Primer on Tax Aspects and Mechanics of Entity Conversion

Transcription

1 American Bar Association 2010 Joint Fall CLE Meeting, Toronto, ON, September 24, 2010 Primer on Tax Aspects and Mechanics of Entity Conversion Cassady V. Brewer Morris, Manning & Martin, LLP Panelist: Lisa M. Rico Gilmore, Rees & Carlson, P.C. Atlanta, GA Wellesley Hills, MA Allen Sparkman Sparkman Shaffer Perlick LLP Denver, CO

2 Primer on Tax Aspects and Mechanics of Entity Conversion These materials were originally prepared by Cassady V. Brewer as Taxation of Business Transactions: Entity Conversions and updated by Lisa M. Rico for this presentation.

3 Entity Conversions: Overview This is an important area to understand because, if done right, it can save you and your client much grief. If done wrong, however, it can be a tax disaster. Complexity stems in part from two sources: Promulgation of inter-entity conversion statutes (e.g., LLC to corporation and vice versa). LLCs can be taxed in three different ways: (i) disregarded; (ii) partnership; or (iii) corporation.

4 Entity Conversions: Overview Tax lawyers and tax accountants tend to LOVE this area, while business people and other lawyers HATE it, because it illustrates a fundamental rule that keeps tax lawyers and tax accountants gainfully employed: FORM MEANS EVERTHING; SUBSTANCE IS MEANINGLESS, EXCEPT WHEN IT ISN T....

5 Background on Conversion Legislation In many states (e.g., Delaware, Massachusetts, and Georgia), its LLC Act permits conversion from domestic corporation to domestic LLC.

6 Conversion Transactions: Why? Straight conversion avoids transferring assets and may involve little disruption of the business whereas merger or other conversion transaction usually involves asset transfers and some disruption of business. Further, in certain circumstances it may be advantageous to have one type of income tax treatment (e.g., S corporation), but a unique statelaw characteristic (e.g., restrictions on transfer and/or forfeiture of interests) associated with an LLC.

7 Conversion Transactions: Why? In all cases, the advisor must be mindful of the tax implications that arise as part of the conversion. If nothing else, remember this: Conversion from LLC to corporation generally is nontaxable, but conversion of a corporation (even an S corporation) into an LLC almost always is taxable (despite the fact that there will be no cash event out of which to pay the tax). Conversion to or from disregarded entity from or to partnership either to add investors to entity or remove members.

8 Conversion Transactions: Defined Five basic types of conversion transactions: 1. Juridical/ Formless 2. Merger Into Newly-Formed Shell Entity 3. Tax-Only 4. Dissolution and Reformation Transactions 5. Pure Re-Domestication Transactions As explained further below, we will focus on first three. Number four is undertaken only in unusual circumstances. Number five seldom has any income tax consequences.

9 Conversion Transactions: Defined Juridical/ Formless conversions are those undertaken pursuant to state law inter-entity conversion statutes. Example: Delaware LLC elects to convert to a Delaware or Delaware corporation. Juridical/ formless conversions generally have both tax and state law implications.

10 Conversion Transactions: Defined A merger into a newly-formed shell entity is both a juridical and tax conversion and, as such, can have both tax and state law implications. Example: Merger of an existing Delaware LLC with and into a newly-formed Delaware shell corporation. Not formless because a second entity must be formed and the original entity merged with and into the newlyformed entity. Prior to the promulgation of the inter-entity conversion statutes, this is the way most conversion transactions were accomplished.

11 Conversion Transactions: Defined Tax-only conversions most often involve LLCs and have income tax but generally no state law implications. For instance, as explained further below tax-only conversions of LLCs may occur by either: (i) filing IRS Form 8832, or (ii) certain changes in ownership. Often-used but deceptively simple example: The LLC S corporation. See Reg (c)(1)(v)(C).

12 Conversion Transactions: Defined In dissolution and reformation conversions the actual transaction steps are undertaken to convert an entity from one form to another. Example: Liquidation and dissolution of an LLC followed by transfers of the assets from the former LLC members to a newly-formed corporation. These conversion transactions are highly-tax sensitive and, moreover, are less often used unless there is a very particular tax or possibly state law reason why the actual dissolution and reformation steps must occur (as opposed to using some other type of conversion technique).

13 Conversion Transactions: Defined Pure re-domestication conversions simply involve moving the state of organization of an entity without changing its state law or tax form. Example: Converting a Georgia LLC into a Delaware LLC, or a Georgia corporation into a Delaware corporation. Re-domestication conversions generally have state law implications but no income tax consequences provided the form of the entity remains the same between the two states.

14 Conversions: Underlying Tax Rules To properly advise our clients and to take full advantage of the various entity conversion techniques, it is necessary to understand some fundamental tax rules. Primarily, these are the so-called Check the Box rules, and they are found in IRC 7701 and the regulations thereunder.

15 Conversions: Underlying Tax Rules The Check the Box rules govern how an entity is classified (i.e., treated as disregarded, as a partnership, or as a corporation) for federal income tax purposes. By default, the rules generally classify entities in the most favorable category (i.e., disregarded or partnership treatment) with the option to elect into corporate treatment if desired. But, as common sense would dictate, a corporation formed under state law will be classified as a corporation for income tax purposes as well.

16 CHECK THE BOX DEFAULT RULE CHART Eligible Entities All Entities Per Se Corporations Made in USA Eligible Entities Not Made in USA 1. Incs. 2. Listed Foreign Entities 3. Banks 4. Etc. No Member Liable Domestic Eligible Entities Foreign Eligible Entities Single Owner Two or More Owners Any Member Liable Corporation* (Whether 1 or more owners) Disregarded for Tax Purposes Partnership Foreign Member Liability Entity Single Owner Two or More Owners *But can elect on Form 8832 to be treated as a passthrough. Disregarded for Tax Purposes Partnership

17 Some Tax Conventions = Individual = Corporation = Partnership = Disregarded OR OR

18 The Basics: An Inc. is a Tax Corporation Too Individual 100% Corporation Pursuant to Check the Box regulations, normal corporations formed under state law automatically are treated as corporations (i.e, associations ) for income tax purposes. Reg (a).

19 Single Member LLC Is Disregarded: Reg (b)(1) Individual 100% LLC

20 Single Member LLC Is Disregarded: Reg (b)(1) Corporation 100% LLC

21 Multiple Member LLC Is Partnership: Reg (b)(1) Individual Corporation 50% 50% LLC

22 Purchase of Single Member LLC Acquiror Legal: Cash for LLC Interest Tax: Cash for Assets Individual 100% Ordinary Income and/or Capital Gain Depending On Assets If the selling entity is a single member LLC, then the transaction will be treated for tax purposes as an asset sale, even if the purchaser acquires the owner s LLC interest for state law purposes. Note different treatment for gift of an interest in a single member LLC under Pierre v. Commissioner, 133 T.C. No. 2 (8/24/2009), which held for gift tax purposes treated as transfer of an entity rather than transfer of underlying assets. Single Member LLC FYI: Allocation of Purchase Price Key Due to Characterization Issues

23 Tax-Only Conversions Election on Form 8832 or Changes From Single- to Multi-Member Status or Vice Versa Tax-only conversions do not involve a change in the entity under state law. Tax-only conversions primarily involve LLCs. Generally, will be tax-free, but possibly for different reasons depending upon situation: Form 8832 election or ownership change.

24 Tax-Only Conversions Election on Form 8832 If electing corporate treatment on Form 8832, IRC 351 applies, but as noted above liabilities in excess of basis can cause gain. See Reg (g)(1). Can be retroactive as much as 75 days. See Form Same subtle tax issues present. Example: FEIN stays same. Reg (h). New tax year, accounting method changes, employment tax credit, etc. are still concerns.

25 Single Member LLC Is Disregarded: Reg (b)(1) Individual 100% LLC

26 Unless Form 8832 Is Filed, Then Association Individual 100% LLC Association If file Form 8832, then can elect association status for income tax purposes. Associations are taxed as corporations for income tax purposes.

27 Tax-Only Conversion Transactions from Ownership Changes Changes From Single- to Multi-Member Status or Vice Versa Tax-only conversions also occur when an LLC that is disregarded or treated as a partnership changes from a single-member LLC to a multi-member LLC or vice versa. See Rev. Rul and 99-6 for tax treatment.

28 Tax-Only Conversions: Rev. Rul Step 1: A $ 50% Interest B 100% LLC

29 Tax-Only Conversions: Rev. Rul Step 2: A B 50% 50% LLC

30 Tax-Only Conversions: Rev. Rul Purchase of less than 100% interest from sole owner. Assumptions: Neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness. No election was made under Treas. Reg (c). How is this transaction treated if there is indebtedness? Treated as a purchase of assets from existing owner of disregarded entity, followed by a joint contribution to newlyformed partnership of (i) remaining assets by existing owner and (ii) purchased assets by purchaser. Generally taxable only to seller of interest under IRC 1001; treated as partial asset sale. No gain or loss recognized under IRC 721(a) to existing owner or purchaser. Purchaser s basis = amount paid. Existing owner s basis = basis in its share of LLC assets. See IRC 722. Purchaser s holding period begins on day following deemed sale. See IRC 1223(1). See Rev. Rul. 99-5, C.B FEIN stays same (assuming entity was not using sole owner s FEIN). See Reg (h) and Rev. Rul , 2001 C.B. 573.

31 Tax-Only Conversions: Rev. Rul Step 1: A B $ 100% 50% Interest LLC

32 Tax-Only Conversions: Rev. Rul Step 2: A B 50% 50% LLC

33 Tax-Only Conversions: Rev. Rul Investment into the disregarded LLC of either cash or assets in exchange for a newlyissued interest to an additional owner. Assumptions: Neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness. No election was made under Treas. Reg (c). How is this transaction treated if there is indebtedness? Treated as a contribution of (i) existing assets owned by single owner and (ii) cash or other assets owned by investor, in each case to a newlyformed partnership. Generally not taxable; treated as formation of new partnership. No gain or loss recognized under IRC 721(a). Investor s basis = amount paid. Existing owner s basis = basis in its share of LLC assets. See IRC 722. Investor s holding period begins on day following deemed sale. See IRC 1223(1). See Rev. Rul. 99-5, C.B FEIN stays same (assuming entity was not using sole owner s FEIN). See Reg (h) and Rev. Rul , 2001 C.B. 573.

34 Tax-Only Conversions: Rev. Rul Step 1: A $ 50% Interest B 50% 50% LLC

35 Tax-Only Conversions: Rev. Rul Step 2: A B 100% LLC

36 Tax-Only Conversions: Rev. Rul Purchase by one owner of all interests of other owners. Assumptions: Neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness. No election was made under Treas. Reg (c). Departing owner is treated as having sold his/its partnership interest, while the remaining owner is considered to have acquired all of the assets of the partnership (i) by liquidating distribution with respect to the partnership interest already owned and (ii) by purchase with respect to the remaining assets of the partnership. Partnership terminated under IRC 708(b)(1)(A). Generally taxable only to sellers of interests; gain reported under IRC 741. Purchaser s basis in purchased interest= amount paid. See IRC 1012 Purchaser s holding period begins on day following deemed sale. See IRC 1223(1). Purchaser must recognize gain or loss on deemed liquidating distribution under IRC 731(a) to extent required.

37 Tax-Only Conversions: Rev. Rul Purchase by one owner of all interests of other owners. Assumptions: Neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness. No election was made under Treas. Reg (c). How is this transaction treated if there is indebtedness? Purchaser s basis in these assets determined under IRC 732(b) (carry over basis money distributed) and purchaser s holding period for these assets includes the LLC s holding period under IRC 735(b). See Rev. Rul. 99-6, C.B FEIN stays same (assuming entity was not using sole owner s FEIN). See Reg (h) and Rev. Rul , 2001 C.B. 573.

38 Tax-Only Conversions: Rev. Rul Step 1: A B $ $ C 50% 50% LLC

39 Tax-Only Conversions: Rev. Rul Step 2: A B C 100% LLC

40 Tax-Only Conversions: Rev. Rul Purchase by third party of all interests. Assumptions: Neither LLC is liable for any indebtedness, nor are the assets of the LLCs subject to any indebtedness. No election was made under Treas. Reg (c). Existing owners are treated as having sold their partnership interests, while the new owner is treated as having acquired all of the assets of the partnership by purchase. Partnership terminated under IRC 708(b)(1)(A). Generally taxable to sellers of interests; gain reported under IRC 741. Purchaser s basis in purchased interest= amount paid. See IRC 1012 Purchaser s holding period begins on day following sale. See IRC 1223(1). See Rev. Rul. 99-6, C.B FEIN stays same (assuming entity was not using sole owner s FEIN). See Reg (h) and Rev. Rul , 2001 C.B. 573.

41 Tax-Only Conversion Transactions from Ownership Changes Remember: Selling members will have tax concerns (especially in conversion from multi-member LLC to single-member LLC): Cut-off of tax year and tax distributions for short-year income. Allocations and/or distributions with respect to short year. Indemnification for existing and contingent liabilities.

42 Biography Lisa M. Rico is a partner in the Estate Planning Group at Gilmore, Rees & Carlson, P.C., focusing on estate planning, probate and tax law. Ms. Rico's practice includes estate, gift, generation-skipping transfer and income tax planning for high net worth individuals, estate and trust administration, and the representation of nonprofit organizations and charitable trusts. She also provides tax advice to partnerships and other pass through entities. LISA M. RICO Partner lrico@grcpc.com 20 Walnut Street Wellesley Hills, MA Ms. Rico often lectures and has authored numerous materials on estate planning issues, including family limited partnerships, estate liquidity and the generation skipping transfer tax. EDUCATION: LL.M., New York University School of Law, 1994, J.D., Western New England College School of Law, cum laude, 1991 B.A., Western New England College, magna cum laude, ADMISSIONS: Massachusetts, Connecticut, New York, Maryland. MEMBERSHIPS AND PROFESSIONAL ACTIVITIES: American Bar Association, Massachusetts Bar Association, Taxation Law Section, Chair , Boston Bar Association, Boston Estate Planning Council, Estate Planning and Administration for Business Owners, Farmers and Ranchers Committee of Business Planning Group of the ABA's Real Property Trust and Estate Law Section, Co-Chair,