should apply to an upstream
reorganization followed by a drop, but not to a
cross-chain reorganization.
- 104 B.
Example 33 - B Reorganization14
T
Shareholders
P
P Voting
Stock
100%
T Stock
T
LLC
14
1.
Facts: P forms a wholly owned LLC. LLC does not elect to be taxed as
an association and is, thus, treated as a disregarded entity. LLC acquires T
stock from the T shareholders in exchange for P voting stock.
2.
Tax Consequences: Because LLC’s separate existence is disregarded, P
should be treated as exchanging its voting stock for the T stock in a
reorganization that qualifies under section 368(a)(1)(B).
a.
This result is consistent with the Service’s position on the use of
transitory subsidiaries in similar situations. See Rev. Rul. 67-448,
1967-2 C.B. 144 (where a transitory subsidiary was merged into a
target corporation, the Service disregarded the transitory subsidiary
and recast the transaction as a direct exchange of the acquiring
corporation’s stock for the target stock).
b.
What if T were immediately liquidated into LLC as part of the
overall transaction?
Section 368(a)(1)(B) treats as a reorganization the acquisition by one corporation, in
exchange solely for all or part of its voting stock (or voting stock of a corporation in control of
the acquiring corporation), of stock of another corporation if, immediately after the acquisition,
the acquiring corporation has control of such other corporation. For this purpose, control is
defined as 80 percent of the voting power and 80 percent of the number of shares of nonvoting
stock. Section 368(c).
- 105 -
C.
(i)
The Service would likely treat the transaction as an
acquisition of T assets by P under section 368(a)(1)(C).
See Rev. Rul. 67-274, 1967-2 C.B. 141.
(ii)
What if the subsequent liquidation were done by means of a
statutory merger of T into LLC (assuming that state law
permits mergers of corporations and LLCs)? Such a
transaction should be treated as if T merged into P. See
King Enterprises, Inc. v. Commissioner, 418 F.2d 511 (Ct.
Cl. 1969); Rev. Rul. 2001-46; P.L.R. 9539018 (June 30,
1995); see also Old Temp. Reg. § 1.368-2T(b)(1),
discussed in Section VI.A. above.
Example 34 - C Reorganization15
T
Shareholders
P
P Voting Stock
100%
LLC
1.
15
P
Voting
Stock
T
T Assets and
Liabilities
Facts: P forms a wholly owned LLC, which is treated as a disregarded
entity. P wants LLC to acquire the T assets in a tax-free reorganization. T
also has some recourse liabilities. T transfers its assets and liabilities to
LLC in exchange for P voting stock. T distributes all of the P voting stock
to its shareholders in complete liquidation.
Section 368(a)(1)(C) treats as a reorganization the acquisition by one corporation, in
exchange solely for all or part of its voting stock (or voting stock of a corporation in control of
the acquiring corporation), of substantially all of the properties of another corporation.
- 106 2.
Tax Consequences: Because LLC’s separate existence is disregarded, P
should be treated as exchanging its voting stock for T’s assets and
liabilities in a reorganization that qualifies under section 368(a)(1)(C).
3.
Assumption of Liabilities
a.
Under section 368(a)(1)(C), the acquisition of assets must be solely
for voting stock of the acquiring corporation. However, in
determining whether the exchange is solely for voting stock,
liabilities assumed by the acquiring corporation are not taken into
account. The Service has ruled that the assumption of liabilities by
a corporation other than the acquiring corporation can destroy a
tax-free C reorganization. See Rev. Rul. 70-107, 1970-1 C.B. 78.
But see G.C.M. 39,102 (recommending revocation of Rev. Rul.
70-107 and suggesting that any party to a triangular reorganization
should be able to assume part or all of the liabilities).
b.
In the above example, does the assumption by LLC of T’s recourse
liabilities constitute an assumption by the acquiring corporation?
(i)
P is treated as the acquiring corporation, because LLC is
disregarded. But for state law purposes, LLC is treated as
becoming the obligor on the liabilities. Thus, as a technical
matter, LLC’s assumption of T’s liabilities may be treated
as boot in the C reorganization.
(ii)
For purposes of the reorganization provision, however, P
should be treated as assuming T’s liabilities.
(iii)
(a)
The check-the-box regulations apply for all federal
tax purposes and provide that whether an entity is
treated as separate from its owners is a matter of
federal, not state, law. Reg. § 301.7701-1(a).
(b)
Moreover, the Service has looked to the owner as
the debtor in situations where a division has
incurred debt. For example, in Rev. Rul. 80-228,
1980-2 C.B. 115, the Service disregarded
intercompany debt between divisions of the same
corporation, noting that such intercompany debt
cannot give rise to a debtor-creditor relationship,
because a corporation cannot be liable for a debt to
itself. See also P.L.R. 9109037 (Nov. 30, 1990)
(involving the transfer of division assets and
liabilities in a section 351 transaction).
However, as discussed further below in Section X.A., the
Service has looked to state law rights and obligations in
- 107 holding that the conversion of a corporation into a singlemember LLC did not result in a modification of debt owed
by the corporation under Reg. § 1.1001-3. P.L.R.
200630002; P.L.R. 200315001. Arguably this treatment is
limited to situations where the federal tax consequences
themselves depend on the rights and obligations of the
debtor and creditor with respect to the debt.
c.
Assuming that P is considered to have assumed T’s liabilities for
federal tax purposes, are the liabilities considered recourse or
nonrecourse with respect to P? Because LLC is still considered the
obligor for state law purposes, recourse liability could not attach to
P. P would only be liable for the liabilities to the extent of the
value of the assets in LLC. Thus, the liabilities should be
considered nonrecourse liabilities of P for federal tax purposes.
d.
Has a significant modification of T’s debt occurred for purposes of
section 1001?
(i)
Although there has been a change in the obligor on the
debt, such change resulted from a section 381(a)
transaction and, thus, is not considered a significant
modification. Reg. § 1.1001-3(e)(4)(i).
(ii)
Although the nature of the debt changed from recourse to
nonrecourse, such change is not considered significant if
the instrument continues to be secured by its original
collateral, which would appear to be the case here. Reg.
§ 1.1001-3(e)(5)(ii)(A), (B)(2).
- 108 D.
D Reorganizations16
1.
Example 35 – Acquisitive D Reorganization
P
T
Stock
P
100%
100%
100%
A
T
A
100%
T
LLC
Merger
16
a.
Facts: P owns all of the stock of two corporations, T and A. P
contributes all of its T stock to A. Immediately thereafter, A forms
a wholly owned LLC, and T merges into LLC.
b.
Tax Consequences: The contribution of T stock and the
subsequent merger of T into LLC should be integrated and treated
as if T transferred all of its assets directly to A in exchange for A
stock and then distributed the A stock to P in complete liquidation.
The transaction, as recharacterized, should qualify as a tax-free
acquisitive D reorganization. P.L.R. 200445016 (Jul. 20, 2004);
See Rev. Rul. 2004-83, 2004-2 C.B. 157 (taxable sale of subsidiary
stock to another subsidiary followed by an actual liquidation
treated as a D reorganization); P.L.R. 201003012 (Sept. 25, 2009)
(parent corporation’s contribution of stock in one wholly-owned
Section 368(a)(1)(D) treats as a reorganization a transfer by a corporation of all or part
of its assets to another corporation if, immediately after the transfer, the transferor or one or more
of its shareholders, is in control of the transferee corporation, but only if, in pursuance of the
plan, stock or securities of the transferee corporation are distributed in a transaction that qualifies
under section 354, 355, or 356. If such distribution occurs pursuant to section 354 and 356, then
the transaction is an acquisitive D reorganization; if it occurs pursuant to section 355 and 356,
then it is a divisive D reorganization. For purposes of this rule, control is defined as 50 percent
of the vote or value of stock. Sections 304(c); 368(a)(2)(H).
- 109 subsidiary to Newco, followed by conversion of subsidiary into
LLC and then a contribution of stock of a second wholly-owned
subsidiary to Newco followed by conversion of the second
subsidiary into LLC qualified as an F reorganization of the first
subsidiary and a D reorganization of the second one); P.L.R.
200252055 (Sept. 13, 2002) (contribution of subsidiary stock to
another subsidiary followed by conversion to LLC treated as a D
reorganization); see also Reg. § 1.1361-4(a)(2), Ex. 3 (concluding
that an individual’s contribution of stock of one corporation (“Y”)
to a wholly-owned S corporation (“X”), immediately followed by a
qualified subchapter S subsidiary election for Y constitutes a D
reorganization); P.L.R. 200735003 (May 30, 2007) (same); P.L.R.
200708019 (Nov. 16, 2006) (same); P.L.R. 200430025 (Apr. 2,
2004) (same).
c.
If T were already an eligible entity, the liquidation necessary for
the D reorganization could be achieved by a check-the-box
election. See P.L.R. 200732001 (May 15, 2007) (U.S.
corporation’s contribution of stock of directly owned CFC to an
indirectly owned CFC followed by a check-the-box election to
classify the CFC as a disregarded entity treated as a D
reorganization).
(i)
The timing of the election can, however, affect the
classification of the transaction if the election is effective
the day of the contribution, the deemed liquidation is
treated as occurring as of the close of the day before the
election becomes effective, Reg. § 301.7701-3(g)(3), when
T was still owned by P. The contribution of T’s assets
would thus follow the deemed liquidation of T and would
likely be characterized as an upstream C reorganization
followed by a section 368(a)(2)(C) contribution. See
Section VI.,A.,7., above.
(ii)
If the election is effective the day after the contribution,
then the deemed liquidation is treated as occurring as of the
close of the day of the contribution, when T is owned by A.
Thus, the contribution followed by the deemed liquidation
should be treated as a D reorganization.
(iii)
The timing is of particular importance in the context of a
foreign T where an inbound liquidation followed by a
section 368(a)(2)(C) contribution would be taxable, see
section 367(a); Reg. § 1.367(b)-3(b)(3), but a foreign-toforeign D reorganization is tax free under section 367(b).
- 110 Example 36 – Divisive D Reorganization
2.
D Shareholders
D Shareholders
D
D
C
C-LLC
C
Conversion
a.
Facts: D owns all of the interests in C-LLC, a disregarded entity.
D wants to distribute C to its shareholders in a tax-free spin-off.
Pursuant to state law, C converts into a corporation, and then D
distributes the C stock to its shareholders.
b.
Tax Consequences: The conversion of C-LLC from an LLC to a
corporation is treated as a contribution by D of all of C-LLC’s
assets to C. The deemed contribution of assets, followed by a
distribution of C stock should qualify as a tax-free divisive D
reorganization. See P.L.R. 200725016 (Mar. 20, 2007); P.L.R.
200716012 (Jan. 11, 2007) (supplemented by P.L.R. 201014047);
P.L.R. 200422003 (Feb. 13, 2004); P.L.R. 200411034 (Dec. 10,
2003); P.L.R 201115006 (Jan. 4, 2011); P.L.R. 201220011 (Feb. 3,
2012); P.L.R. 201232014 (February 16, 2012); cf. P.L.R.
2000735001 (May 31, 2007) (where a spin-off of a QSub
terminated its election resulting in a deemed contribution of the
QSub’s assets to a new corporation; deemed contribution treated as
a D reorganization); P.L.R. 200306033 (Nov. 5, 2002) (same);
P.L.R. 200735001 (May 31, 2007) (same); P.L.R. 201010023
(Nov. 25, 2009) (same).
Similarly, a contribution of stock of a corporation by D to C,
followed by checking the box on the contributed subsidiary and the
- 111 distribution of C stock qualifies as a tax-free divisive D
reorganization. P.L.R. 200743007 (Jul. 10, 2007).
E.
F Reorganizations17
1.
Example 37 – Basic F Reorganization
P Shareholders
P
17
P Shareholders
P Shareholders
P-LP
Check
the Box
Check
Election
the Box
Election
P
a.
Facts: P is a closely held corporation. Pursuant to a state statute,
P’s shareholders convert P into a limited partnership and elect
under the check-the-box regulations to treat the state law limited
partnership as an association taxable as a corporation for federal
tax purposes, effective on that same date.
b.
Tax Consequences: Because the effective date of the check-thebox election immediately follows the last day of P Corp.’s taxable
year, P-LP would never exist as a partnership for federal tax
purposes. Assuming the other requirements are satisfied, the
transaction should qualify as a tax-free reorganization under
section 368(a)(1)(F). See P.L.R. 200839017 (June 24, 2008);
P.L.R. 200622025 (Feb. 13, 2006); P.L.R. 200528021 (Apr. 8,
2005); P.L.R. 200450012 (Aug. 26, 2004); P.L.R. 200335019
Section 368(a)(1)(F) treats as a reorganization a merge change in identity, form, or
place of organization of one corporation, however effected.
- 112 (May 27, 2003); P.L.R. 200422047 (May 28, 2004); F.S.A.
200237017 (June 7, 2002).
c.
Query how should this be reported on the Form 8832 (Entity
Classification Election), which provides only boxes for (i) initial
classification by a newly formed entity, or (ii) change in current
classification.
Example 38 – Conversion as F Reorganization
2.
1
P
P
1% S
Stock
99%
LLC
2
S
LLC
S-LLC
S-LLC
1%
Convert/
Check the Box
a.
Facts: P owns all of the stock of S, a state law corporation. P
would like to convert S to a state law limited partnership.
Accordingly, P contributes 1 percent of the S stock to newly
formed LLC that is a disregarded entity. Pursuant to a state statute,
S converts from a corporation to a limited partnership and elects
under the check-the-box regulations to be treated as a corporation
for federal tax purposes.
b.
Tax Consequences: The conversion of S from a state corporation
to a state limited partnership, together with the election to treat S
as a corporation for federal tax purposes, should qualify as a taxfree reorganization under section 368(a)(1)(F). See Prop. Reg.
§ 1.368-2(m)(5), Ex. 8; P.L.R. 200505010 (Oct. 14, 2004); see also
P.L.R. 200731002 (May 1, 2007) (check-the-box election to treat a
disregarded entity as a corporation and the corporate owner as a
disregarded entity was an F reorganization).
- 113 -
3.
c.
Alternatively, a contribution of subsidiary stock to a newly formed
corporation followed by a check-the-box election may be treated as
an F reorganization. E.g., P.L.R. 201003014 (Sept. 30, 2009);
P.L.R. 201003012 (Sept. 25, 2010); P.L.R. 201001002 (Sept. 30,
2009); P.L.R. 200608018 (Nov. 18, 2005); see also P.L.R.
200725012 (May 19, 2007) (contribution of stock to a newly
formed S corporation followed by Qsub election was an F
reorganization).
d.
Similarly, a sideways merger into an LLC taxed as a corporation
may be treated as an F reorganization. E.g., P.L.R. 200718014
(Jan. 25, 2007).
Example 39 - F Reorganization Preceding an Acquisition
T Shareholders
4
LLC
Interests
T
1
T Shareholders
(Bus. A & B)
5
New T
New T
Stock
Bus. A
3
New T
P
(Bus. A)
Merger
Merger
LLC
(Bus. B)
2
LLC
a.
Facts: T is a publicly traded company that is engaged in the
conduct of two businesses, A and B. In addition, T has some
contingent liabilities. P has recently approached T regarding the
acquisition of T. P does not wish to acquire T’s Business B assets
and does not wish to succeed to T’s contingent liabilities. To
accomplish P’s objectives, the companies undertake the following
transactions:
(i)
Step 1: T forms New T, a wholly-owned subsidiary, and
contributes its Business A assets to New T. In addition,
New T assumes certain liabilities directly related to the
conduct of Business A.
- 114 -
b.
(ii)
Step 2: New T forms LLC, a new disregarded entity.
(iii)
Step 3: T merges with LLC, with LLC surviving. In the
merger, T’s shareholders receive shares of New T stock in
exchange for their T stock. As a result, New T is owned by
T’s former shareholders and holds Business A, the business
wanted by P. The remainder of T’s assets and liabilities,
including the contingent liabilities, are owned by LLC.
(iv)
Step 4: New T distributes the LLC interests to its
shareholders, which is treated as a taxable asset
distribution. Alternatively, if the requirements of section
355 can be satisfied, New T could form a new corporation
and cause LLC to merge into it. Then, New T could
distribute the stock of the new corporation to its
shareholders in a tax-free spin-off.
(v)
Step 5: New T merges into P. Note that if the merger
results in a 50 percent or greater acquisition of New T, then
section 355(e) would impose a corporate-level tax on the
spin-off referred to in Step 4.
Tax Consequences
(i)
All of T’s assets and liabilities should be treated as held by
New T at the conclusion of Step 3 for federal income tax
purposes either directly or through LLC, which is
disregarded. Thus, T should be treated as merely
undergoing a change in identity for purposes of section
368(a)(1)(F). See P.L.R. 200725001 (Mar. 19, 2007);
P.L.R. 200608018 (Nov. 18, 2005); P.L.R. 200510012
(Nov. 17, 2004); P.L.R. 199902004 (Oct. 7, 1998); P.L.R.
201003014 (Sept. 30, 2009); P.L.R. 201208019 (Nov. 28,
2011) ; see also P.L.R. 201033016 (May 20, 2010) (merger
of subsidiary into disregarded LLC owned by new
corporation formed by subsidiary’s sole corporate
shareholder qualifies as F reorganization); P.L.R.
201007043 (Oct. 22, 2009) (merger of S corp into its
wholly owned Qsub will be a F reorganization and will not
affect S corporation status); E.C.C 200941019 (Nov. 18,
2009) (in a reorganization where an S corporation becomes
a Qsub of a new holding company, the reorganization will
qualify as an F reorganization, and the S election will carry
over to the new holding company, only if a Qsub election is
made for the old S corporation immediately following the
transaction) P.L.R. 201115016 (Jan. 5, 2011) (same).
- 115 Thus, this transaction is useful when a potential target
would like to shed itself of contingent liabilities in
preparation for an acquisition.
(ii)
(iii)
Step Transaction Issues
(a)
The Service has long ruled that an F reorganization
would not lose its status even if occurring as part of
an overall plan involving subsequent tax-free
restructurings. See, e.g., Rev. Rul. 96-29, 1996-1
C.B. 50. Moreover, the Service has issued private
letter rulings indicating that a transaction may
constitute an F reorganization even though it occurs
as part of a planned tax-free distribution under
section 355 of the Code. See, e.g., P.L.R.
200825031 (Mar. 19, 2008); P.L.R. 200001011
(Jan. 7, 2000); P.L.R. 2000215027 (Jan. 10, 2002).
Regulations were proposed in August 2004 to
confirm the result of Rev. Rul. 96-29 that related
events that precede or follow an F reorganization
will not cause that transaction to fail to qualify as an
F reorganization. Prop. Reg. § 1.368-2(m)(3)(ii).
(b)
Note that if New T’s shareholders had sold the
stock of New T to P instead of engaging in a taxfree reorganization, it could disqualify the F
reorganization. Under the continuity of interest
(“COI”) regulations, COI is not preserved if the
issuing corporation or a related person acquires
target stock with consideration other than issuing
corporation stock. Reg. § 1.368-1(e)(1)(ii); Reg. §
1.368-1(e)(2). For this purpose, relatedness is
tested immediately before or after the acquisition of
stock involved. Reg. § 1.368-1(e)(3)(ii)(A).
Because P is related to New T after the sale of the
New T stock to P and New T’s shareholders receive
cash in the sale, COI is technically not satisfied.
(c)
Reg. § 1.368-1(b), which was finalized in February
2005, addressed these issues by providing that COI
and COBE are not required for a transaction to
qualify as an F reorganization.
Alternative Structure – If T had been a wholly owned
subsidiary of another corporation, the F reorganization
could have been accomplished by T’s forming New T and
contributing the wanted assets to New T, then electing to be
- 116 a disregarded entity. The Service has treated this
transaction as an F reorganization. P.L.R. 200626037
(Mar. 24, 2006); see also P.L.R. 200930030 (Jan. 15, 2009)
(merger into Target followed by check-the-box election to
treat Target as a disregarded entity qualified as an F
reorganization).
F.
Use of LLCs in Spin-Off Transactions
1.
Example 40 – Spin-Off
P Shareholders
D
S-1
S-2
S-3
S-4
Qualif. T/B
Qualif. T/B
Nonqualif.
Nonqualif.
a.
Facts: D is a holding company. It has four wholly owned
subsidiaries, S-1, S-2, S-3, and S-4. The subsidiaries are each
actively engaged in a trade or business for purposes of section 355.
S-3 and S-4, however, were acquired in taxable transactions during
the past five years. As a result, S-3 and S-4 are not engaged in
qualifying active businesses under section 355(b). D wants to
spin-off S-1 to its shareholders.
b.
Tax Consequences: Assuming that the value of S-3 and S-4
exceeds 10 percent of D’s net value, D will not be considered to be
engaged in an active trade or business, because “substantially all”
of its assets are not stock or securities in subsidiaries that are so
engaged. Section 355(b)(2).
c.
Alternatives
- 117 (i)
In order to satisfy the active trade or business requirement,
D could contribute the stock of S-3 and S-4 to S-2. After
the contribution, D would only hold stock of subsidiaries
engaged in qualifying active businesses, and should be able
to spin-off S-1 in a tax-free section 355 transaction.
(ii)
D could also liquidate S-2. D will then be considered to be
directly conducting an active trade or business and will not
be subject to the substantially all requirement. See Rev.
Rul. 74-79, 1974-1 C.B. 8.
(iii)
D could convert S-2 into a wholly owned LLC by merging
it into a newly formed LLC.
P Shareholders
D
S-1
S-2
Qualif. T/B
Qualif. T/B
LLC
S-3
S-4
Nonqualif.
Nonqualif.
Merger
(a)
The merger of S-2 into LLC should be treated as a
section 332 liquidation. Thus, as in alternative b,
above, D will then be considered to be directly
conducting an active trade or business. See Rev.
Rul. 74-79; P.L.R. 199952050 (Sept. 30, 1999).
(b)
This alternative provides an additional benefit of
shielding D’s assets from the liabilities of S-2. No
such protection exists where S-2 actually liquidates.
Further, D may not want to provide additional value
to S-2’s creditors by contributing the stock of S-3
and S-4.
- 118 (c)
(iv)
2.
Protecting one or more businesses from the risks of
another business may constitute a valid business
purpose for spin-off. See, e.g., Rev. Proc. 96-30,
1996-1 C.B. 696, Appendix A, § 2.09; Rev. Rul. 78383, 1978-2 C.B. 142; P.L.R. 200306033 (Nov. 5,
2002); P.L.R. 200215027 (Jan. 10, 2002); P.L.R.
199923011 (Mar. 2, 1999); P.L.R. 9827031 (Apr. 3,
1998); P.L.R. 9726012 (Mar. 28, 1997). However,
the ability to isolate contingent liabilities in singlemember LLCs may reduce the use of the risk
reduction business purpose set forth in Rev. Proc.
96-30.
Section 355 was amended in 2006 to obviate the need for
such restructuring to meet the active trade or business
requirement. Section 355(b)(3)(B) adopts an affiliated
group rule that treats all members of a corporation’s
separate affiliated group as one corporation for purposes of
satisfying the active trade or business requirement. Thus,
D and S-2 (as well as S-2 and S-4) would be treated as a
single corporation for purposes of the active trade or
business requirement, so there would be no need to
liquidate S-2.
Example 41 – Distribution of LLC Interests as a Spin-Off
A
B
D
LLC
C
- 119 -
a.
Facts: Individuals A and B own all of the stock of D. D owns all
of the interests in LLC, which is disregarded as a separate entity.
LLC owns all of the stock of C. D distributes all of the LLC
interests to A and B.
b.
Tax Consequences: Because LLC is disregarded, the transaction
should be treated as if D distributed all of the assets of LLC, and A
and B thereafter contributed such assets to a partnership in
exchange for partnership interests. See Rev. Rul. 99-5, 1999-1
C.B. 434. Thus, D is treated as distributing all of the stock of C.
Does the distribution qualify as a section 355 spin-off?
(i)
Because D is treated as owning 100 percent of the C stock
and is treated as distributing 100 percent of the C stock, and
assuming the active trade or business requirements are
satisfied, the distribution appears to qualify as a section 355
spin-off. See P.L.R. 200703030 (Oct. 17, 2006) (reaching
the same conclusion under a similar but more complicated
structure).
(ii)
However, the deemed transfer of the C stock to the
partnership immediately after the distribution raises certain
issues under section 355.
i.)
(a)
The transfer should not violate the device
requirement, because the transfer should be tax free
pursuant to section 721.
(b)
In addition, the transfer should not violate section
355(e), because A and B continue to own all of the
stock of C by reason of the attribution rules of
section 318(a)(2). Section 355(e)(4)(C)(ii).
(c)
The regulations under section 355 also impose a
continuity of interest requirement. Reg. § 1.3552(c). Regulations under section 368 addressing the
continuity of interest requirement for
reorganizations, provide considerable flexibility
with respect to post-reorganization dispositions.
Reg. § 1.368-1(e). However, these regulations do
not apply to section 355 transactions. Preamble to
Reg. § 1.368-1(e), 63 Fed. Reg. 4174, 4176 (Jan.
28, 1998).
It is unclear what test is applied in determining whether
continuity of interest is satisfied with respect to a spin-off.
- 120 ii.)
3.
A tax-free reorganization following a spin-off has been
held not to violate the continuity of interest requirement.
See Commissioner v. Mary Archer W. Morris Trust, 367
F.2d 794 (4th Cir. 1966); Rev. Rul. 70-434, 1970-2 C.B.
83. Presumably a tax-free drop of stock to a partnership
under section 721 should not violate the continuity of
interest requirement.
Example 42 – Avoiding the Requirements of Section 355
STEP 2
STEP 1
P
P
LLC
D
LLC
C
C
a.
Facts: P owns all of the stock of D. D owns all of the stock of C.
D wants to distribute C to P, but a section 355 spin-off is not
available. Thus, P forms a single-member LLC, which is
disregarded as a separate entity, and merges D into the LLC. LLC
then distributes all of the C stock to P.
b.
Tax Consequences:
(i)
Because LLC is disregarded as an entity separate from P, D
is treated as liquidating into P when it merges into the LLC.
See, e.g., P.L.R. 200104003 (Aug. 3, 2000); P.L.R.
200129024 (Apr. 20, 2001); P.L.R. 9822037 (Feb. 27,
1998); see also Reg. § 301.7701-3(g)(1)(iii) (an association
electing to be a disregarded entity is treated as distributing
- 121 all of its assets and liabilities to its owner in complete
liquidation).
4.
(ii)
What is the result if the requirements of section 355 are
satisfied? Does section 332 or 355 apply? The answer
could have implications not only with respect to P’s basis
in C but also with respect to D/LLC’s tax attributes.
(iii)
LLC is thereafter treated as a division of P, so the
distribution of the C stock to P is treated as an
interdivisional transaction, which is ignored for federal tax
purposes.
(iv)
The Service has reached the same conclusion under
essentially the same facts. See P.L.R. 200944011 (July 24,
2009); P.L.R. 200035031 (June 6, 2000).
(v)
Thus, P and D have achieved a tax-free distribution of the
C stock without the necessity of meeting all of the
requirements of section 355.
Example 43 - Avoiding the Requirements of Section 355: Distribution of
Assets
LLC-2
Interests
P
3
(Bus. A &
B)
S-2
LLC
Merge
LLC-2
6
5
1
S-1
LLC-2
Interests
P
(Bus. A)
LLC
S-2
(Bus. B)
(Bus. A)
4
Business A
2
LLC-2
- 122 a.
Facts: S-1 is a subsidiary of P engaged in the conduct of Business
A and Business B. As part of a larger restructuring, P wishes to
align all of its Business A operations under S-2 and its Business B
operations under S-1. In order to separate S-1’s Business A and B,
P forms LLC, a new disregarded entity. S-1 merges into LLC with
LLC surviving (or S-1 converts to an LLC under state law pursuant
to a state conversion statute). LLC forms LLC-2, a new
disregarded entity. LLC contributes all of S-1’s Business A assets
to LLC-2. LLC then distributes the LLC-2 interests to P. P, in
turn, contributes the LLC-2 interests to S-2. (Alternatively, LLC
might be able under state law to transfer the LLC-2 interests
directly to S-2 for no consideration.)
b.
Tax Consequences
c.
(i)
The transaction should be treated as a section 332
liquidation of S-1 followed by a contribution by P of S-1’s
assets to S-2 under section 351. See P.L.R. 200852003
(Sept. 25, 2008); P.L.R. 200830003 (July 25, 2008); P.L.R.
200420019 (Feb. 5, 2004) (note that the Service did not
express an opinion on this transaction).
(ii)
However, if the Business A assets constitute a significant
portion of S-1’s assets, the Service could apply the
liquidation-reincorporation doctrine to treat S-1 as having
transferred the Business A assets cross-chain to S-2 and
distributed the Business B assets to P in a taxable
distribution. If LLC-2 holds substantially all of S-1’s
assets, the combined steps may qualify as a cross-chain
section 368(a)(1)(D) reorganization.
(iii)
Alternatively, this transaction should qualify as a
reorganization of S-1 into P under section 368(a)(1)(C),
followed by a contribution of S-1’s assets to subsidiaries
controlled by P (i.e., S-2) under section 368(a)(2)(C). See,
e.g., Reg. 1.368-2(d)(4), (k); Rev. Rul. 69-617, 1969-2 CB
57.
What if S-1 converted back to a C corporation or made an election
to be taxed as a corporation following the distribution of LLC-2—
should the deemed liquidation be ignored and the distribution of
LLC-2 be treated as taxable? P.L.R. 200830003 (Apr. 25, 2008)
presented a similar set of facts, and the Service respected the form
of the transaction, concluding that the LLC conversion was a
section 332 liquidation and the subsequent reconversion to a C
corporation was a section 351 transaction.
- 123 d.
5.
Similarly, in P.L.R. 200843024 (July 16, 2008), the Service
respected the conversion of a disregarded entity into a corporation
after the distribution of a significant portion of its assets. The
Service ignored the distribution and concluded that the conversion
was a tax-free section 351 transaction.
Example 44– Section 355(e) Transaction
STEP 1
STEP 2
D
Shareholders
D
D
Shareholders
D
100%
C
P
33-1/3 %
66-2/3 %
LLC
C
a.
Facts: D distributes all of the stock of its wholly owned
subsidiary, C, in a tax-free spin-off pursuant to section 355. Six
months later, P offers to acquire the stock of C in a tax-free
reorganization. C agrees instead to a transaction wherein it drops
its assets into a newly formed LLC in exchange for 33-1/3 percent
of the LLC membership interests, and P drops some of its assets
into the LLC in exchange for 66-2/3 percent of the membership
interests.
b.
Tax Consequences:
(i)
Does this transaction qualify as a tax-free spin-off under
section 355?
(a)
Section 355(b)(1)(A) requires that D and C be
engaged immediately after the distribution in the
active conduct of a trade or business. Because C
has transferred all of its assets (and employees) to
LLC, it will not be directly engaged in the conduct
of an active trade or business. However, C’s 33-
- 124 1/3% ownership of LLC is a significant interest in
the LLC, so C should be treated as conducting the
business of LLC. Rev. Rul. 2007-42, 2007-2 C.B.
44. C may also qualify as conducting an active
trade or business if C can establish that, through its
officers, it performs active and substantial
management functions for LLC. Rev. Rul. 92-17,
1992-1 C.B. 142.
(b)
(ii)
The regulations under section 355 also contain a
continuity of business enterprise (“COBE”)
requirement. Reg. § 1.355-1(b). The preamble to
the final COBE regulations (Reg. § 1.368-1(d))
acknowledges that the proposed regulations did not
extend to transactions qualifying under section 355
and notes that “[t]he COBE provisions in the final
regulations apply to all reorganizations for which
COBE is relevant.” If the COBE regulations apply
to section 355 transactions, then C will be treated as
conducting the business of LLC, and thus, the
COBE requirement will be met, because C owns a
“significant interest” in LLC. See Reg. § 1.3681(d)(4)(iii)(B), -1(d)(5), Ex. 9.
Does the transfer of C’s assets to LLC avoid the application
of section 355(e)?
(a)
Section 355(e) provides in general that a
distributing corporation must recognize gain on the
distribution of the stock of a controlled corporation
if the distribution is part of a plan or series of
related transactions pursuant to which one or more
persons acquire, directly or indirectly, stock
representing a 50-percent or greater interest in
either the distributing or controlled corporation.
(b)
If P had acquired the stock of C in a tax-free
reorganization as part of the same plan as the
distribution, then D would be required to recognize
corporate-level gain under section 355(e).
(c)
In this example, however, P is not acquiring a 50percent or greater interest in C. Rather, P acquires a
66-2/3 percent interest in an LLC that owns the
assets previously held by C.
- 125 i.)
The Service appears to view these transactions as
acquisitions in violation of section 355(e). See P.L.R.
200905018 (Oct. 21, 2008) (note that section 355(e) did not
apply because section 355(d) applied, see section
355(e)(2)(D)); see also Sheryl Stratton, Corporate Regs
Highlighted, 2000 TNT 40-4 (Feb. 28, 2000); Preamble to
Prop. Reg. § 1.355-8, 69 Fed. Reg. 67,873 (2005) (both
indicating that the Service was looking closely at the issue).
ii.)
Regulations under section 355(e) appear to treat this
transaction as part of a plan.
iii.)
a)
The regulations generally treat as
part of a plan any acquisition that
was negotiated or agreed upon by the
parties in connection with a spin-off,
or a similar acquisition. The
regulations define “similar
acquisition” to include an acquisition
that effects a combination of all or a
significant portion of the same
business operations as the original
acquisition, and the ultimate owners
of the business operations are
substantially the same. Reg.
§ 1.355-7(h)(8).
b)
Is P’s acquisition of LLC “similar”
to the acquisition of C originally
negotiated? Does it matter what
portion of P’s assets were
contributed to the LLC? Does it
matter whether P originally
negotiated an acquisition of C’s asset
or stock? What if P acquires less
than 50 percent of the LLC interests?
Even if the acquisition is similar and, therefore, part of a
plan pursuant to the regulations, it arguably should not
constitute an acquisition within the meaning of section
355(e). Section 355(e)(3)(B) treats certain asset
acquisitions (i.e., A, C, or D reorganizations) as stock
acquisitions. Section 721 transactions are not mentioned,
but the statute gives the Service the authority to specify
other transactions in regulations.
- 126 iv.)
VII.
Although one could argue that the LLC should be viewed
as a successor of C for purposes of section 355(e),
proposed regulations appropriately reject treating the LLC
as a successor to C. Instead, they define successor by
reference to section 381 transactions. Prop. Reg. § 1.3558(c)(1).
USE OF LLCS IN CONSOLIDATED RETURN CONTEXT
A.
Selective Consolidation
1.
In General
By filing a consolidated return, an affiliated group of corporations may
combine their items of income, deduction, gain, and loss in the
computation of the group’s tax liability for the year. Under section 1501,
an affiliated group of corporations may file a consolidated tax return if
each member of the group consents to the election. Once the election is
made, each “includible corporation,” as defined in section 1504(b), that
becomes a member of the affiliated group must join in filing a
consolidated return with the existing consolidated group. Section 1501.
While an election to file a consolidated return may not be beneficial to the
group as a whole, it may be advantageous to combine the tax items of
some members of the group. However, the election to file a consolidated
return is an all-or-nothing proposition. Thus, to obtain the benefits of
combining the taxation of selected members of the group, the conversion
of an existing subsidiary into an LLC should be considered.
2.
Example 45 – Selective Consolidation
P
S-1
LLC
Merger
S-2
- 127 -
B.
a.
Facts: Corporation P owns all the stock of two corporations, S-1
and S-2. P does not want to file a consolidated return with S-2, but
would like to include S-1’s items of income, deduction, gain, and
loss with its own. To accomplish the integration of P and S-1 for
tax purposes, without the inclusion of S-2, S-1 merges into a newly
formed LLC.
b.
Tax Consequences: For federal tax purposes, this conversion
should be treated as a tax-free section 332 liquidation. See, e.g.,
P.L.R. 200104003 (Aug. 3, 2000); P.L.R. 200129024 (Apr. 20,
2001); P.L.R. 9822037 (Feb. 27, 1998); see also Reg. § 301.77013(g)(1)(iii) (an association electing to be a disregarded entity is
treated as distributing all of its assets and liabilities to its owner in
complete liquidation). Under the default rule, S-1 will be
disregarded as an entity separate from P. Thus, S-1 will be treated
as a division of P and all of S-1’s items of income, deduction, gain,
and loss will be included in the calculation of P’s tax liability.
Avoiding SRLY Limitations
1.
In General
When a corporation joins an affiliated group of corporations filing a
consolidated return, the new member’s tax attributes and items of income,
deduction, gain, and loss are generally taken into account in determining
the group’s overall tax liability for the year. However, the consolidated
return regulations restrict the use of certain tax attributes in determining
the group’s tax liability. The use of a new member’s losses by a
consolidated group is limited by the separate return limitation year
(“SRLY”) rules.
For example, if the new member has a net operating loss (“NOL”) when it
joins the consolidated group, the NOL is treated as a SRLY item, and its
use in offsetting the group’s consolidated taxable income is limited to the
income generated by the new member. In order to avoid a target
corporation’s losses from being characterized as SRLY, the target
corporation could be merged into a newly formed LLC wholly owned by
the common parent.
- 128 2.
Example 46 – SRLY Limitations
P
S-1
T
LLC
Merger
S-2
C.
a.
Facts: P is the common parent of an affiliated group of
corporations filing a consolidated return. P would like to acquire
T. T has a large NOL. In order to avoid the treatment of the NOL
as a SRLY item, P could acquire target by having T merge into a
wholly owned LLC pursuant to state law.
b.
Tax Consequences: Because P would be the sole owner of the
LLC, LLC would be disregarded as an entity separate from P, and
the merger of T into LLC should be treated as being directly into P.
(See Reg. § 1.368-2(b)(1), discussed above in Section VI.A.)
Therefore, P should succeed to all of T’s tax attributes under
section 381, and SRLY should not apply. However, it should be
kept in mind that P will not have unfettered use of T’s tax
attributes, because of the restrictions in sections 382, 383, and 384.
Avoiding Intercompany Transaction Rules
1.
In General
The fundamental policy goal of the intercompany transaction rules is to
treat the separate members of the consolidated group as divisions of a
single entity whenever possible. The primary means of effectuating this
policy is through the operation of the matching rule of Reg. § 1.150213(c)(1)(i) (the “matching rule”). Under the intercompany transaction
rules, when one member of the group sells property to another member of
the group, any gain or loss on the transaction is deferred until it is no
- 129 longer possible to treat the members as divisions of a single entity. Thus,
as long as an acceleration event has not taken place, gain or loss on the
sale between members will be deferred. Common examples of
acceleration events are the deconsolidation of the buyer or seller and the
sale of the property outside the group. In a variety of circumstances, these
rules may work to the disadvantage of the group. In such cases, the use of
an LLC is more beneficial to a consolidated group of corporations than the
use of a corporation.
2.
Example 47 – Intercompany Sale
Land
P
Cash
S-2
S-1
50%
LLC
S-3
50%
a.
Facts: Corporation P is the parent of an affiliated group of
corporations filing a consolidated return. P’s group has a large
NOL, which will expire at the close of the tax year. P owns
appreciated investment real estate on which it would like to build a
plant. Management of P would like to insulate P from any liability
associated with the new plant and find a way to utilize the group’s
expiring NOL. P sells the land to LLC, which is owned by two of
the P group members.
b.
Tax Consequences: Because both a corporation and an LLC afford
owners limited liability, shielding P from liability can be
accomplished by using either entity. P would like to sell the
property to the entity in order to generate gain to utilize all or a
portion of the expiring NOL. Unfortunately, a sale of the land to a
subsidiary would be deferred under the matching rule. On the
other hand, a sale of the property to a multi-owner LLC should
produce a different answer.
- 130 (i)
(ii)
c.
Under the default rule, a multi-member LLC is treated as a
partnership. Reg. § 301.7701-3(b)(1)(i). Thus, the entity is
not an includible corporation within the meaning of section
1504(b). A sale of the land to an LLC owned by S-1 and S3 should result in the current recognition of gain, because
the matching rule will not apply. See P.L.R. 9645015
(Aug. 9, 1996). By triggering this gain, P should be able to
utilize all or a portion of its expiring NOL. It should be
noted that, when the intercompany transaction regulations
were in proposed form, they contained an example that
would have deferred the recognition of gain or loss on the
transfer of property to a partnership controlled by the
members of the consolidated group. See Old Prop. Reg.
§ 1.1502-13(h)(2), Ex.2. However, this example was not
included in the final regulations.
(a)
In effect P would get a stepped-up basis in the land
paid for, in whole or in part, by the expiring NOL.
(b)
The Service could argue that the anti-abuse rules of
Reg. § 1.701-2 apply to this transaction and
disallow the gain.
(c)
Query whether the Service would apply the codified
economic substance doctrine to this transaction.
See section 7701(o).
It should be noted that this strategy will not work with a
single-member LLC. A single-member LLC may be
classified as either a disregarded entity (the default rule) or
as an association. In either case, a sale to a single-member
LLC will not avoid the intercompany transaction rules. In
the case of an LLC that is disregarded, such a sale would be
ignored for federal tax purposes as a sale to a division. See
Examples 1 and 2 above. In the case of an LLC taxed as an
association, the LLC would be treated as an includible
corporation and would be required to join the consolidated
group in filing a consolidated return. In such a case, the
matching rule would cause the gain on the sale to be
deferred.
What if, instead of triggering a gain to offset an expiring NOL, P
wanted to generate a loss to offset a capital gain? Under the facts
of this example, the loss would be deferred under section 267(f).
In testing whether (and to what extent) section 267 would apply to
P’s loss, related party status is tested between P and the members
of LLC. Reg. § 1.267(b)-1(b). S-1 and S-3, the members of LLC,
- 131 are related to P within the meaning of section 267(b) and are
members of P's controlled group within the meaning of section
267(f)(1). See also I.L.M. 200924043 (Mar. 9, 2009) (loss
recognized by first-tier subsidiary on a section 301 distribution to
its parent company that was deferred under section 267(f) can be
taken into account when the parent liquidates under section 331 as
a result of LLC conversion).
3.
Example 48 – Intercompany Debt
P
Business A
and P Note
Newco
Stock
S-2
S-1
Newco
S-3
D.
a.
Facts: Corporation P is the common parent of an affiliated group
of corporations filing a consolidated return. P contributed its
Business A and a P note to a newly formed subsidiary (“Newco”).
b.
Tax Consequences: P has unwittingly exposed itself to the highly
complex intercompany debt rules of Reg. § 1.1502-13(g)(3).
Under these regulations, many common transactions involving P,
Newco, or the intercompany obligation could trigger the deemed
satisfaction and reissuance rules of Reg. § 1.1502-13(g)(3). These
rules can often lead to harsh and seemingly unfair results.
Taxpayers should consider avoiding these rules through the use of
a single-member LLC as opposed to a corporate subsidiary.
Deconsolidation of Two-Member Consolidated Group
1.
In General
For a variety of reasons a two-member consolidated group may wish to
- 132 deconsolidate. Generally, if the consolidated group wishes to maintain
both entities, the group is required to continue filing consolidated returns
until the Secretary of the Treasury grants permission to deconsolidate. A
consolidated group will automatically terminate if the common parent is
no longer a member of the group, or the common parent no longer has any
subsidiaries. See Reg. § 1.1502-75(d).
2.
Example 49 – Deconsolidation Using a Single-Member LLC
P
100%
100%
S
LLC
Merger
E.
a.
Facts: Corporation P owns all of the stock of S. P and S file a
consolidated return. P forms a wholly owned LLC, which is
disregarded for federal tax purposes, and S merges into it.
b.
Tax Consequences: By merging the subsidiary into a singlemember LLC, the P group effectively terminates the consolidated
election, because LLC is disregarded for tax purposes. This
approach has the dual benefit of allowing the two entities to
combine their tax items for determination of tax liability for the
year, while avoiding the complexity of the consolidated return
regulations.
Avoid Triggering Restoration of Excess Loss Accounts
1.
In General
Another concept that is unique to consolidated groups is that of an excess
- 133 loss account (“ELA”), or negative basis,18 with respect to the stock of a
subsidiary. The group may wish to deconsolidate, but doing so will result
in gain to the parent corporation as a result of the restoration of the ELA
with respect to the subsidiary’s stock. One means of avoiding the gain on
the restoration of the ELA would be to liquidate the subsidiary into the
parent corporation. However, management of the parent corporation does
not wish to expose the assets of the parent corporation to the subsidiary’s
liabilities.
2.
Example 50 – Avoiding Trigger of ELAs
P
ELA
100%
S
LLC
Merger
a.
Facts: Corporation P owns all of the stock of S. P and S file a
consolidated return. P has an ELA in its S stock. P forms a wholly
owned LLC, which is disregarded for federal tax purposes, and S
merges into it.
b.
Tax Consequences: As a result of the merger, S will be treated as
liquidating into P. See, e.g., P.L.R. 200104003 (Aug. 3, 2000);
P.L.R. 200129024 (Apr. 20, 2001); P.L.R. 9822037 (Feb. 27,
1998); see also Reg. § 301.7701-3(g)(1)(iii) (an association
electing to be a disregarded entity is treated as distributing all of its
assets and liabilities to its owner in complete liquidation). Under
An ELA typically results from the use of the subsidiary’s losses in excess of the
parent’s stock basis or distributions in excess of parent’s stock basis in its subsidiary. See Reg.
§ 1.1502-19.
18
- 134 sections 332 and 337, the liquidation will be tax free to both P and
S, and under Reg. § 1.1502-19(e), the ELA will be eliminated.
Under the default rule, the single-member LLC will be disregarded
for tax purposes. Reg. § 301.7701-3(b)(1)(ii). Thus, P will be
treated as owning LLC’s assets directly. The merger should,
however, insulate P from the liabilities of S.
VIII. USE OF MULTI-MEMBER LLCs IN CORPORATE TRANSACTIONS
A.
Mergers Involving Multi-Member LLCs - The default classification for a multimember LLC is a partnership. Reg. § 301.7701-3(b)(1)(i). A partnership,
however, cannot be a party to a reorganization. See Section 368(b).
1.
Example 51 – Merger of Target Corporation Into LLC
P
99%
T
Shareholders
S
1%
T
LLC
Merger
a.
Facts: P and its wholly owned subsidiary, S, formed LLC, with P
receiving a 99-percent interest and S receiving a 1-percent interest.
LLC does not elect to be treated as an association. LLC acquires
the assets of T in exchange for LLC interests pursuant to a state
statute providing for corporation-to-partnership mergers.
b.
Tax Consequences: The merger should be treated as the transfer
by T of its assets and liabilities to LLC in exchange for LLC
interests, followed by a distribution of the LLC interests to the T
shareholders in complete liquidation. T will not recognize gain or
loss upon the transfer of its assets to LLC under section 721, but T
and its shareholders will recognize gain or loss upon the
liquidation under sections 331 and 336.
- 135 -
c.
(i)
In Rev. Rul. 69-6, 1969-1 C.B. 104, a stock savings and
loan merged into a nonstock savings and loan. The Service
ruled that the transaction did not qualify as a tax-free
reorganization under section 368(a)(1)(A) or (a)(1)(C),
because the continuity of interest requirement was not met.
Instead, the transaction was treated as a taxable sale of
assets, followed by a liquidation of the target corporation.
(ii)
The Service has relied on Rev. Rul. 69-6 to characterize the
merger of a corporation into a partnership as a section 721
transfer, followed by a complete liquidation of the
corporation. P.L.R. 200214016 (Dec. 21, 2001) (statutory
merger of corporation into partnership); P.L.R. 9701029
(Oct. 2, 1996) (statutory merger under Delaware law of a
corporation into an LLC classified as a partnership); P.L.R.
9701008 (Sept. 26, 1996) (statutory merger of corporation
into partnership); P.L.R. 9543017 (July 26, 1995) (merger
of S corporation into an LLC classified as a partnership);
P.L.R. 9404021 (Nov. 1, 1993) (statutory merger under
Louisiana law of a corporation into an LLC classified as a
partnership).
What if LLC used P voting stock, instead of LLC interests, as
consideration for the merger? There appear to be two alternative
ways to characterize such a transaction.
(i)
First, the transaction could be treated as (i) the transfer of T
assets to P in exchange for P stock, followed by (ii) the
contribution by P of the assets to LLC under section 721.
The transfer of T assets in exchange for P stock should
qualify as a reorganization under section 368(a)(1)(C). The
drop down of the assets to LLC will not violate the
continuity of business enterprise requirement, because P
and members of P’s group own a significant interest in
LLC. Reg. § 1.368-1(d)(4)(iii); see also P.L.R. 9727031
(Apr. 8, 1997).
(ii)
Alternatively, the transaction could be treated as (i) a
contribution of P stock to LLC, followed by (ii) a purchase
of the T assets by LLC using the P stock as consideration.
Although the contribution of P stock to LLC in step 1
should be tax free under section 721, step 2 would
constitute a taxable sale. Thus, T would recognize gain or
loss on the sale of its assets, and LLC would recognize gain
on the use of P stock in the taxable exchange, because LLC
would have a zero basis in the P stock under section 723.
But see T.A.M. 9822002 (Oct. 23, 1997) (ruling that a
- 136 partnership is properly treated as an aggregate of its
partners for purposes of applying section 1032 and
implying that a zero basis would not carry over to the
partnership where section 1032 applies).
2.
Example 52 – Merger of LLC Into Acquiring Corporation
P
99%
A
Shareholders
S
1%
A
LLC
Merger
a.
Facts: P owns a 99-percent interest in an LLC, and P’s subsidiary,
S, owns the remaining 1-percent interest in the LLC. LLC has not
elected to be treated as an association. LLC merges into A
Corporation pursuant to a state merger statute.
b.
Tax Consequences: The merger of LLC into A should be treated
as (i) the transfer of LLC’s assets to A in exchange for A stock,
followed by (ii) the distribution of A stock to P and S in
termination and liquidation of LLC.
(i)
LLC’s transfer of assets in exchange for A stock should
constitute a taxable exchange of assets. The transfer does
not qualify as a tax-free reorganization under section 368,
because LLC is not a corporation and, thus, cannot be a
party to the reorganization under section 368(b).
Moreover, the transfer would not qualify as a tax-free
section 351 exchange, unless LLC receives 80 percent or
more of A’s outstanding stock in the transfer.
- 137 (ii)
B.
Upon the distribution of A stock to the members, no
additional gain or loss should be recognized by P, S, or
LLC.
Example 53 – Multi-Member LLCs in the Consolidated Return Context
STEP 1
STEP 2
P
P
S
Stock
A
S
A
B
C
Merger
S
LLC
1.
Facts: P is the common parent of a consolidated group. P owns all of the
stock of A, and A owns all of the stock of S. In Year 1, A distributes all of
the stock of S to P, realizing gain under section 311(b), but deferring such
gain under Reg. § 1.1502-13. In Year 2, P decides that S’s business
should be conducted in partnership form. P forms two new corporations,
B and C, to be the members of a newly formed LLC. LLC does not elect
to be taxed as an association and is, thus, classified as a partnership by
default. S then merges into LLC pursuant to a state statute providing for
corporation-to-partnership mergers.
2.
Tax Consequences: These are the facts of T.A.M. 9644003 (July 23,
1996). The Service ruled that the merger of S into LLC was treated as the
transfer of assets by S to LLC in exchange for membership interests,
followed by the distribution of the LLC interests to P in complete
liquidation.
3.
Deferred Intercompany Gain - The Service further ruled in T.A.M.
9644003 that, as a result of the deemed transfers, S was treated as
redeeming its stock held by P. Thus, applying pre-July 12, 1995 law, A
was required to restore its deferred section 311 gain under Prior Reg.
§ 1.1502-13(f)(1)(vi).
- 138 Under the current regulations, the section 311 gain is accelerated under
Reg. § 1.1502-13(f)(5)(i) as a result of the deemed liquidation of S.
C.
Example 54 - Recognizing Losses Using Multi-Member LLCs
X
Y
2
$
Class A
Stock
X
$
$
Class
A
Business
Y
Public
3
Class B
Stock
Class
A
$
S
S
50%
50%
LLC
Interest
50% LLC
Interest
1
$
4
50%
20% LLC
Interest
1
LLC
LLC
X
Class
A
40%
Y
Public
Class B
S
Class
A
40%
20%
LLC
1.
Facts: X operates a business. X would like to raise additional capital, but
would still like to utilize future losses associated with the business. X
contributes the business, and Y contributes cash, to LLC in exchange for a
50-percent interest in LLC. X and Y then form a new corporation, S,
transferring a small amount of cash in exchange for Class A voting
- 139 common stock. S then issues Class B voting stock to the public in an IPO.
The Class A stock has 99 percent of the voting power and 1 percent of the
economic value, while the Class B stock has 1 percent of the voting power
and 99 percent of the economic value. S contributes the proceeds of the
IPO to LLC in exchange for a 20-percent interest in LLC.
2.
D.
Tax Consequences: The formation of LLC and S should be tax free under
sections 721 and 351, respectively. Moreover, X has raised capital for its
business, while retaining 40 percent of the future losses associated with
the business.
Change in Number of Members of Multi-Member LLC
1.
Example 55 – Conversion of Multi-Member LLCs Into Single-Member
LLCs
50% LLC Interest
A
B
$10,000
50%
50%
LLC
a.
Facts: A and B each own a 50-percent interest in LLC. A sells his
entire interest to B for $10,000. After the sale, the business is
continued by LLC, which is owned solely by B. LLC does not
elect to be taxed as an association.
b.
Tax Consequences: Upon the sale of A’s 50-percent interest to B,
LLC no longer has two owners, but rather has only a single owner.
Thus, under the default rules, LLC becomes a disregarded entity.
Reg. § 301.7701-3(b)(ii). The Service addressed the consequences
of this conversion in Rev. Rul. 99-6, 1999-1 C.B. 432.
(i)
Consequences to A. The partnership terminates under
section 708(b)(1)(A) when B purchases A’s entire interest
- 140 in the LLC. Thus, A must treat the transaction as a sale of
a partnership interest. See Reg. § 1.741-1(b).
(ii)
2.
Consequences to B. For purposes of determining the tax
consequences to B, the LLC is deemed to make a
liquidating distribution of all of its assets to A and B, and B
is then treated as acquiring those assets from A. See
McCauslen v. Commissioner, 45 T.C. 588 (1966).
(a)
B must recognize gain or loss, if any, on any
deemed distribution of cash in excess of B’s basis in
his partnership interest to the extent required under
section 731. B’s basis in these assets is determined
under section 732(b), and B’s holding period for
these assets includes the partnership’s holding
period for these assets under section 735(b).
(b)
With respect to the assets attributable to A’s 50percent interest, B takes a cost basis of $10,000
under section 1012, and its holding period for these
assets begins on the day immediately following the
sale. B is also subject to the residual method of
allocation of section 1060 if the acquisition
constitutes an applicable asset acquisition. See Reg.
§ 1.1060-1(b)(4).
Example 56 – Conversion of Multi-Member LLCs Into Single-Member
LLCs in the Consolidated Return Context
P
50% LLC Interest
Y
X
$10,000
50%
50%
LLC
- 141 a.
Facts: P owns all the stock of X and Y. P, X, and Y join in filing a
consolidated return. X and Y each own a 50-percent interest in
LLC. X sells its entire interest in LLC to Y for $10,000. After the
sale, the business is continued by LLC, which is owned solely by
Y. LLC does not elect to be taxed as an association.
b.
Tax Consequences: As set forth above in Example 55, Rev. Rul.
99-6 treats this transaction differently as to X and Y. Generally,
under the matching rule of Reg. § 1.1502-13(c), gain or loss
resulting from a sale of property between members of a
consolidated group is deferred until such time as it is no longer
possible to treat the members as divisions of a single entity (i.e.,
the occurrence of an acceleration event). However, because X is
treated as selling a partnership interest and Y is treated as
purchasing an interest in assets, Rev. Rul. 99-6 arguably precludes
the operation of the matching rule and causes acceleration of X’s
gain or loss.
(i)
Under Reg. § 1.1502-13(c)(1), the separate entity attributes
of X and Y are redetermined to the extent necessary to
produce the same effect on consolidated taxable income as
if X and Y were divisions of a single entity. If the
partnership interest sold by X is an attribute for purposes of
Reg. § 1.1502-13(c)(1), then the transaction could be
redetermined to treat X as selling assets to Y. By treating
X as selling assets to Y, the matching rule should operate to
defer any gain or loss on the sale. However, if the
partnership interest sold by X is not an attribute for
purposes of Reg. § 1.1502-13(c)(1), then one is still faced
with the question of how to apply the matching rule.
(ii)
The Service has, in a private letter ruling, reconciled Rev.
Rul. 99-6 and the matching rule. In P.L.R. 200334037
(May 13, 2003), the common parent of a consolidated
group and one of its subsidiaries owned interests in a
general partnership. The parent contributed cash to a newly
formed single-member LLC, and the LLC purchased the
subsidiary’s interest in the general partnership, thereby
terminating the partnership (since the parent was treated as
owning all of the partnership interests).
(a)
Under Rev. Rul. 99-6, the subsidiary treats the
termination as a sale of its partnership interest and
determines its income, gain, or loss under sections
741 and 751(a).
- 142 -
E.
(b)
In addition, under Rev. Rul. 99-6, the partnership is
deemed to make a liquidating distribution of all of
its assets to the parent and subsidiary, and the parent
is treated as acquiring the assets deemed distributed
to the subsidiary in liquidation of its partnership
interest.
(c)
The Service concluded that the sale by the
subsidiary of its partnership interest is an
intercompany transaction. In applying the matching
rule, the subsidiary’s intercompany items are the
income, gain, and/or loss realized from the sale of
the partnership interest; the parent’s corresponding
items are items with respect to the assets that it is
deemed to acquire from the subsidiary; and the
parent’s recomputed corresponding items are based
on the bases that the subsidiary would have had in
the assets had those assets been received in a
liquidating distribution. P.L.R. 200334037; see also
P.L.R. 200737006 (Sept. 27, 2006).
Treatment of Holder of Multi-Member LLC Interest as General or Limited
Partner
1.
Section 469 Passive Activity Loss Rules
a.
The passive activity loss rules generally limit the losses that may
be deducted by a taxpayer with respect to an activity in which the
taxpayer does not “materially participate.” The standard of
material participation for a taxpayer holding an interest in a limited
partnership as a limited partner is higher than that for a general
partner. See Temp. Reg. § 1.469-5T(e).
b.
The Service has previously taken the position that LLC members
should generally be treated as limited partners for purposes of the
material participation rules. See IRS Audit Guide, IRPO ¶
216,001.
c.
However, this position has been rejected by several courts. See
Gregg v. United States, 186 F. Supp. 2d 1123 (D. Ore. 2000);
Thompson v. United States, 87 Fed. Cl. 728 (2009), acquiesced in
result only, AOD 2010-002; Garnett v. Commissioner, 132 T.C.
368 (2009); Hegarty v. Commissioner, T.C. Summ. Op. 2009-153;
Newell v. Comm’r, TC Memo 2010-23.
d.
In November 2011, the IRS and Treasury issued proposed
regulations that provide that an interest in an entity will be treated
- 143 as a limited partnership interest if (i) the entity in which such
interest is held is classified as a partnership for Federal income tax
purposes under Treas. Reg. 301.7701-3 and (ii) the holder of such
interest does not have rights to manage the entity at all times
during the entity’s taxable year under the law of the jurisdiction in
which the entity was organized and under the governing
agreement. Rights to manage include the power to bind the entity.
Prop. Reg. § 1.469-5(e)
2.
IX.
Self-Employment Tax
a.
A general partner’s distributive share of income from the
partnership’s trade or business is subject to the self-employment
tax. Sections 1401, 1402(a). However, a limited partner’s
distributive share is generally excluded from the self-employment
tax. Section 1402(a)(13).
b.
Where a general partnership has converted to an LLC taxed as a
partnership, the Service has ruled that the LLC members’
distributive shares were subject to the self-employment tax. See
P.L.R. 9525058 (Mar. 28, 1995); P.L.R. 9452024 (Sept. 29, 1994);
P.L.R. 9432018 (May 16, 1994).
c.
In an effort to address the limited partner exclusion more fully in
the context of LLCs, the Service issued proposed regulations in
1997. Prop. Reg. § 1.1402-2, 62 Fed. Reg. 1702 (1997). These
proposed regulations were widely criticized as an attempt by
Treasury and the Service to impose new taxes on partners.
Congress responded in the Taxpayer Relief Act of 1997, P.L. 10534, by placing a moratorium on the issuance of regulations
defining the term “limited partner” for purposes of the selfemployment tax until July 1, 1998.
d.
Thus, the treatment of LLC members for purposes of the selfemployment tax is currently uncertain.
DISADVANTAGES OF USING LLCs
As set forth above, there appear to be a number of circumstances in which it may prove
more beneficial to operate a business in the form of an LLC as opposed to a corporation.
However, there are also situations in which use of an LLC may prove less beneficial.
Besides the disadvantages listed below, additional disadvantages may arise under state
law. For a discussion of issues arising under state law, see section XI below.
A.
Certain LLCs Cannot Be Parties to Reorganizations
1.
In General
- 144 Except as provided in Reg. § 1.368-2(b)(1) (permitting A reorganizations
involving disregarded entities), LLCs that are classified as either
partnerships or as disregarded entities may not be parties to a
reorganization. See section 368(b). Thus, the owners of such LLCs may
not dispose of their interests in the LLC via a tax-free reorganization. In
addition, it appears that an attempt to convert such an LLC into a
corporation immediately before a reorganization will be disregarded. See
Rev. Rul. 70-140, 1970-1 C.B. 73.
2.
Example 57– Achieving Results Similar to a Tax-Free Reorganization
P
100%
LLC
X
Pref’d
Stock
Assets
Assets
Newco
Common
Stock
a.
Facts: Corporation P owns all of the membership interests in LLC.
LLC has not elected to be taxed as an association. X would like to
acquire LLC in a tax-free transaction. LLC transfers all of its
assets to a newly formed corporation (“Newco”), in exchange for
Newco preferred stock. At the same time X Corporation
contributes property to Newco in exchange for common stock. In
order to convert P’s interest in LLC into stock of X, the Newco
preferred stock is convertible into the X stock after a period of
years. The conversion feature requires P to present its Newco
stock to X for conversion into X stock.
b.
Tax Consequences: The transaction should qualify as a tax-free
exchange under section 351.
(i)
The preferred stock received by LLC in the section 351
exchange should not constitute nonqualified preferred stock
within the meaning of section 351(g)(2), provided it does
not contain any of the terms enumerated in that section.
- 145 -
B.
(ii)
However, the right to convert the Newco stock into X stock
may be treated as boot to P. See Rev. Rul. 69-265, 1969-1
C.B. 109, providing that the right to convert the Newco
stock into X stock (obtained directly from X) constitutes
boot on the initial transfer of property to Newco. Thus, the
fair market value of the right to convert the Newco stock
into X stock would be taxable to P at the time LLC
transfers all its assets to Newco.
(iii)
Conversely, if the conversion option requires P to obtain
the X stock directly from Newco, the conversion right will
not be treated as boot to P when LLC transfers its assets to
Newco. However, the subsequent exercise of this right
would result in a taxable transaction to P. Thus, P’s goal of
obtaining X’s stock in a tax-free transaction would be
frustrated. In addition, Newco may be forced to recognize
gain on the conversion (under the zero basis rules) equal to
the difference between its basis in the X stock and the
stock’s fair market value.
Spinning Off a Lower Tier LLC
1.
In General
For valid business reasons a corporation may want to distribute the assets
associated with a trade or business carried on by the corporation. If the
trade or business is carried on through a corporate subsidiary, the
distribution may be accomplished by distributing the stock of the
subsidiary to the parent corporation’s shareholders. Assuming all the
requirements of section 355 are satisfied, the distribution of stock of the
subsidiary will be tax free to both the parent corporation and its
shareholders. However, such result cannot be obtained using a
disregarded entity without first undertaking to convert the disregarded
entity to a corporation.
- 146 2.
Example 58 – Spin-off of an LLC
P
Shareholders
P
100%
Newco
Stock
LLC
Assets
N Stock
Newco
a.
Facts: Corporation P owns all of the membership interests in LLC.
LLC has not elected to be taxed as an association. P would like to
distribute the interests of LLC to its shareholders in a tax-free spinoff. LLC transfers all of its assets to a newly formed corporation
(“Newco”), in exchange for Newco stock. P then distributes the
Newco stock to its shareholders in a section 355 spin-off.
b.
Tax Consequences: Because LLC is disregarded as an entity
separate from P, P is treated as owning LLC’s assets directly. If P
were to spin-off LLC directly, P would be treated as having
distributed assets to its shareholders and would be required to
recognize gain under section 311. Accordingly, in order to effect a
tax-free spin-off of LLC to P’s shareholders, P must first effect a
reorganization within the meaning of section 368(a)(1)(D) by
transferring LLC’s assets to a newly formed subsidiary. Following
this D reorganization, P may distribute the Newco stock to its
shareholders in a tax-free spin-off.
c.
Alternatively, LLC could convert into, or elect to be classified as,
an association. Because, LLC would then be treated as a
corporation for all federal income tax purposes, P could distribute
its membership interests in LLC to its shareholders in a section 355
spin-off. See P.L.R. 201033019 (May 20, 2010); P.L.R.
- 147 200422003 (Feb. 13, 2004); P.L.R. 200411034 (Dec. 10, 2003); cf.
P.L.R. 200306033 (Nov. 5, 2002) (where a spin-off of a QSub
terminated its election resulting in a deemed contribution of the
QSub’s assets to a new corporation; deemed contribution treated as
a D reorganization).
C.
Loss of Basis in the Stock of a Corporate Subsidiary
1.
In General
In the conversion of a corporate subsidiary into an LLC, the subsidiary is
usually deemed to liquidate. While this liquidation is generally tax free to
both the subsidiary and its parent corporation, it also presents a potential
downside to the parent corporation. When a subsidiary liquidates into its
parent, the parent’s basis in the subsidiary’s stock is permanently lost.
Thus, in situations where the parent paid a premium for the stock of the
subsidiary and did not make an election under section 338(g) or (h)(10),
the loss of basis may be too high a cost for the benefit offered by
converting to an LLC.
2.
Example 59 – Disappearing Basis
P
$300
Basis
100%
S
LLC
Merger
a.
Facts: Corporation P owns all of the stock of S. P and S file a
consolidated return. P acquired the stock of S five years ago and
has a basis of $300 in the stock. S’s assets have an aggregate basis
equal to $50. P forms a wholly owned LLC, which is disregarded
for federal tax purposes, and S merges into it.
- 148 b.
X.
Tax Consequences: As a result of the merger, S will be treated as
liquidating into P. See, e.g., P.L.R. 200104003 (Aug. 3, 2000);
P.L.R. 200129024 (Apr. 20, 2001); P.L.R. 9822037 (Feb. 27,
1998); see also Reg. § 301.7701-3(g)(1)(iii) (an association
electing to be a disregarded entity is treated as distributing all of its
assets and liabilities to its owner in complete liquidation). Under
sections 332 and 337, the liquidation will be tax free to both P and
S, and P will take a $50 carryover basis in those assets. Because S
has liquidated, P’s $300 basis in S disappears.
OTHER ISSUES
A.
Treatment of Indebtedness
1.
Whose Debt Is It—the Disregarded Entity’s or the Owner’s?
a.
If one follows the general rule of the regulations that a disregarded
entity is disregarded for all federal tax purposes, then one would
conclude that debt of a disregarded entity is treated as debt of its
owner. See P.L.R. 200938010 (Jun. 11, 2009) (as a result of
conversion of subsidiary into disregarded entity, payment in kind
facility of subsidiary becomes outstanding obligation of parent).
Because for state law purposes, a creditor on a recourse obligation
of the disregarded entity has recourse only against the assets of the
disregarded entity, it would appear that the debt should be treated
as nonrecourse with respect to the owner.
b.
This is the approach taken by Example 6 of Reg. § 1.465-27(b)(6).
In that example, A wholly owns an LLC, X, which borrows money
to purchase real estate. X is personally liable on the debt, and the
lender may proceed against X’s assets if X defaults. The example
concludes that, with respect to A, the debt will be treated as
qualified nonrecourse financing secured by real property.
c.
This is also the approach taken by Reg. § 1.752-2(k). The
regulations view the owner of a disregarded entity that holds a
partnership interest as the partner; however, the partner’s share of
partnership debt is viewed as recourse only to the extent of the net
value of the disregarded entity.
d.
Modification of Debt – However, for purposes of determining
whether there has been a modification of debt for purposes of Reg.
§ 1.1001-3, the Service has looked to the state law rights of the
debtor and creditor and respected the debt of the disregarded
entity. P.L.R. 200315001 (Sept. 19, 2002).
- 149 (i)
Reg. § 1.1001-3(b) provides that a modification of a debt
instrument will result in a taxable exchange only if it is a
“significant modification.”
(a)
A modification is any alteration, including a change
in obligor, the addition or deletion of a co-obligor,
or a change in the recourse or nonrecourse nature of
the instrument. Reg. § 1.1001-3(c)(1), (2)(i).
(b)
A modification is significant if legal rights that are
altered and the degree to which they are altered are
economically significant. Reg. § 1.1001-3(e)(1).
For example, a change in obligor on a recourse debt
instrument is a significant modification, but a
change in obligor on a nonrecourse instrument is
not. Reg. § 1.1001-3(e)(4)(i)(A), (e)(4)(ii). In
addition, a change in the recourse or nonrecourse
nature of a debt obligation is a significant
modification, unless it continues to be secured by
the same collateral. Reg. § 1.1001-3(e)(5)(ii).
(ii)
In P.L.R. 200315001 (Sept. 19, 2002), the Parent group
restructured into a holding company structure with Parent
becoming a wholly owned subsidiary of New Parent.
Parent then converted to a single-member LLC, LLC1.
Parent achieved this conversion by filing a certificate, not
by merging into a new legal entity.
(iii)
The Service determined that under the applicable State A
law, the conversion of Parent into LLC1 would not affect
the legal rights or obligations between debt holders and
Parent because, as a matter of State A law, LLC1 remains
the same legal entity as Parent. The Service therefore
determined that the conversion of Parent into LLC1 did not
result in either a change in the obligor or a change in the
recourse nature of the debt; therefore, there was no
modification of the debt for purposes of Reg. § 1.1001-3.
See also P.L.R. 201010015 (Nov. 5, 2009); P.L.R.
200709013 (Nov. 22, 2006); P.L.R. 200630002 (Apr. 24,
2006).
(iv)
Arguably, the debt modification rules are unique and
warrant treating the debt as that of the disregarded entity,
because such rules seek to determine whether there has
been a change in the legal rights or obligations of the
debtor and creditor, and state law controls such rights and
obligations.
- 150 2.
Cancellation of Debt (“COD”) Income
a.
Arguably, the debt of a single-member LLC is treated as debt of its
owner. However, for state law purposes, the LLC is the obligor.
Thus, a creditor can cancel debt of an LLC. How does section 108
apply to this cancellation?
b.
In general, section 108(a) provides that gross income does not
include income from the discharge of indebtedness, if the
discharge occurs in a title 11 bankruptcy case, or if the discharge
occurs when the taxpayer is insolvent.
(i)
(ii)
What if the debt of a single-member LLC, which is a
disregarded entity, is discharged in a title 11 bankruptcy
proceeding? Is its owner permitted to exclude the COD
income?
(a)
Section 108(d)(2) defines a “title 11 case” to
include “a case under title 11 of the United States
Code, but only if the taxpayer is under the
jurisdiction of the court in such case and the
discharge of indebtedness is granted by the court or
is pursuant to a plan approved by the court.”
(Emphasis added.)
(b)
The owner of the single-member LLC is the
taxpayer, and only a portion of its assets (those
owned by the LLC) are under the jurisdiction of the
bankruptcy court. Thus, it would appear that the
owner is not entitled to exclude the COD income.
(c)
Proposed regulations issued in April 2011 provide
that the taxpayer for purposes of section 108 is the
owner of the disregarded entity, so if the
disregarded entity is under the jurisdiction of the
court in a Title 11 case, but the owner of the
disregarded is not, the owner cannot exclude the
COD income. Prop. Treas. Reg. § 1.108-9(a).
Now assume that a debt of a single-member LLC is
discharged, but the discharge does not occur in a title 11
case (and the other exceptions for farm indebtedness or real
property business indebtedness do not apply). In order to
exclude the COD income, the taxpayer must be insolvent.
At what level is insolvency tested? Because the LLC is a
disregarded entity, insolvency would be tested at the owner
level. Thus, if the owner is solvent, and a debt of the LLC
- 151 is discharged, presumably the owner has COD income,
even if the LLC is insolvent.
(a)
(iii)
c.
3.
Proposed regulations issued in April 2011 provide
that the insolvency exception is only available to the
extent the owner is insolvent. Prop. Treas. Reg. §
1.108-9(a).
For purposes of the qualified real property business
indebtedness exception to section 108, the Service has
concluded that both the debt and the real property securing
the debt may be held in disregarded entities. In P.L.R.
200953005 (Sept. 23, 2009), the taxpayer, an LLC taxed as
a partnership, owned through another disregarded entity all
of disregarded Borrower LLC, which incurred the debt.
Borrower LLC owned all of disregarded Owner LLC,
which owned the real property securing the debt. The
Service concluded that the taxpayer was treated as
incurring the debt and owning the property directly for
purposes of the qualified real property business
indebtedness exception of section 108.
Section 108(b) requires that the amount excluded from income
under section 108(a) be applied to reduce certain tax attributes.
Presumably, such attribute reduction is not limited to the attributes
of the single-member LLC, but rather all attributes of the owner
are potentially subject to reduction.
Indebtedness to Owner of Disregarded Entity
a.
Debt between a disregarded entity and its owner is disregarded
because the debtor and the creditor are one in the same. Thus, the
owner may not take a section 166 bad debt deduction when the
obligee is the disregarded entity. P.L.R. 200814026 (Dec. 17,
2007).
b.
Changes in ownership of a disregarded entity can result in changes
in the status of debt owed by the disregarded entity to its owner.
c.
Disregarded debt becomes regarded
(i)
If a disregarded entity is indebted to its owner, such debt is
disregarded for federal tax purposes. However, if the
owner contributes all of the interests in the disregarded
entity to a subsidiary, the debt is no longer between
divisions of the same company. As such, the debt becomes
regarded.
- 152 -
d.
19
(ii)
What are the tax consequences? It would appear that the
debt would be treated as newly issued. If the face amount
exceeds the issue price, there would be original issue
discount.
(iii)
If a taxpayer inadvertently moves debt and it becomes
regarded, the Service may permit the taxpayer to rescind
the movement of the debt. See P.L.R. 201021002 (Feb. 19,
2010).
Regarded debt becomes disregarded
(i)
If a disregarded entity is indebted to a subsidiary of its
owner, it is treated as if the owner is indebted to the
subsidiary. If the owner contributes all of the interests in
the disregarded entity to the creditor subsidiary, the
obligation is transferred to the creditor subsidiary and the
debt becomes disregarded.
(ii)
What are the tax consequences? It would appear that the
merger of the debtor and creditor interests results in the
extinguishment of the debt. If the contribution of the
disregarded entity interests is treated as a section 351
transaction, the transfer of the P’s obligation to S should be
viewed as the assumption of a liability for purposes of
section 357(c). See Kniffen v. Commissioner, 39 T.C. 553
(1962), acq., 1965-2 C.B. 5; Rev. Rul. 72-464, 1972-2 C.B.
214.
(iii)
The Service will apparently respect self-help measures to
extinguish intercompany debt. In P.L.R. 200830003 (July
25, 2008), P owned all of the stock of Sub 1, which in turn,
owned stock of lower tier subsidiaries. Sub 1 was indebted
to P. Sub 1 converted into a single-member LLC, which
was treated as tax-free19 and resulted in an extinguishment
of the intercompany debt. Sub 1 (which was then
disregarded) distributed its subsidiary to P and then
reconverted into a corporation in a deemed section 351
transaction. Thus, by converting into a disregarded entity
and then reconverting, P and Sub 1 were able to extinguish
The ruling does not specify whether the conversion qualified as tax-free under section
332 or section 368; the taxpayer made representations for both a section 332 liquidation and a
section 368(a)(1)(C) reorganization.
- 153 their intercompany debt and transfer an asset from Sub 1 to
P tax free.
B.
Treatment of Outstanding Interests as Equity
1.
Automatic Classification Change - If a single-member LLC, which is
treated as a disregarded entity, has outstanding third-party debt that is
recharacterized by the Service as equity, the LLC is automatically
reclassified as a partnership, because it no longer has a single member.
Reg. § 301.7701-3(f)(2).
2.
Example 60 – Convertible Debt
P
A
100%
Convertible
Debt
Cash
LLC
a.
Facts: P owns 100 percent of LLC, which is a disregarded entity.
LLC issues indebtedness to A Corporation, which is secured by
LLC’s assets. The debt is convertible at A’s option into a
membership interest in LLC.
b.
Tax Consequences: As discussed above, it is not clear whether the
debt is treated as debt of P or of LLC. Nonetheless, prior to the
conversion of the debt (and assuming the debt is not considered
equity), LLC should not be considered to have more than one
member.
(i)
How should the conversion feature be treated? If the debt
is considered to be issued by P, it is not convertible into
stock of P. Rather, it is convertible into an interest in an
entity that does not yet have a separate existence. Should
the conversion feature be considered an option to acquire P
assets? Does it matter whether P has guaranteed the debt?
- 154 (ii)
3.
C.
If A exercises its conversion option and receives
membership interests in LLC, LLC will no longer have a
single member and, thus, will automatically be reclassified
as a partnership. Reg. § 301.7701-3(f)(2). A will be
treated as having purchased assets from P and contributed
them to a newly formed partnership. See Rev. Rul. 99-5,
1999-1 C.B. 434; see also Example 15, above.
Granting Nonvested Equity Interests to Employees
a.
A grant of a nonvested equity interest to an employee should not
result in the entity’s having more than one owner until such
property becomes substantially vested. Until that time, the
transferor is treated as the owner of the property. See Reg. § 1.831(a), (f), Ex. 1.
b.
However, if the employee makes a section 83(b) election to
include the value of the property in gross income, the employee
may be treated as an owner of the LLC.
Start-Up v. Expansion Costs
1.
Section 195 provides, in pertinent part, that start-up expenditures may, at
the election of the taxpayer, be deducted ratably over a period of not less
than five years beginning with the month the business began. In general,
start-up expenditures are amounts paid or incurred in connection with the
creation or acquisition of an active trade or business. Amounts paid or
incurred after the beginning of an active trade or business may be
currently deducted under section 162. Thus, costs to expand an existing
trade or business are currently deductible under section 162.
2.
For purposes of claiming a deduction for expansion costs under section
162, the existing business of a parent corporation cannot be attributed to
its subsidiaries. See Specialty Restaurants Corp. v. Commissioner, T.C.
Memo. 1992-221. In Specialty Restaurants, a parent corporation formed
nine subsidiaries for the purpose of establishing and operating theme
restaurants. Pre-opening expenses were incurred, which were paid by the
parent corporation. The Tax Court held that because the subsidiaries were
separate entities apart from the parent, the expenses did not constitute
expansion costs deductible by the parent, but rather could only be
amortized as start-up costs by the subsidiaries. Accordingly, the parent’s
payment of such expenses constituted a capital contribution to the
subsidiaries.
3.
The parent corporation in Specialty Restaurants could use single-member
LLCs to convert the amortizable start-up costs into deductible expansion
costs. Because the single-member LLCs are disregarded as entities
- 155 separate from the parent, the activities of the LLCs will be treated as an
expansion of the parent’s existing trade or business, thus allowing a
current deduction.
D.
Like-Kind Exchanges
1.
In General - Section 1031(a) provides that no gain or loss is recognized on
the exchange of property held for productive use in a trade or business or
for investment if such property is exchanged solely for property of like
kind, which is to be held either for the productive use in a trade or
business or for investment. Section 1031(a)(3) permits deferred
exchanges if the replacement property is identified and received within the
specified time limitations.
2.
Qualifying property
a.
Section 1031(a)(2)(D) – Section 1031(a)(2)(D) provides that an
exchange of an interest in a partnership is not eligible for
nonrecognition treatment under section 1031. Presumably, a
similar limitation exists with respect to interests in an LLC that is
classified as a partnership. Use of a single-member LLC, however,
may permit section 1031 exchanges of property held by the LLC
b.
Example 61 – 1031 Exchange
A
B
Interests in LLC-2
C
LLC-1
Apartment Complex
LLC-2
(i)
LLC-2
Facts: LLC-1, a two-member LLC, owns all of the
membership interests in LLC-2, which has not elected to be
taxed as an association. LLC-2 owns an apartment
- 156 complex. An individual, C, also owns an apartment
complex. LLC-1 transfers its interest in LLC-2 to C in
exchange for the apartment complex owned by C.
(ii)
3.
Tax Consequences: Because LLC-2 is disregarded as an
entity separate from LLC-1, LLC-1 is deemed to own the
assets of LLC-2, including the apartment complex, directly.
Thus, the transaction should qualify for section 1031
nonrecognition treatment. See P.L.R. 200118023 (Jan. 31,
2001).
Acquiring Replacement Property – As noted above, section 1031 permits
deferred exchanges if the taxpayer acquires replacement property within
the specified time limitations.
a.
The use of single-member LLCs may provide added flexibility in
the acquisition of replacement property.
(i)
For example, in P.L.R. 9751012 (Sept. 15, 1997), the
taxpayer corporation held all of the stock of two
subsidiaries. The subsidiaries transferred their hotel
properties and identified replacement property. Before
acquiring the replacement property, however, the
subsidiaries liquidated, and the taxpayer corporation
formed separate, wholly owned LLCs for each replacement
property. The Service ruled that the transaction qualified
under section 1031. The taxpayer succeeded to the
subsidiaries’ tax attributes in the liquidation, including their
status with respect to the section 1031 exchanges, so the
taxpayer was treated as the transferor. The taxpayer was
also treated as the transferee of the replacement property,
because the assets of the LLCs are treated as owned
directly by their owner. See also P.L.R. 200131014 (May
2, 2001); P.L.R. 199911033 (Dec. 18, 1998); P.L.R.
9850001 (Aug. 31, 1998); P.L.R. 9807013 (Nov. 13, 1997).
(ii)
In P.L.R. 200732012 (May 11, 2007), the taxpayer owned
LLC1, which in turn, owned LLC2, both of which were
disregarded entities. LLC1 entered into a like-kind
exchange agreement with a qualified intermediary with
respect to hotel property owned by LLC1. The qualified
intermediary contract was assigned to LLC2 and then to the
taxpayer. The taxpayer formed LLC3, another disregarded
entity, which acquired replacement property. The Service
concluded that the entire arrangement was treated as taking
place within the taxpayer and, therefore, qualified under
section 1031.
- 157 (iii)
b.
E.
In P.L.R. 200807005 (Nov. 9, 2007), the taxpayer was a
limited partnership engaged in the real estate business. The
taxpayer transferred real estate to a qualified intermediary,
formed a single-member LLC, and caused the LLC to
acquire 100% of the interests in a partnership owning the
replacement property. The Service concluded that (i) the
taxpayer was deemed to acquire the assets of the
partnership because the partnership became a disregarded
entity upon its acquisition by a single owner, Rev. Rul. 996, and (ii) because LLC was disregarded, the taxpayer was
treated as acquiring the replacement property directly.
Accordingly, the arrangement qualified under section 1031.
Similar flexibility should be permitted in acquiring replacement
property for purposes of the involuntary conversion provisions of
section 1033. See P.L.R. 199945038 (Aug. 18, 1999); P.L.R.
199909054 (Dec. 3, 1998).
Personal Holding Companies
1.
A personal holding company (“PHC”) is a corporation (i) at least 60
percent of the adjusted ordinary gross income of which is PHC income
(i.e., dividends, interest, royalties, and certain rents), and (ii) more than 50
percent of the stock of which is owned by five or fewer individuals. PHCs
are subject to an additional tax of 39.6 percent on their undistributed PHC
income. See sections 541-547.
2.
A consolidated group may apply the PHC rules on a consolidated basis.
Reg. § 1.542-4. However, if any member of the group (i) derives 10
percent or more of its income from outside the group, and (ii) 80 percent
or more of such outside income is PHC income, then the PHC rules apply
on a separate company basis.
3.
Disregarded Entities May Be Useful in Avoiding the PHC Tax
a.
A corporation with 60 percent PHC income may convert active
subsidiaries into disregarded entities so that their active income
flows up and dilutes the corporation’s PHC income below 60
percent.
b.
Similarly, a member of a consolidated group that meets the 10/80
test to cause the PHC rules to apply on a separate company basis
can be converted into a disregarded entity in order to combine its
income with that of its parent in an effort to avoid meeting the
10/80 test.
- 158 F.
Employment Issues
1.
Employer Identification Number (“EIN”)
a.
The final check-the-box regulations did not address the issue of
whether a disregarded entity is required or permitted to obtain its
own EIN. The regulations under Reg. § 301.6109-1 were
subsequently amended to add special rules for disregarded entities.
The amendments provide that a disregarded entity “must use its
owner’s taxpayer identification number (“TIN”) for federal tax
purposes.” Reg. § 301.6109-1(h)(2)(i) (emphasis added).
Moreover, the amendments provide that when a disregarded entity
becomes recognized as a separate entity, the entity “must acquire
an EIN and not use the TIN of the single owner.” Id. § 301.61091(h)(2)(ii) (emphasis added). This language could be interpreted to
mean that a disregarded entity is not permitted to obtain an EIN
that is separate from its owner’s.
(i)
2.
Similar rules apply for QSubs. See Reg. § 301.6109-1(i)(1)
& (i)(2).
b.
However, the preamble to the amendments provides that there is
no restriction on a disregarded entity obtaining its own EIN. 64
Fed. Reg. at 66,582. For example, some states may require that the
disregarded entity have its own EIN.
c.
The Service has ruled that if a partnership becomes a disregarded
entity, or vice versa, by reason of a change in the number of
owners, and the disregarded entity calculates, reports, pays its
employment taxes under its own name and EIN pursuant to Notice
99-6, the entity retains its EIN upon the automatic classification
change. Rev. Rul. 2001-61, 2001-2 C.B. 573.
d.
In Rev. Rul. 2008-18, 2008-13 I.R.B. 674, the Service ruled that
when an S corporation becomes a QSub of a newly formed
corporation in a section 368(a)(1)(F) reorganization, the new
corporation must obtain a new EIN. The QSub must retain its
original EIN and use it for employment and excise tax purposes
and whenever it is treated as a separate corporation.
Employment and Withholding Taxes – Is a disregarded entity considered
an employer for federal employment tax purposes? The Service’s position
on this issue has evolved over time.
a.
The Service had initially concluded that the owner of the
disregarded entity was considered the employer for employment
tax purposes. Notice 99-6, 1999-1 C.B. 321; I.L.M. 199922053
(Apr. 16, 1999).
- 159 (i)
This was consistent with the general rule in Reg.
§ 301.7701-1(a) that the check-the-box regulations apply
for “federal tax purposes,” which implies applicability for
all federal tax purposes, including the Code’s employment
tax provisions.
(ii)
Moreover, this was consistent with cases and rulings
dealing with employees of divisions or branches. See In re
Rutherford, 95-1 U.S.T.C. ¶ 50,281 (S.D. Ohio 1995)
(shareholder/president of corporation that had two separate
divisions was the responsible party for withholding tax
purposes); T.A.M. 8422012 (Feb. 8, 1984) (employees of
both divisions of a corporation were held to be employees
of the corporation); T.A.M. 7939011 (June 13, 1979)
(parent corporation was the employer for withholding and
FICA tax purposes, even though regular wages were paid
by the corporation’s separate divisions or subsidiaries).
(iii)
Recognizing the administrative difficulties faced by
employers operating through disregarded entities in
reporting for state law purposes the Service provided some
flexibility. In Notice 99-6, the Service provided that until
final guidance was issued, the Service would generally
accept reporting and payment of employment taxes with
respect to employees of a QSub or an entity disregarded as
an entity separate from its owner under Reg. § 301.7701-2
if made in one of two ways.
(a)
First, calculation, reporting, and payment of all
employment tax obligations with respect to
employees of a disregarded entity by its owner (as
though the employees of the disregarded entity are
employed directly by the owner) and under the
owner’s name and the owner’s EIN.
(b)
Second, separate calculation, reporting, and
payment of all employment tax obligations by each
state law entity with respect to its employees under
its own name and EIN. If the second method was
chosen, the owner retained ultimate responsibility
for employment tax obligations of the owner
incurred with respect to employees of the
disregarded entity. The Service reiterated the
applicability of this Notice in the preamble to the
amendments. 64 Fed. Reg. at 66,582.
- 160 b.
The Service ultimately concluded that because most states
recognize disregarded entities as separate employers for reporting,
payment, and collection of employment taxes, it would be simpler
to align federal and state practices.
(i)
Thus, on August 16, 2007, the Service adopted final
regulations that treat employment taxes as obligations of
the disregarded entity, thereby reversing Notice 99-6. Reg.
§ 301.7701-2(c)(2)(iv).
(ii)
Nonetheless, the entity will be disregarded for all other
purposes (e.g., the owner would still be treated as selfemployed for purposes of the self-employment tax).
(a)
(iii)
20
The Service issued regulations to clarify that a
single-owner eligible entity that is regarded as a
separate entity for certain employment and excise
tax purposes will be treated as a corporation. Treas.
Reg. § 301.7701-2(c)(2)(iv)(B), (v)(B) See T.D.
9553, 76 Fed. Reg. 66181-83 (Oct. 26, 2011).
The regulations apply to wages paid on or after January 1,
2009. Notice 99-6 remains effective for all wages paid
prior to that date. Thus, it appears that until January 1,
2009, the owner of the disregarded entity will continue to
be liable for the employment taxes of its disregarded entity.
See McNamee v. IRS, 488 F.3d 100 (2d Cir. 2007);
Littriello v. United States, 484 F.3d 372 (6th Cir. 2007);
Seymour v. United States, 2008-2 U.S.T.C. ¶ 50,406 (W.D.
Ky. 2008); L&L Holding Company, LLC v. United States,
2008-1 U.S.T.C. ¶ 50,234 (W.D. La. 2008); Stearn &
Company, L.L.C., v. United States, 499 F.Supp.2d 899
(E.D. Mich. 2007); Kandi v. United States, 2006-1
U.S.T.C. ¶ 50,231 (W.D. Wash. 2006), aff’d per curiam,
295 Fed.Appx. 873 (9th Cir. 2008); Med. Practice
Solutions, LLC v. Commissioner, 132 T.C. 125 (2009),
aff’d per curiam, 2010-2 U.S.T.C. ¶ 50,584 (1st Cir.
2010)20; Comensoli v. Commissioner, T.C. Memo. 2009242; Leedreau v. Commissioner, T.C. Summ. Op. 2009195; E.C.C 201112014 (March 25, 2011).
See also Med. Practice Solutions, LLC v. Commissioner, T.C. Memo. 2010-98 (2010),
addressing subsequent tax periods.
- 161 (iv)
c.
However, the Service has indicated that the sole owner of a
disregarded LLC is not personally liable for the
employment taxes incurred by the LLC while it was a
multi-member LLC treated as a partnership for federal tax
purposes. See F.A.A. 20093701F (July 27, 2009); E.C.C.
200946050 (July 17, 2009).
Where the employment tax liability was reported by the
disregarded entity pursuant to Notice 99-6, the Service’s practice
was to assess employment taxes against the disregarded entity and
provide notice and demand for payment to such disregarded entity.
The Service also added the owner’s name to the assessment to
facilitate collection. I.L.M. 200235023 (June 28, 2002); I.L.M.
200216028 (Mar. 20, 2002). Nonetheless, the Service took the
position that assessment and notice and demand for payment of
employment taxes made with respect to the disregarded entity may
serve as valid assessments against the owner of the disregarded
entity. See I.L.M. 200235023; I.L.M. 200216028; F.S.A.
200114006 (Apr. 10, 2001); F.S.A. 200105045 (Nov. 1, 2000).
However, collection due process notices under sections 6320 and
6330 should be provided separately to the disregarded entity and
the owner. I.L.M. 200216028.
(i)
However, the Service cannot levy the disregarded entity’s
assets to satisfy the employment tax liability, because under
state law, the owner of the disregarded entity has no rights
in the disregarded entity’s property. See I.L.M. 200338012
(Sept. 19, 2003) (citing Drye v. United States, 528 U.S. 49
(1999)); I.L.M. 199930013 (Apr. 18, 1999).
(a)
(ii)
d.
As a result, successor liability does not attach to the
disregarded entity’s assets. I.L.M. 200840001
(Aug. 28, 2008).
This is true even if the LLC is a multi-member LLC taxed
as a partnership, because the Service cannot under state law
collect employment taxes from the LLC members. Rev.
Rul. 2004-41, 2004-1 C.B. 845.
In final and temporary regulations effective November 1, 2011, the
Service permitted certain disregarded entities to qualify for the
FICA and FUTA employment tax exceptions for family members
and members of certain religious faiths. The regulations provide
that the disregarded entity will continue to be treated as a
corporation for all employment tax purposes, except that it will be
disregarded for applying the exceptions of sections 3121(b)(3),
3127, and 3306(c)(5). In addition, the regulations clarify that the
- 162 owner of the disregarded entity, not the disregarded entity, is
responsible for backup withholding and information reporting of
reportable payments under section 3406. Temp. Treas. Reg. §§
31.3121(b)(3)-1T, 31.3127-1T, 31.3306(c)(5)-1T, 301.7701-2T.
3.
e.
The disregarded entity is not considered an “other person” for
purposes of section 3505(a), which imposes liability for withheld
taxes on a lender, surety, or other person who is not the employer
but who directly pays the wages. I.L.M. 200338012.
f.
The Service has also said that employees of a single member LLC
will not be included as employees of its sole member for purposes
of applying the special common paymaster rules under section
3121(s) applicable to health professionals employed by a state
university and a medical faculty practice plan. The Service
reasoned that, as of January 1, 2009, an LLC is treated as a
corporation separate from its owner for employment tax purposes.
P.L.R. 200944016 (Oct. 30, 2009).
Employee Retirement Plans
a.
Section 401(a) provides that a trust “forming part of a stock bonus,
pension, or profit sharing plan of an employer for the exclusive
benefit of his employees or their beneficiaries” constitutes a
qualified trust if it meets the other requirements of section 401.
(Emphasis added.) Thus, if a disregarded entity cannot be an
employer for federal tax purposes, it cannot separately maintain a
qualified plan, and any plan established by the disregarded entity
would be treated as a plan of its owner. See P.L.R. 200334040
(May 30, 2003) (ruling that employees of a wholly owned LLC of
a section 501(c)(3) organization were covered by the section
403(b) plan of the organization); P.L.R. 200116051 (Jan. 24, 2001)
(ruling that second and third-tier single member LLCs were treated
as part of the parent’s controlled group for ESOP purposes); P.L.R.
199949046 (Sept. 15, 1999) (same).
b.
Even if the disregarded entity could separately maintain a
retirement plan, the disregarded entity and its owner would likely
be treated as a single employer for purposes of applying the
qualification rules of the Code. See section 414(b), (c).
c.
Nothing prevents employees of the disregarded entity from being
specifically covered by retirement plan established by the owner.
See, e.g., Rev. Rul. 79-388, 1979-2 C.B. 270 (employee of foreign
branch covered by corporation’s plan); P.L.R. 8845053 (Aug. 17,
1988) (employees of divisions covered by corporation’s plan).
- 163 4.
G.
Incentive Stock Option Plans
a.
Section 421(a) provides for favorable tax treatment to employees
who receive stock in connection with the exercise of an incentive
stock option or under an employee stock purchase plan. One of the
requirements to obtain such favorable tax treatment is that the
optionee must remain an employee of the granting corporation or
of a parent or subsidiary of the granting corporation.
b.
The Service has ruled that an employee of an LLC wholly owned
by a subsidiary of the granting corporation is treated as an
employee of the subsidiary for purposes of these rules. P.L.R.
200112021 (Dec. 15, 2000).
Filing Requirements
1.
A disregarded entity should not be required to file a separate income tax
return.
a.
However, in Announcement 2004-4, the Service requested
comments from the public on proposed new Form 8858,
Information Return of U.S. Persons With Respect to Foreign
Disregarded Entities. The 3-page form will be required filing for
U.S. persons that own a foreign disregarded entity directly, or in
certain circumstances, indirectly or constructively.
b.
There is also an exception for employment tax returns with respect
to wages paid to employees of disregarded entities on or after
January 1, 2009, and excise tax returns for liabilities incurred on or
after January 1, 2008. Reg. § 301.7701-2(c)(2)(iv) & (v); -2(e)(5)
& (6).
2.
This is consistent with rulings involving arrangements under which all of
the economic interests of a foreign entity are held by a single U.S. person.
In such instances, the Service has held that because the entity is neither a
corporation nor a partnership, it is not required to file a Form 1120 or
Form 1065. See, e.g., P.L.R. 7802012 (Oct. 11, 1977); P.L.R. 7748038
(Aug. 31, 1977); P.L.R. 7743060 (July 28, 1977).
3.
The Service has announced that this rule also applies to tax-exempt
entities.
a.
The owner of a tax-exempt entity must include in its Form 990
financial and operating information of any wholly owned
disregarded entity. Announcement 99-102, 1998-1 C.B. 433.
- 164 b.
XI.
The disregarded entity is also not required to file a separate Form
1023 exemption application. See P.L.R. 200134025 (May 22,
2001).
STATE TAX CONSIDERATIONS
A.
State Treatment of LLCs
Currently, all 50 states and the District of Columbia have adopted legislation that
permits the formation of an LLC. A majority of these states have either issued
public rulings, regulations or adopted legislation stating that they will conform to
the federal check-the-box regulations. See Bruce P. Ely, Christopher R. Grissom,
William T Thistle, State Tax Treatment of Limited Liability Companies and
Limited Liability Partnerships, 56 STATE TAX NOTES 509 (May 17, 2010).
1.
Certain states allow single-member LLCs but do not completely follow the
federal classification of single-member LLCs.
a.
Kentucky did not follow the federal income tax treatment of LLCs
and LLPs from January 1, 2005, to December 31, 2006, subjecting
LLCs and LLPs to the Kentucky corporate income tax. See 2005
H.B. 272. However, since January 1, 2007, Kentucky again
follows the federal income tax treatment of LLCs and LLPs. See
2006 H.B. 1.
b.
Louisiana follows the federal check-the-box regulations, but only
with respect to corporate income, not franchise, tax.
c.
Massachusetts follows the federal check-the-box regulations for
LLCs. Until 2009, the classification of LPs and LLPs was
determined under common law and the Kinter regulations, but
effective January 1, 2009, Massachusetts will follow the federal
check-the-box regulations for those entities as well.
d.
In Minnesota, foreign single-member LLCs with a corporate
member cannot be disregarded.
e.
New Hampshire follows the federal classification of multi-member
LLCs; however, the treatment of single-member LLCs is unclear.
f.
In Rhode Island, corporate owned single-member LLCs are treated
as C corporations for withholding purposes.
g.
In Tennessee, single-member LLCs are disregarded only if the
member is a corporation.
h.
Texas taxes LLCs as corporations; however, it should be noted that
Texas does not have a personal income tax.
- 165 -
2.
i.
Washington taxes LLCs as partnerships; however, it should be
noted that Washington does not have a personal income tax.
j.
Some states, such as Florida (effective January 1, 2003), Georgia,
Michigan, and the District of Columbia, do not conform to the
federal check-the-box regulations for sales, use, and other related
taxes. It should be noted that Florida does not have a personal
income tax.
k.
Some states, such as California, Delaware, Illinois, and
Pennsylvania, restrict the use of LLCs by banks and/or insurance
companies.
l.
Nevada, South Dakota, and Wyoming do not have income taxes;
therefore, the classification of an entity is irrelevant for state
purposes.
Certain states impose franchise or other entity-level taxes on LLCs.
a.
States imposing such taxes include: Alabama, Arkansas,
California, Connecticut, Delaware, District of Columbia, Illinois,
Kansas, Kentucky, Michigan, Minnesota, New Hampshire, New
Jersey, New York, South Dakota, Tennessee, Texas, Vermont,
Washington, and West Virginia.
b.
Florida amended its statute in 1998 to drop the corporate income
tax previously levied on LLCs doing business in Florida.
Pennsylvania is phasing out its LLC tax by 2014. However,
Pennsylvania subjects professional LLCs to entity-level taxes.
c.
Maine imposes an entity-level tax on LLCs that are financial
institutions. Rhode Island imposes an entity level tax on LLCs
taxed as partnerships. Wisconsin imposes a “temporary recycling
surcharge” on LLCs with more than $4 million in gross receipts.
d.
North Carolina includes an LLC’s assets in a corporate member’s
franchise tax base if the corporation (and its affiliates) own more
than 50 percent of the capital interests (70 percent for tax years
beginning before January 1, 2005). Effective January 1, 2007,
LLCs electing to be taxed as C corporations are subject to the
franchise tax. Effective January 1, 2009, LLCs electing to be taxed
as S corporations are also subject to the franchise tax.
e.
Ohio includes a corporation’s proportionate share of amounts from
any pass-through entity in its franchise credit calculations. Ohio
also passed a law to subject LLCs to a commercial activity tax
effective July 1, 2005, which will be phased in by 2009.
- 166 f.
Wisconsin imposes a recycling surcharge tax on LLCs with more
than $4 million in gross receipts.
g.
Certain states impose a tax or require the withholding of tax on a
nonresident member’s/partner’s distributive share of income,
including Alabama, Connecticut, Indiana, Maryland, Michigan
(except corporate members), North Carolina (with respect to
individual members), Pennsylvania, Utah, Vermont, Virginia, and
Wisconsin.
h.
(i)
Other states require withholding only if the member/partner
does not file a jurisdictional consent or is not included in
the entity’s composite tax return, such as Arkansas,
California, Colorado, Georgia, Idaho, Illinois, Kansas,
Louisiana, Maine, Massachusetts, Minnesota, Missouri,
Montana, Nebraska, New Mexico, North Carolina (with
respect to corporate members), North Dakota, Ohio,
Oklahoma, Oregon, Rhode Island, South Carolina, and
West Virginia. See Peter A. Lowry & Juan F. Vasquez, Jr.,
When Is It Unconstitutional For States to Tax Nonresident
Members of Limited Liability Companies, 2003 STATE
TAX TODAY 96-3 (May 19, 2003).
(ii)
Certain other states require withholding unless the
nonresident owners certify that they have complied with the
estimated tax and tax return filing requirements, such as
Iowa, Kentucky, and New York.
(iii)
Mississippi generally does not impose a withholding tax,
but the LLC is jointly and severally liable if the tax is not
paid.
In Northwest Energetic Services, LLC v. California Franchise Tax
Board, 71 Cal. Rptr.3d 642 (Cal. Ct. App. 2008), the California
Court of Appeal held that California’s tax on LLCs was
unconstitutional because it was not apportioned. In Ventas
Finance I, LLC v. California Franchise Tax Board, 81 Cal.Rptr.3d
823 (Cal. Ct. App. 2008), cert denied, 129 S. Ct. 1917 (2009), the
California Court of Appeal again confirmed that California’s tax
on LLCs was unconstitutional because it was not apportioned
based on California business activity. In response to the decision
in Ventas Finance I, the California Franchise Tax Board published
FTB Notice 2009-04, which provides the methods by which refund
claims for LLC tax will be determined for similarly situated
taxpayers. Before both decisions, the California legislature passed
Assembly Bill 198 and changed the tax so that it is now based on
an LLC's total income from all sources reportable to California.
- 167 Assembly Bill 198 also limits refunds for taxes paid when the law
was unconstitutional. See William Hays Weissman, What Is the
Remedy for California’s Tax Problems?, 2007 STATE TAX TODAY
243-9 (Dec. 17, 2007).
B.
i.
In Kmart Michigan Property Services LLC v. Dept. of Treasury,
No. 282058 (May 12, 2009), the Michigan Court of Appeals held
that a disregarded entity for federal tax purposes cannot be
required to file as a disregarded entity for state tax purposes. In
response, the Michigan Department of Treasury issued a notice
concluding that a single-member LLC is a separate taxpayer and
thus must retroactively file single business tax returns. On March
31, 2010, the Michigan legislature enacted HB 5937 reversing the
ruling and permitting a single-member LLC to join in its owner’s
return.
j.
New York has imposed liability on any members of an LLC for
unpaid sales and use taxes, even passive investors. Although the
law seems to have been an unintended consequence of extending
the partnership laws to cover LLC when they came into existence,
the state tax authorities have taken the position that all members
are liable and the state tax court has agreed. See Matter of Santo,
Tax Appeals Tribunal (Dec. 23, 2009); Noonan, The Continuing
Saga of Unlimited Liability Companies in New York, 2010 STT
69-2.
Achieving Consolidated Results In States That Prohibit Consolidation
Some states do not permit the filing of consolidated returns. Thus, consolidated
groups are not able to combine their tax items in determining the group’s state tax
liability. It may be possible to obtain results similar to consolidation through the
use of single-member LLCs as opposed to corporate subsidiaries. There are a
number of states that follow the federal classification of entities and treat a singlemember LLC as disregarded entity. In these jurisdictions, single-member LLC
would be treated as divisions of a corporate owner, and the tax items of the LLC
would flow directly to the corporate owner. Thus, corporations that choose to
operate their “subsidiary” activities through a single-member LLC will be able to
achieve state tax consolidation, while a consolidated group of corporations will
have to file separate state tax returns.
C.
Achieving Section 338(h)(10) Results in States That Do Not Recognize the
Election
1.
General – An election under section 338(h)(10) allows a purchaser to step
up the basis of the assets of a purchased entity to reflect the purchase price
paid for the entity. The cost of such an election is that the selling group
must recognize gain on the difference between the purchase price and the
- 168 target’s basis in its assets. The gain triggered is included in the seller’s
consolidated taxable income and may be offset by losses sustained by
other group members. Because many states do not recognize this election,
a purchaser will have different a basis for the acquired entity’s assets for
federal and state tax purposes.
2.
Example 62 – Achieving Section 338(h)(10) Treatment for State Tax
Purposes
100% LLC Interests
P
X
Cash
100%
100%
S
LLC
Merger
a.
Facts: Corporation P owns all of the stock of S. P and S were
organized in a state that does not permit section 338(h)(10)
elections, but that does follow the check-the-box regulations. P
forms a wholly owned LLC and merges S into the LLC. P then
sells 100 percent of the LLC interests to X, an unrelated party, in
exchange for cash.
b.
Tax Consequences: As discussed above, the conversion of S into
an LLC will be treated as a section 332 liquidation. See, e.g.,
P.L.R. 200104003 (Aug. 3, 2000); P.L.R. 200129024 (Apr. 20,
2001); P.L.R. 9822037 (Feb. 27, 1998); see also Reg. § 301.77013(g)(1)(iii) (an association electing to be a disregarded entity is
treated as distributing all of its assets and liabilities to its owner in
complete liquidation). Because the state follows the check-the-box
regulations, the LLC will be disregarded as an entity separate from
P. Thus, upon the sale of its interests in LLC, P should be treated
as selling the assets of LLC directly to X, and X should be treated
as purchasing LLC’s assets directly from P. Therefore, a purchaser
of an interest in a single-member LLC should be able achieve the
- 169 same tax treatment as if the state recognized the section 338(h)(10)
election.