Cross Species Conversions and Mergers

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1 Cross Species Conversions and Mergers 591 Cross Species Conversions and Mergers JOHN B. TRUSKOWSKI * The adoption by many states of both conversion statutes 1 statutes allowing one form of business organization, such as a limited liability company, to convert to another form of business organization, for example, a corporation, by simply filing a form with the appropriate state office and cross specie merger statutes 2 statutes allowing one form of business organization to merge with another form of business organization, such as a limited liability company with a corporation raises issues on how these conversions or mergers will be treated for federal income tax purposes. Parts I and II of this Article summarize these tax consequences, and Part III discusses in more detail some specific tax issues. This Article only considers limited liability companies (LLCs) with more than one member that are classified as partnerships for federal income tax purposes. However, to match the terminology used in the Code, regulations, rulings, and cases, this Article will generally refer to partnerships and partners rather than LLCs and members. I. Partnership to Corporation A. Specific Methods to Incorporate a Partnership Before we consider conversions and mergers, we must review the tax consequences of structured incorporation transactions. In Revenue Ruling , the Service ruled that regardless of how a partnership was actually incorporated, the tax consequences would be determined as an Assets Over transaction (described below). 3 However, in Revenue Ruling , the Service reversed course, recognizing that the tax consequences were not the same, and the Service ruled that taxpayers could choose the tax consequences of a partnership incorporation transaction by actually structuring the transaction in one of three ways: 4 * Of Counsel, Locke Lord LLP, Chicago, Illinois; Certified Public Accountant; University of Illinois, B.S. (Accountancy) 1967; University of Chicago Law School, J.D. (1970). Mr. Truskowski passed away before this article went to press. He was the immediate past chairman of the American Bar Association Section of Taxation's Committee on S Corporations. The Tax Lawyer thanks Laurence A. Hansen, a partner in Locke Lord LLP, for his assistance with the final steps of the editorial process for this article. 1 See, e.g., Delaware Limited Liability Company Act, Del. Code Ann. tit. 6, (2011). 2 See, e.g., Illinois Limited Liability Company Act, 37-20, 805 ILCS 180/37-20 (1998). 3 Rev. Rul , C.B Rev. Rul , C.B

2 592 section OF TAXATION 1. Assets Over, where the partnership contributes its assets and liabilities to a corporation and then liquidates, distributing the corporate stock to its partners. 2. Assets Up, where the partnership liquidates, distributing its assets and liabilities to its partners, and the partners then contribute those assets and liabilities to the corporation. 3. Interests Over, where the partners contribute their interests in the partnership to the corporation, and as the result of the corporation owning 100% of the interests in the partnership, the partnership terminates for tax purposes. 5 Although the tax consequences of these alternatives are similar, they are not identical. Revenue Ruling sets forth the general tax consequences of each transaction. 1. Assets Over For an Assets Over transaction where the partnership transfers its assets and liabilities to the corporation and then liquidates Revenue Ruling states that under section 351, 6 the partnership recognizes no gain or loss on the transfer of all of its assets to the corporation. 7 It also states that under section 358(a), the partnership s basis in the stock of the corporation is the same as its basis in the assets transferred to the corporation, reduced by the liabilities assumed by R [the corporation], which assumption is treated as a payment of money to X [the partnership] under section 358(d). Section 357(a) provides that the corporation s assumption of liabilities is not treated as money for purpose of section 351, thereby confirming the Ruling s conclusion that no gain or loss is recognized under section Section 357(c) provides that if the sum of the amount of the liabilities assumed by the corporation exceeds the total of the basis of the assets contributed to the corporation, then the excess is recognized as a gain from the sale or exchange of the assets contributed to the corporation. 9 Although Revenue 5 In the case of an LLC, if the LLC is not liquidated under the laws under which it was organized, it continues for Federal income tax purposes as a disregarded entity. I.R.S. Publication 3402 (Mar. 2010). 6 References to the Code, I.R.C. or section other than a section of this Article are to the Internal Revenue Code of 1986, as amended. 7 Rev. Rul , C.B I.R.C. 357(a)(2). 9 I.R.C. 357(c). Section 357(b)(1)(B) provides that if the purpose for the corporation s assumption of liabilities was tax avoidance and not a bona fide business purpose, then the liabilities assumed are considered money under section 351. For purposes of this Article, it is assumed that there is no tax avoidance purpose for the corporation s assumption of liabilities. I.R.C. 357(b)(1)(B).

3 Cross Species Conversions and Mergers 593 Ruling did not address section 357(c), Revenue Ruling did. This Ruling considered a limited partnership that had incurred nonrecourse liabilities in the ordinary course of its business. For valid business reasons, limited partners owning 35% of the partnership interests transferred those interests to a newly organized corporation in a transfer qualifying under section 351. The Ruling concluded that each transferring limited partner s share of the partnership s nonrecourse liabilities was considered as a liability to which the partnership interest was subject for purposes of section 357(c). Thus, each partner recognized gain under section 357(c) to the extent that the partner s share of the nonrecourse liabilities exceeded the basis in its partnership interest. Therefore, the tax consequences set forth below recognize the possibility of a recognized gain under section 357(c). The tax consequences of the corporation s assumption of liabilities are discussed in detail in Part III.A.1. The tax consequences of an Assets Over transaction are as follows: a. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on its receipt of assets and assumption of liabilities The basis in the assets in the hands of the corporation equals their basis in the hands of the partnership, increased by any gain recognized by the partnership such gain flows through to the partners and increases their basis in their partnership interests. 13 However, unless the election described in Part I.A.1.b.2 immediately below is made, the aggregate basis cannot exceed the fair market value of the assets The corporation s holding periods for the assets transferred to it includes the periods they were held by the partnership. 15 b. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on the transfer of its assets and liabilities to the corporation unless the corpora- 10 Rev. Rul , C.B I.R.C. 1032(a). 12 The Code speaks in terms of basis and adjusted basis. For simplicity, this Article uses the term basis to mean both basis and adjusted basis. 13 I.R.C. 362(a). 14 I.R.C. 362(e)(2). See infra Part III.B for a detailed discussion of basis. 15 I.R.C. 1223(2).

4 594 section OF TAXATION tion is an investment company, 16 or to the extent the amount of the liabilities transferred including liabilities secured by transferred assets 17 exceeds the tax basis of the assets transferred. 18 The distribution of the stock to the partners on liquidation of the partnership does not violate the control requirements of sections 351(a) and 368(c). 2. The partnership s basis in the stock it receives equals the basis in the assets transferred to the corporation, decreased by the liabilities assumed by the corporation, and increased by any gain recognized by the partnership. 19 If the aggregate basis of the assets transferred to the corporation exceeds their aggregate fair market value, the partnership and corporation can jointly elect to limit the partnership s basis in the stock to the fair market value of the assets, thereby avoiding the decrease in the assets basis noted in Part I.A.1.a.2 immediately above The holding period for stock received in exchange for capital and section assets includes the period the transferred assets were held by the partnership. 23 The holding period for stock received in exchange for all other assets begins on the day after the day on 16 I.R.C. 351(e) provides that transfers of property to an investment company are not tax free under Code section 351(a). An investment company is not specifically defined in Code section 351(e), although investment assets are. Regulation section (c) provides that a transfer of property will be considered to be a transfer to an investment company if (i) the transfer results, directly or indirectly, in diversification of the transferors interests, and (ii) the transferee is (a) a regulated investment company, (b) a real estate investment trust, or (c) a corporation more than 80% of the value of whose assets excluding cash and nonconvertible debt obligations from consideration are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts. For purposes of this Article, it is assumed that any corporation or partnership to which property is transferred is not an investment company. 17 For convenience, liabilities assumed by the transferee and liabilities secured by assets transferred to the transferee will be referred to as assumed liabilities or as liabilities assumed by the transferee. 18 I.R.C. 351(h)(1), 357(c)(1). 19 I.R.C. 358(a), (d). 20 I.R.C. 362(e)(2)(C). See infra Part III.B for a detailed discussion of basis. 21 A capital asset is defined in Code section 1221(a) as any property held by a taxpayer whether or not connected with its trade or business subject to certain statutory exceptions. The primary exceptions are stock in trade and depreciable property used in a trade or business. 22 Property is described in Code section 1231(b) as property used in a trade or business, of a character which is subject to the allowance for depreciation provided in Code section 167, held for more than 1 year, and real property used in a trade or business, held for more than 1 year.... Specifically excluded from Code section 1231(b) is property properly includible in inventory and property held primarily for sale to customers in the ordinary course of the taxpayer s trade or business. 23 I.R.C. 1223(1).

5 Cross Species Conversions and Mergers which they were contributed to the corporation. 24 No gain or loss is recognized by the partnership on the transfer of the stock to its partners on its liquidation. 25 c. Tax Consequences to Partners The corporation s assumption of the partnership s liabilities including receipt of property securing liabilities is treated as a deemed distribution to each partner equal to its share of those liabilities, as determined under section 752, thereby reducing each partner s basis in its partnership interest. 26 This deemed distribution could result in a partner recognizing gain if its share of these liabilities exceeds its basis in its partnership interest. The tax consequences of the corporation s assumption of the partnership s liabilities are discussed in detail in Part III.A.1. The partners recognize no gain or loss on receipt of the stock on the liquidation of the partnership. 27 Each partner s basis in the stock received on the liquidation of the partnership equals its adjusted basis in its partnership interest immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of its liquidation. 28 Each partner s holding period for the stock received includes the partnership s holding period for the stock, which generally includes the period the partnership held the assets contributed to the corporation Assets Up The tax consequences of an Assets Up transaction, where the partnership liquidates and the partners transfer assets and liabilities to the corporation, are similar to those for an Assets Over transaction, although the corporation s basis in the assets it receives may be different. These tax consequences are as follows: 24 Rev. Rul , C.B See Part III.C for a detailed discussion of holding periods. 25 I.R.C. 731(b). 26 I.R.C. 732(b). 27 I.R.C. 731(a). 28 I.R.C. 732(b). 29 I.R.C. 735(b), 1223(1); see also supra Part I.A.1.a.2. See infra Part III.C for a detailed discussion of holding periods.

6 596 section OF TAXATION a. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on the transfer of its assets and liabilities to its partners on its liquidation. 30 b. Tax Consequences to Partners In general, the partners recognize no gain or loss on receipt of the assets and assumption of the liabilities on the liquidation of the partnership, but they will recognize gain to the extent the amount of money distributed exceeds each partner s basis in its interest in the partnership immediately before the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation. 31 Each partner s basis in the assets received on the liquidation of the partnership equals the adjusted basis in its interest in the partnership immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation, decreased by the amount of money received. 32 Each partner s holding period for the assets received includes the period the partnership held those assets. 33 No gain or loss is recognized by the partners on the transfer of the assets and liabilities to the corporation unless the corporation is an investment company, 34 or except to the extent the amount of the liabilities transferred including liabilities secured by transferred assets exceeds the tax basis in the assets transferred. 35 Each partner s basis in the stock it receives equals its basis in the assets transferred to the corporation which is the basis in the interests in the partnership 36 decreased by the liabilities assumed by the corporation, including liabilities secured by assets transferred to the corporation, and increased by any gain recognized on the transfer of the assets to the corporation. 37 If the aggregate basis of the assets transferred to the corporation exceed their fair market 30 I.R.C. 731(b). 31 I.R.C. 731(a). 32 I.R.C. 732(b). See infra Part III.B for a discussion of the allocation of basis among the assets received. 33 I.R.C. 735(b). 34 See I.R.C. 357; see also supra text accompanying note I.R.C. 351, See supra Part I.A.2.b I.R.C. 358(a).

7 Cross Species Conversions and Mergers 597 value, the partners and corporation can jointly elect to limit the partner s basis in the stock to its fair market value, thereby avoiding a decrease in the basis in the assets For stock received in exchange for capital and section 1231 assets, each partner s holding period for the stock includes the holding period for the assets transferred to the corporation, which is the partnership s holding period for those assets. 39 For stock received in exchange for all other assets, each partner s holding period begins on the day after those assets were transferred to the corporation. 40 c. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on the receipt of the assets and the assumption of the liabilities The basis in the assets in the hands of the corporation equals their basis in the hands of the partners which is the basis in the partners interests in the partnership immediately prior to the liquidation 42 increased by any gain recognized by the partners. 43 However, unless the election noted in Part I.A.2.b.5 is made, the aggregate basis cannot exceed the fair market value of the assets The corporation s holding period for the assets transferred to it is the same as the holding period in the hands of the partners which, in general, includes the period the partnership held the assets. 45 Thus, the only difference between an Assets Over and an Assets Up transaction is the corporation s basis in the assets it receives. If there is a difference between the partners outside basis in their partnership interests and the partnership s inside basis in its assets, the transaction which results in the higher basis should be used in order to maximize the basis to the corporation. 3. Interests Over Determining the tax consequences of an Interests Over transaction where the partners transfer their partnership interests to the corporation and the 38 I.R.C. 362(e)(2)(C). This is noted below in Part I.A.2.c.2. See infra Part III.B for a detailed discussion of basis. 39 I.R.C. 1223(1); see discussion supra Part I.A.2.c Rev. Rul , C.B See infra Part III.C for a detailed discussion of holding periods. 41 I.R.C See supra Part I.A.2.b I.R.C. 362(a). 44 I.R.C. 362(e). See infra Part III.B for a detailed discussion of basis. 45 I.R.C. 1223(2).

8 598 section OF TAXATION partnership terminates as set forth in Revenue Ruling , requires a more detailed analysis as the result of a subsequent Revenue Ruling, 46 and an earlier Tax Court case 47 and Revenue Ruling, 48 neither of which were referred to in Revenue Ruling As with the Assets Over transaction, Revenue Ruling does not address the possibility of a recognized gain if the partnership has liabilities. It simply states that, under section 351, no gain or loss is recognized on the transfer of the partnership interests to the corporation. 49 As with the Assets Over transaction, the Ruling states that each partner s basis in the stock received equals its basis in its interest in the partnership reduced by Z s [the partnership] liabilities assumed by T [the corporation], the release from which is treated as a payment of money to Z s partners under sections 752(d) and 358(d). 50 Section 752(d) provides that on a sale or exchange of a partnership interest, liabilities are treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. 51 Under Regulation sections (h) and (a)(1), when a partnership interest is sold, the selling partner s share of the partnership s liabilities is considered additional consideration received by the selling partner. No reference was made to these regulatory provisions or to section 357(c) in Revenue Ruling As noted with regard to Assets Over transactions, section 357(a) provides that the assumption of liabilities is not considered the receipt of money for section 351 purposes. 52 The question is whether section 357(c), requiring the recognition of gain if the amount of liabilities transferred to the corporation exceed the basis in the assets transferred, applies where a partnership interest is transferred to the corporation. As noted above, Revenue Ruling confirms that the partnership s liabilities are taken into account for section 357(c) purposes. 53 a. Tax Consequences to Partners. Whether the Revenue Ruling or Revenue Ruling approach applies, the tax consequences to the partners are the same. These tax consequences are fairly straightforward: 1. In general, no gain or loss is recognized by the partners on the transfer of their partnership interests to the corporation, unless the corporation is an investment company If the partnership has liabilities, the corporation s indirect assumption of the partnership s liabilities including receipt of property 46 Rev. Rul , C.B. 432; see also supra Part I.A.2.b McCauslen v. Commissioner, 45 T.C. 588 (1966). 48 Rev. Rul , C.B See I.R.C Rev. Rul , C.B I.R.C. 752(d). 52 See I.R.C. 357(a). 53 See Rev. Rul , C.B I.R.C. 351; see also supra note 9.

9 Cross Species Conversions and Mergers 599 securing liabilities could subject the partners to tax, if the partner s share of the liabilities exceeds the partner s basis in the partnership interest Each partner s basis in the stock it receives equals the basis in the partnership interest transferred to the corporation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the portion of the partnership s taxable year during which the interest in the partnership was owned, 56 decreased by its share of the partnership s liabilities, and increased by any gain recognized on the transfer to the corporation. 57 If the aggregate basis of the interests transferred to the corporation exceed their fair market value, the partners and corporation can jointly elect to limit the partners basis in the stock to its fair market value, thereby avoiding a decrease in the basis in the assets In general, the holding period for the stock received by each partner includes the period the partnership interest was held by the partner. However, for stock received in exchange for a partner s interest in section 751 assets 59 that are neither capital nor section 1231 assets, the holding period begins on the day after the partnership interests were transferred to the corporation. 60 b. Tax Consequences to the Corporation. The corporation s tax consequences may be less clear. Revenue Ruling states correctly that the partnership terminates when all of its interests are owned by the corporation. 61 As a result of such termination, the corporation owns all of the partnership s assets. The Ruling concludes that the corporation s basis for the assets received equals the basis of the partners in their partnership interests allocated in accordance with section 732(c), and the corporation s holding period for the assets includes the period the partnership held the assets. No specific statutory citations are given for these particular conclusions, although sections 362(a) and 1223(1) are described generally at the beginning of the Ruling. However, for this alternative the Ruling states [o]n the transfer of 55 I.R.C. 357(c). See infra Part III.A.1 for a detailed discussion of this issue. 56 Since the partnership terminates as the result of the corporation owning all of the interests in the partnership, the partnership s books would be closed as of the day of the contribution to the corporation and all of the partnership s income, gains, losses, deductions, and credits for the short year ending on that date would be allocated to the partners in accordance with the partnership or operating agreement. 57 I.R.C. 358(a), (d). 58 This is noted below in Part I.A.3.b.1.b. See Code section 362(e)(2)(C) and infra Part III.B for a detailed discussion of basis. 59 Section 751 assets are unrealized receivables and inventory items that have appreciated substantially in value. 60 See Rev. Rul , C.B See infra Part III.C for a detailed discussion of holding periods. 61 See Rev. Rul , C.B. 88.

10 600 section OF TAXATION the partnership interests to the corporation, Z [the partnership] terminated under section 708(b)(1)(A) of the Code. Section 708(b)(1)(A) provides that a partnership terminates if no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership. Since neither the earlier Tax Court case nor Revenue Ruling which are discussed next is cited, these conclusions would seem to be based on treating the partnership as existing momentarily after the corporation acquires ownership of all of the interests in the partnership. Assuming the momentary existence of the partnership following the transfer of all of the partnership interests to the corporation, the steps and tax consequences would be as follows: 1. The partnership exists as a partnership for federal income tax purposes immediately after the corporation acquires ownership of all of the partnership interests. 62 a. No gain or loss is recognized by the corporation. b. The corporation s basis in the partnership interests equals the part- ners basis in those interests, increased by any gain recognized by the partners. 63 However, unless an election 64 is made, the basis cannot exceed the fair market value of the partnership interests. 65 c. The corporation s holding period for the partnership interests includes the period the interests were held by the partners The partnership terminates, distributing its assets and liabilities to the corporation. a. The corporation recognizes no gain or loss on termination of the partnership unless the amount of money received exceeds the corporation s basis for the partnership interests. 67 The corporation s basis in the assets is the basis in the partner- ship interests, which is the same as the partners basis in their partnership interests, but limited to the fair market value of the interests, 68 plus any gain recognized. 69 b. 62 I.R.C I.R.C. 362(a). 64 This is noted above in Part I.A.3.a I.R.C. 362(e). See infra Part III.B for a detailed discussion of basis. 66 I.R.C. 1223(2). 67 I.R.C Because the corporation owns 100% of the partnership, liabilities of the partnership are not relevant the decrease in the corporation s share of partnership liabilities, which is treated as a distribution under section 752(b), equals the increase in the corporation s liabilities on liquidation of the partnership, which is treated as a contribution to the partnership under section 752(a). 68 See supra Part I.A.3.b.1.b. 69 I.R.C See Part III.B for a discussion of basis.

11 c. Cross Species Conversions and Mergers 601 The corporation s holding period for the assets includes the period the assets were held by the partnership. 70 An earlier Tax Court case and Revenue Ruling characterize the transaction differently where a partnership terminated following acquisition by one partner of all of the interests in a partnership, which is similar to what occurs in an Interests Over transaction. McCauslen v. Commissioner 71 involved the determination of gain from the sale of partnership property following one partner s acquisition of all of the interests in the partnership. McCauslen and his brother formed an equal partnership to conduct a nursery business. When the brother died, McCauslen purchased his brother s interest. This resulted in a termination of the partnership. McCauslen continued the nursery business as a sole proprietorship. Two months later, McCauslen sold a greenhouse and greenhouse equipment previously owned by the partnership. Although the sale occurred within six months of McCauslen s purchase of his brother s interest, the sale occurred more than six months after the partnership had acquired the property that was sold. The issue was the holding period for the property sold. 72 The holding period for long-term capital gain treatment at that time was only six months. The Tax Court held that since the purchase of the brother s interest terminated the partnership, McCauslen actually bought the partnership assets relating to his brother s interest, rather than receiving the assets as the result of a distribution from the partnership on its termination. 73 Thus, the holding period for the portion of the assets acquired indirectly from his brother began when the brother s interest was purchased, rather than when the partnership had purchased those assets. In essence, the purchase of the brother s interest was treated similar to an Asset Up transaction the assets were deemed to be distributed up to the brother s estate, which then sold them to McCauslen. Note that this case does not address the tax consequences to the brother s estate which sold the interest. There is no indication that the sale, from the estate s standpoint, would also be treated as a sale of the partnership s assets. Rather, the Tax Court refers to section 741, noting that a partnership interest is a capital asset which may be sold or exchanged. 74 Therefore, if the issue had been before the Tax Court, it is likely it would have decided that, from the estate s standpoint, this was a sale of a partnership interest, not a sale of a portion of the partnership s assets. Revenue Ruling involved similar facts. D and E were equal partners in a two-man partnership. Pursuant to an agreement between them, when D died, E bought D s interest and continued the business as a sole 70 I.R.C. 735(b) T.C. 588 (1966). 72 Id. at Id. at Id. at Rev. Rul , C.B. 168.

12 602 section OF TAXATION proprietorship. The Ruling stated: Although it is recognized that one partner in a two-man partnership may sell his partnership interest to his partner (sec (b) of the regulations), such a transaction is viewed as though one partner acquired by purchase, the assets attributable to the partnership interest sold by the other partner. No distribution of property by the partnership occurred with respect to such assets. However, the purchasing partner is considered to have received as a distribution in kind, through liquidation of his partnership interest, those assets attributable to his own former interest in the partnership. 76 As to the deceased partner, this Ruling seems to confirm that the estate transferred its partnership interest to E, and not its proportionate share of the partnership s assets. 77 If this approach were applied to an Interests Over transaction, the corporation would be deemed to have received the partnership s assets in exchange for the stock and assumption of liabilities, following a deemed liquidation of the partnership and distribution of those assets and liabilities to the partners. The only difference between an Interest Over transaction and the situations described in McCauslen and Revenue Ruling is that in an Interests Over transaction a third party the corporation acquires all the partnership interests, and not an existing partner. Is this significant enough to require a different result? This question is answered in the negative in Revenue Ruling This Ruling considered two situations involving the conversion of a multi-owner LLC taxed as a partnership into a disregarded entity. In Situation 1, A and B are equal members in an LLC. A sells his interest to B, and the LLC continues to conduct its business. In Situation 2, C and D, also equal members in an LLC, sell their membership interests to E, an unrelated party. Again, after the sale the LLC continues to conduct its business. After citing the various Code authorities governing partnerships, the Revenue Ruling then cites McCauslen and Revenue Ruling , noting the conclusions in each that although the surviving partner purchased the deceased partner s interest, he was deemed to have purchased the assets attributable to the interest. 79 The Ruling first recognizes that since in both Situation 1 and Situation 2 the LLCs end up with only one owner, they terminate under section 708(b)(1)(A). Revenue Ruling also concluded that in an Interests Over transaction the partnership terminates under section 708(b)(1)(A). 80 With respect to Situation 1, the Ruling holds that the selling member (A) must treat the transaction as the sale of a partnership interest, 76 Id., C.B. at Id. 78 Rev. Rul , C.B Id. 80 Rev. Rul , C.B. 88.

13 Cross Species Conversions and Mergers 603 citing Regulation section (b). 81 It then continues that under McCauslen and Revenue Ruling , to determine the tax consequences to B the purchasing member the partnership is deemed to make a liquidating distribution of all of its assets to A and B, and following this distribution, B is treated as acquiring the assets deemed to have been distributed to A [the selling member].... Thus, B s basis for the assets attributable to A s one-half interest in the LLC is the price paid for the interest, and B s holding period for those assets begins on the day after the sale. Similarly, in Situation 2, C and D are treated as having sold their interests in the LLC to E in accordance with section As to E, however, the Ruling states: For purposes of classifying the acquisition by E, the CD partnership is deemed to make a liquidating distribution of its assets to C and D. Immediately following this distribution, E is deemed to acquire, by purchase, all of the former partnership s assets. Compare Rev. Rul , C.B. 88 (Situation 3), which determines the tax consequences to a corporate transferee of all interests in a partnership in a manner consistent with McCauslen, and holds that the transferee s basis in the assets received equals the basis of the partnership interests, allocated among the assets in accordance with 732(c). 83 Thus, E s basis for the assets is the purchase price paid to C and D, and its holding period for those assets begins on the day after the sale. Contrary to the quoted language, the conclusions in Revenue Ruling may not be consistent with McCauslen. Revenue Ruling does not describe the Interests Over transaction from the corporation s standpoint as a liquidating distribution of the partnership s assets to its partners, followed by a transfer of those assets to the corporation that is, an Assets Up transaction. Rather, it treats the transaction as it was structured a transfer of the partnership interests to the corporation, followed by its termination. 84 Thus, under the Revenue Ruling approach, the purchaser s basis for the assets received on termination of the partnership is the price paid for the partnership interests, and the holding period begins on the day after the day those assets are deemed to have been purchased. Although this seems to dictate different tax consequences than those set forth in Revenue Ruling , generally, the tax consequences under Revenue Ruling are the same as those described in Revenue Ruling , because the tax consequences of the transfer of the partnership interests to the corporation are governed by section 351. However, an exception applies where the money received by the corporation exceeds the corporation s basis in the partner- 81 Rev. Rul , C.B Id. 83 Id., C.B. at Rev. Rul , C.B. 88.

14 604 section OF TAXATION ship, which is taxable under the Revenue Ruling approach but not under the Revenue Ruling approach. Under the Revenue Ruling approach, as to the corporation, the steps and tax consequences would be as follows: 1. a. The partnership liquidates, distributing its assets and liabilities to its partners. Solely for purposes of determining the corporation s tax conse- quences under step 2 immediately below, each partner s basis in the assets received on the deemed liquidation of the partnership equals the basis in its interest in the partnership immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation, decreased by the amount of money received, and increased by any gain recognized by the partner. 85 The impact of liabilities on this calculation is discussed in Part III.A.1. Solely for purposes of determining the corporation s tax conse- quences under step 2 immediately below, each partner s holding period for the assets received includes the period the partnership held the assets. 86 b. c. The corporation is not impacted by this deemed liquidation. 2. The partners transfer the assets and liabilities to the corporation. a. No gain or loss is recognized by the corporation on the receipt of the assets and the assumption of the liabilities. 87 b. The basis in the assets in the hands of the corporation equals their basis in the hands of the partners which is the basis in the partners interests in the partnership immediately prior to the deemed liquidation 88 increased by any gain the partners would have recognized on the deemed contribution to the corporation. 89 However, unless the election noted above is made, the basis cannot exceed the fair market value of the assets I.R.C. 732(b). 86 I.R.C. 735(b). 87 I.R.C See supra Part I.A.3.b.1.b. 89 I.R.C. 362(a). 90 I.R.C. 362(e).

15 Cross Species Conversions and Mergers 605 c. The corporation s holding period for the assets transferred to it is the same as the holding period in the hands of the partners which includes the period the partnership held its assets. 91 c. Tax Consequences to Partnership. The partnership recognizes no gain or loss on its termination. 4. Summary The following table summarizes the general tax consequences of the three methods of incorporating a partnership. Each consequence is the final tax consequence after all steps have been completed. Partners gain or loss Partners basis in stock Partners holding period for stock Corporation s gain or loss Assets Over Assets Up Rev. Rul None, unless share of liabilities exceeds basis in partnership interest Same as basis in partnership interest* Generally includes period partnership held assets** None, unless money received exceeds basis in partnership interest or share of liabilities exceeds basis in assets**** Same as basis in partnership interest decreased by share of liabilities assumed by corporation* Generally includes period partnership held assets** None, unless share of liabilities exceeds basis in partnership interest**** Same as basis in partnership interest, decreased by share of liabilities, and increased by any gain recognized* Generally includes period partnership interest held** None None None, unless money received exceeds basis in partnership interest Interest Over Rev Rul None, unless share of liabilities exceeds basis in partnership interest**** Same as basis in partnership interest, decreased by share of liabilities, and increased by any gain recognized* Generally includes period partnership interest held** None 91 This includes the period the partnership held its assets. I.R.C. 1223(2); see also text accompanying note 66.

16 606 section OF TAXATION Corporation s basis for assets Corporation s holding period for assets Partnership s gain or loss Basis in hands of partnership plus any recognized gain, but limited to FMV of assets Includes period assets held by partnership None**** unless liabilities exceed basis of assets*** Partners basis in partnership interests, but limited to FMV of interests Generally includes period assets held by partnership Partners basis in partnership interests plus any gain recognized, but limited to FMV of interests Includes period assets held by partnership None None None Partners basis in partnership interests plus any gain recognized, but limited to FMV of interests Includes period assets held by partnership *After taking into account the allocation of any income, gains. losses, expenses, and distributions for the portion of the partnership s taxable year during which the interest in the partnership was owned. Also, if basis exceeds the fair market value of the assets or interests, the transferor and corporation can elect to limit basis to such far market value, thereby avoiding the limitation on basis in the hands of the corporation. **The difference in holding periods for stock received in exchange for capital and section 1231 assets and stock received in exchange of all other assets is discussed in Part III.C. ***Any gain or loss flows through to the partners in accordance with the partnership or operating agreement, increasing or decreasing the partner s basis for its partnership interest. ****This assumes the corporation is not an investment company. B. The Check-the-Box Regulations On December 18, 1996, the Treasury Department issued final regulations under section 7701 permitting taxpayers to elect the tax classification of certain business organizations the check-the-box regulations. 92 Generally, an unincorporated U.S. entity, such as a limited partnership or multi-member LLC, will be classified for federal income tax purposes as a partnership unless it elects to be taxed as a corporation. Although these regulations are generally considered in the context of choosing the tax form of an eligible business organization at the time it is organized that is, a domestic multi-member LLC being treated as a partnership upon formation or electing to be taxed as a corporation from the time of its formation 93 the check-the-box regulations also apply to elections to change tax status after the business organization has been organized and operating. For example, a multi-member LLC that has been in business for a 92 Reg to A discussion of why a domestic LLC would want to be taxed as a corporation is beyond the scope of this Article.

17 Cross Species Conversions and Mergers 607 number of years and has been taxed as a partnership can elect to be taxed as a corporation. 94 Regulation section (g)(1)(i) specifically provides that if a business entity taxed as a partnership, such as a multi-member LLC, elects to be taxed as a corporation, the following events are deemed to occur: 1. The partnership contributes all of its assets and liabilities to the corporation in exchange for stock in the corporation, and 2. The partnership liquidates, distributing all of the stock to its partners. These deemed events are an Assets Over transaction, the tax consequences of which were discussed in Part I.A.1 above. C. Conversions from Partnership to Corporation Form In Revenue Ruling , 95 the Service ruled that a conversion of an entity classified as a partnership for federal income tax purposes to a corporation under a state law formless conversion statute is treated as an Assets Over transaction. This treatment is the same as a check-the-box election by a partnership to be taxed as a corporation. Therefore, the tax consequences are the same as those described in Part I.A.1 above. Where a partner s basis in its interest in the partnership its outside basis is greater than that partner s share of the partnership s basis in its assets its inside basis an Assets Up transaction can result in a higher basis in the assets in the hands of the corporation. Therefore, if this higher basis is desired, rather than converting an LLC into a corporation, the incorporation transaction should be specifically structured as an Assets Up transaction. D. Merger of a Partnership into a Corporation Although a merger of an LLC and a corporation may be a merger under state law, it does not constitute a merger for federal income tax purposes. Section 368(a)(1)(A) defines a reorganization to mean a statutory merger or consolidation. The regulations expand on this definition, requiring that the participants in the statutory merger be corporations. 96 Thus, a merger of an LLC into a corporation or a corporation into an LLC is not a merger under section 368(a)(1)(A), and therefore is not a tax-free reorganization under sections 354, 355, and 356. Unlike conversions, the Service has issued no formal guidance on how a merger of a partnership into a corporation is to be treated. In a private let- 94 An election can be effective for up to 75 days prior to its filing and up to 12 months after its filing. When an election is made, generally another election cannot be made for 60 months. Reg (c)(iv). 95 Rev. Rul , C.B Reg

18 608 section OF TAXATION ter ruling, however, the Service applied the Assets Over approach. 97 Therefore, until formal guidance is issued by the Service, the tax consequences of a merger of a partnership into a corporation should be determined as an Assets Over transaction described in Part I.A.1 above. 98 As in a conversion, where a partner s outside basis is greater than that partner s inside basis, an Assets Up transaction can result in a higher basis in the assets in the hands of the corporation. Therefore, if this higher basis is desired, rather than merging the LLC into the corporation, the incorporation transaction should be specifically structured as an Assets Up transaction. II. Corporation to Partnership A. Specific Methods to Change from Corporate to Partnership Form The Service has not issued a Revenue Ruling similar to Revenue Ruling on the tax consequences of a change from the corporate to partnership form of business a disincorporation. However, there would seem to be the same three methods of doing so: 1. Assets Over, where the corporation contributes its assets to a partnership and then liquidates, distributing the partnership interests to its shareholders. 2. Assets Up, where the corporation liquidates, distributing its assets to its shareholders, and the shareholders then contribute those assets to the partnership. 3. Interests Over, where the shareholders contribute their stock in the corporation to the partnership, and the corporation then liquidates. Assuming the Service were to similarly rule that the method selected dictates the tax consequences, those tax consequences should be as follows. 1. Assets Over There are two variations of an Assets Over transaction, depending upon how the partnership is formed. In one variation, the corporation forms the partnership and becomes its sole partner at the time it transfers its assets and liabilities to the partnership. Because a partnership requires more than one partner, the partnership would likely be disregarded until it has more than one partner. If the entity is an LLC, a single-member LLC is treated as a disregarded entity. Thus, in either case, for tax purposes the corporation should still be treated as the owner of those assets, and no tax consequences would result from the transfers to the partnership. When the interests in the partnership are transferred to the shareholders, the entity becomes a partnership for federal income tax purposes. 97 P.L.R (Mar. 4, 1994). 98 Informal consultation suggests that this should be the correct approach.

19 Cross Species Conversions and Mergers 609 In Revenue Ruling , 99 the Service set forth the tax consequences when a single-member LLC becomes a partnership in two situations. In Situation 1, the sole member of an LLC (A) sells one-half of its LLC interest to an unrelated third party (B). With respect to this Situation, the Service ruled that B s purchase of a one-half interest in the LLC is treated as the purchase of a 50% interest in each of the LLC s assets, which are treated as held directly by A. Immediately thereafter, A and B are treated as contributing their respective interests in those assets to the LLC in exchange for interests in the LLC. Under section 1001, A recognizes gain on this deemed sale to B of A s 50% interest in each of the LLC s assets. By analogy, the formation of the single-partner partnership or single-member LLC by the corporation, followed by the distribution of the interests in the partnership or LLC to the corporation s shareholders, should be treated as a transfer of the assets which are deemed to be owned by the corporation to its shareholders, followed by the contribution of those assets by the shareholders to the partnership. This is the same as the Assets Up transaction discussed next. As discussed in Part II.B below, the regulations provide that if an eligible entity that is taxed as a corporation elects to be taxed as a partnership, the following events are deemed to occur: (i) the corporation liquidates, distributing all of its assets and liabilities to its shareholders; and (ii) the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. 100 These deemed events are also an Assets Up transaction, the same as described in Revenue Ruling Thus, until further guidance is provided by the Service, it would seem reasonable to apply the Assets Up rules to this variation of an Assets Over transaction. In the other variation, the shareholders form the partnership, making nominal capital contributions in proportion to what their ownership percentages will be when all of the transfers are complete. In this variation, the partnership will not be a disregarded entity but a partnership for federal income tax purposes from its formation, to which the corporation makes a capital contribution. Thus, neither Revenue Ruling nor the check-the-box Regulations should apply. Without further guidance from the Service, it would seem reasonable to apply an Assets Over analysis similar to that set forth in Revenue Ruling The tax consequences of this variation, where the partnership is not disregarded, are as follows: a. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on the transfer of its assets and liabilities to the partnership unless the partnership 99 Rev. Rul , C.B Reg (g)(1)(ii).

20 610 section OF TAXATION would be treated as an investment company as defined in section 351 if the partnership were incorporated. 101 The corporation s basis in the partnership interest it receives equals the amount of money and the basis in the assets transferred to the partnership. 102 However, this basis must be adjusted if any liabilities are assumed by the partnership. 103 For partnership interests received in exchange for capital and section 1231 assets, the holding period for the interests received by the corporation includes the period the transferred assets were held by the corporation. 104 For partnership interests received in exchange for all other assets, the holding period begins the day after these assets were transferred to the partnership. 105 On liquidation of the corporation, the corporation will recognize gain or loss as if it had sold the partnership interests distributed to its shareholders for their fair market value. 106 b. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on its receipt of assets and assumption of liabilities The basis in the assets in the hands of the partnership equals their basis in the hands of the corporation, increased by any gain recognized by the corporation. 108 The partnership s holding periods for the assets transferred to it includes the periods they were held by the corporation. 109 c. Tax Consequences to Shareholders. 1. Each shareholder will recognize gain or loss on receipt of the partnership interest on liquidation of the corporation equal to the 101 I.R.C. 721(a). For simplicity purposes, a partnership which would be an investment company under section 351 if it were incorporated will be referred to as an investment partnership. For purposes of this Article, it is assumed that any partnership to which property is transferred would not be an investment partnership. 102 I.R.C See infra Part III.A.2 for a detailed discussion of liabilities. 104 I.R.C. 1223(1). 105 Rev. Rul , C.B See infra Part III.C for a more detailed discussion of holding periods. 106 I.R.C I.R.C I.R.C I.R.C. 1223(2).

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