PRACTISING LAW INSTITUTETAX PLANNING FOR DOMESTIC & FOREIGN PARTNERSHIPS, LLCs, JOINT VENTURES &

OTHER STRATEGIC ALLIANCES 2013

December 2012

Use of Limited Liability Companies inCorporate Transactions

Mark J. SilvermanSteptoe & Johnson LLP

Washington, D.C.

Copyright © 2012 Mark J. Silverman, All Rights Reserved

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TABLE 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.

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I. INTRODUCTION..........................................................................................................................1

II. CHECK-THE-BOX REGULATIONS...........................................................................................1

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

III. WHAT IS A DISREGARDED ENTITY?...................................................................................13

A. In General.........................................................................................................................13

B. Determination of Single Owner........................................................................................19

C. Assessment and Collection Issues....................................................................................20

1. Liability for Tax ....................................................................................................20

2. Collection of Tax..................................................................................................22

D. Examples...........................................................................................................................23

1. Transactions Between Disregarded Entities and Their Owners ...........................23

2. Corporate Structures Involving Disregarded Entities ...........................................27

IV. TREATMENT OF CLASSIFICATION CHANGES...................................................................29

A. In General.........................................................................................................................29

B. Timing...............................................................................................................................29

C. Treatment of Elective Classification Changes..................................................................32

1. In General .............................................................................................................32

2. An Association Elects to be Classified as a Partnership.......................................32

3. A Partnership Elects to be Taxed as an Association .............................................34

4. An Association Elects to be a Disregarded Entity ................................................35

5. A Disregarded Entity Elects to be Classified as an Association ..........................36

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6. Legal Effect of Deemed Transactions ..................................................................37

D. Treatment of Automatic Classification Changes..............................................................38

1. Partnership to a Disregarded Entity – Rev. Rul. 99-6 ..........................................38

2. Disregarded Entity to a Partnership – Rev. Rul. 99-5 ..........................................40

3. Conversion of an Ineligible Entity into an Eligible Entity ...................................41

4. Overlap between Automatic and Elective Classification Changes .......................42

E. Treatment of Actual Conversions of An Existing Entity Into An LLC............................43

1. Converting Existing Corporations Into LLCs .......................................................44

2. Converting Existing Partnerships Into LLCs Classified as Partnerships ..............55

F. Solvency of Electing or Converting Entity.......................................................................56

1. In General.............................................................................................................56

2. Deemed Incorporation of Insolvent Entity...........................................................61

V. SALE OF A SINGLE-MEMBER LLC........................................................................................63

A. Sale of All of the Membership Interests...........................................................................63

1. Sale of All of the Membership Interests to a Single Buyer ..................................63

2. Sale of All of the Membership Interests Through a Cash Merger ........................64

B. Sale of Less than All of the Membership Interests...........................................................65

1. Sale of Less than All of the Membership Interests ...............................................65

2. Initial Public Offering of LLC Interests ...............................................................68

VI. REORGANIZATIONS INVOLVING SINGLE-MEMBER LLCS............................................70

A. A Reorganizations Involving Single-Member LLCs........................................................70

1. Definition..............................................................................................................70

2. History of Regulations..........................................................................................70

3. General Definition of Statutory Merger or Consolidation....................................73

4. All of the Assets Requirement..............................................................................77

5. Ceasing Separate Legal Existence Requirement..................................................80

6. Definition and Existence of Transferee and Transferor Units..............................84

7. Upstream Merger..................................................................................................91

8. Two-Step Acqusitions of Target Corporation......................................................92

9. Forward Triangular Merger..................................................................................95

10. Divisive Mergers Involving LLCs........................................................................96

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11. Application of the Final Regulations in the Context of Foreign Entities.............98

B. B Reorganization............................................................................................................103

C. C Reorganization............................................................................................................104

D. D Reorganizations..........................................................................................................107

1. Acquisitive D Reorganization.............................................................................107

2. Divisive D Reorganization.................................................................................109

E. F Reorganizations...........................................................................................................110

1. Basic F Reorganization.......................................................................................110

2. Partnership Formation as F Reorganization.......................................................111

3. F Reorganization Preceding an Acquisition .......................................................112

F. Use of LLCs in Spin-Off Transactions...........................................................................115

1. Spin-Off ..............................................................................................................115

2. Distribution of LLC Interests as a Spin-Off .......................................................117

3. Avoiding the Requirements of Section 355 ........................................................119

4. Avoiding the Requirements of Section 355: Distribution of Assets..................120

5. Section 355(e) Transaction .................................................................................122

VII. USE OF LLCS IN CONSOLIDATED RETURN CONTEXT..................................................125

A. Selective Consolidation ..................................................................................................125

1. In General ...........................................................................................................125

2. Selective Consolidation ......................................................................................125

B. Avoiding SRLY Limitations...........................................................................................126

1. In General...........................................................................................................126

2. SRLY Limitations ...............................................................................................127

C. Avoiding Intercompany Transaction Rules ....................................................................127

1. In General...........................................................................................................127

2. Intercompany Sale ..............................................................................................128

3. Intercompany Debt .............................................................................................130

D. Deconsolidation of Two-Member Consolidated Group .................................................130

1. In General...........................................................................................................130

2. Deconsolidation Using a Single-Member LLC ..................................................131

E. Avoid Triggering Restoration of Excess Loss Accounts ................................................131

1. In General...........................................................................................................131

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2. Avoiding Trigger of ELAs ..................................................................................132

VIII. USE OF MULTI-MEMBER LLCS IN CORPORATE TRANSACTIONS..............................133

A. Mergers Involving Multi-Member LLCs........................................................................133

1. Merger of Target Corporation Into LLC ............................................................133

2. Merger of LLC Into Acquiring Corporation .......................................................135

B. Multi-Member LLCs in the Consolidated Return Context.............................................136

C. Recognizing Losses Using Multi-Member LLCs...........................................................137

D. Change in Number of Members of Multi-Member LLC................................................138

1. Conversion of Multi-Member LLCs Into Single-Member LLCs .......................138

2. Conversion of Multi-Member LLCs Into Single-Member LLCs in the Consolidated Return Context..............................................................................139

E. Treatment of Holder of Multi-Member LLC Interest as General or Limited Partner....141

1. Section 469 Passive Activity Loss Rules ............................................................141

2. Self-Employment Tax .........................................................................................142

IX. DISADVANTAGES OF USING LLCs.....................................................................................142

A. Certain LLCs Cannot Be Parties to Reorganizations.....................................................142

1. In General...........................................................................................................142

2. Achieving Results Similar to a Tax-Free Reorganization ..................................143

B. Spinning Off a Lower Tier LLC.....................................................................................144

1. In General...........................................................................................................144

2. Spin-off of an LLC .............................................................................................145

C. Loss of Basis in the Stock of a Corporate Subsidiary....................................................146

1. In General...........................................................................................................146

2. Disappearing Basis .............................................................................................146

X. OTHER ISSUES.........................................................................................................................147

A. Treatment of Indebtedness..............................................................................................147

1. Whose Debt Is It—the Disregarded Entity’s or the Owner’s? ...........................147

2. Cancellation of Debt (“COD”) Income ..............................................................149

3. Indebtedness to Owner of Disregarded Entity....................................................150

B. Treatment of Outstanding Interests as Equity................................................................152

1. Automatic Classification Change.......................................................................152

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2. Convertible Debt .................................................................................................152

3. Granting Nonvested Equity Interests to Employees ...........................................153

C. Start-Up v. Expansion Costs...........................................................................................153

D. Like-Kind Exchanges.....................................................................................................154

1. In General ...........................................................................................................154

2. Qualifying property............................................................................................154

3. Acquiring Replacement Property.......................................................................155

E. Personal Holding Companies.........................................................................................156

F. Employment Issues.........................................................................................................157

1. Employer Identification Number (“EIN”) ..........................................................157

2. Employment and Withholding Taxes .................................................................157

3. Employee Retirement Plans ................................................................................161

4. Incentive Stock Option Plans ..............................................................................162

G. Filing Requirements........................................................................................................162

XI. STATE TAX CONSIDERATIONS...........................................................................................163

A. State Treatment of LLCs................................................................................................163

B. Achieving Consolidated Results In States That Prohibit Consolidation........................166

C. Achieving Section 338(h)(10) Results in States That Do Not Recognize the Election..166

1. General ................................................................................................................166

2. Achieving Section 338(h)(10) Treatment for State Tax Purposes ......................167

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Examples

1 Contribution to Disregarded Entity....................................................................................................232 Distribution From Disregarded Entity.............................................................................. 243 Debt Between a Disregarded Entity and its Owner.......................................................... 254 Transactions Between Commonly Owned Disregarded Entities...................................... 255 Multiple Disregarded Entities........................................................................................... 276 Preservation of S Corporation Status................................................................................ 287 Corporate Contribution of Assets to an LLC Classified as Either a

Partnership or a Disregarded Entity Followed by Corporate Liquidation........................ 458 Formation of LLC by the Corporation and its Shareholders Followed by

Liquidation of Corporation............................................................................................... 469 Merger of Corporation Into Multi-Member LLC............................................................. 48

10 Merger of Corporation Into Single-Member LLC............................................................ 5111 Merger of Wholly Owned Subsidiary Into Single-Member LLC..................................... 5312 Partnership-to-LLC Conversion........................................................................................ 5513 Sale of All of the Membership Interests to a Single Buyer............................................... 6314 Sale of All of the Membership Interests Through a Cash Merger.................................... 6415 Sale of Less than All of the Membership Interests........................................................... 6516 Initial Public Offering of LLC Interests............................................................................ 6817 Merger Into LLC (Base Case)........................................................................................... 7518 Sprinkling of Assets Among Transferee Unit................................................................... 7919 Consolidation.................................................................................................................... 8120 Forward Triangular Amalgamation................................................................................... 8321 Merger of Disregarded Entity Owned by Partnership....................................................... 8522 Merger into LLC in Exchange for LLC Interests.............................................................. 8623 Merger of Corporate Partner into Partnership................................................................... 8824 Upstream Merger.............................................................................................................. 9125 Merger Into LLC Followed by Merger Upstream............................................................. 9226 Acquisition of T Stock Followed by Alternative Transfers to P....................................... 9327 Forward Triangular Merger.............................................................................................. 9528 LLC Merger Into Corporation........................................................................................... 9629 Merger of Corporation into Multiple LLCs...................................................................... 9730 Transaction Effected Pursuant to Foreign Law................................................................. 9931 Merger with Foreign Entity............................................................................................... 10032 Drop and Check vs. Check and Drop................................................................................ 10133 B Reorganization............................................................................................................... 10334 C Reorganization............................................................................................................... 10435 Acquisitive D Reorganization........................................................................................... 10736 Divisive D Reorganization................................................................................................ 10937 Basic F Reorganization..................................................................................................... 11038 Conversion as F Reorganization....................................................................................... 11139 F Reorganization Preceding an Acquisition...................................................................... 11240 Spin-Off............................................................................................................................ 11541 Distribution of LLC Interests as a Spin-Off...................................................................... 11742 Avoiding the Requirements of Section 355...................................................................... 119

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Examples

43 Avoiding the Requirements of Section 355: Distribution of Assets................................ 12044 Section 355(e) Transaction............................................................................................... 12245 Selective Consolidation..................................................................................................... 12546 SRLY Limitations............................................................................................................. 12747 Intercompany Sale............................................................................................................. 12848 Intercompany Debt............................................................................................................ 13049 Deconsolidation Using a Single-Member LLC................................................................. 13150 Avoiding Trigger of ELAs................................................................................................ 13251 Merger of Target Corporation Into LLC........................................................................... 13352 Merger of LLC Into Acquiring Corporation..................................................................... 13553 Multi-Member LLCs in the Consolidated Return Context............................................... 13654 Recognizing Losses Using Multi-Member LLCs............................................................. 13755 Conversion of Multi-Member LLCs Into Single-Member LLCs..................................... 13856 Conversion of Multi-Member LLCs Into Single-Member LLCs in the

Consolidated Return Context............................................................................................ 13957 Achieving Results Similar to a Tax-Free Reorganization................................................. 14358 Spin-off of an LLC............................................................................................................ 14559 Disappearing Basis............................................................................................................ 14660 Convertible Debt............................................................................................................... 15261 1031 Exchange.................................................................................................................. 15462 Achieving Section 338(h)(10) Treatment for State Tax Purposes.................................... 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 disregarded as an entity separate from its owner (a “disregarded entity”). Id.2

1 “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)).

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.

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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 statute, 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. 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).

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.

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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. § 301.7701-2(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. § 301.7701-2(b)(7); and

e. Those foreign entities listed in Reg. § 301.7701-2(b)(8).5

f. However, the Service has concluded that an otherwise per-se corporation that is administratively dissolved by the state’s

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 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.

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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).

3. 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. § 301.7701-2(e)(3)(ii). Otherwise, the final regulations apply to all business entities existing on or after August 12, 2004. See § 301.7701-2(e)(3)(i).

4. Series LLCs

a. 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).

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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.

(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.

d. 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). Ownership of interests in a series and of the assets associated with a series is determined under general tax principles.

(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.

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(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.

e. 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.

C. 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. 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.

2. Certain entities are deemed to have filed elections. Reg. § 301.7701-3(c)(1)(v).

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.

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3. 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 check-the-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.

4. 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 return 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

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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. § 301.7701-3(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.

D. 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

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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).

E. 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. Thus, the same country exception in section 954(c)(3) applies to exclude the interest from subpart F income.

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.

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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 proposed regulations were finalized without substantial change. See T.D. 9093, 2003-2 C.B. 1156.7

6 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.

7 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).

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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 98-11, 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).

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. § 301.9100-1(c), to file a retroactive election to be a disregarded entity, which the Service reluctantly granted. The parties agreed that the check-the-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

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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 income, without regard to whether it has checked the box to be disregarded.

b. This statute originally expired at the end of 2011, but was extended to December 31, 2013.

9. 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 wholly-owned 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

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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.

10. 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.

III. 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 they were conducted by a division or a branch of the corporation. Reg. § 301.7701-2(a).

3. 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.

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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.

4. 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 to the properties, and solicited new tenants and negotiated leases for the properties).

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.

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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.

5. 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).

(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

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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.

b. 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).

(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

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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. § 301.7701-2(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 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-the-box regulations govern how a single-member LLC is taxed for

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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.

(i) The taxpayer had transferred cash and securities to a single-member 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.

h. Under proposed regulations implementing the Affordable Care Act, a disregarded entity will be regarded for purposes of an 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).

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.

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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.

B. 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).

(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.

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(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).

2. 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.

3. 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).

C. 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. Classified as Corporation

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(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.

b. 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 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. 9220-22 (Feb. 24, 2005).

c. 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. § 301.7701-2(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.

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(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.

2. 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).

(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).

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D. Examples

1. Transactions Between Disregarded Entities and Their Owners

a. Example 1 – Contribution to Disregarded Entity

(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.

P

LLC

Property LLC Interests

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b. Example 2 – Distribution From Disregarded Entity

(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).

P

LLC

Appreciated Property 100%

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c. Example 3 – Debt Between a Disregarded Entity and its Owner

(i) 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.

d. Example 4 – Transactions Between Commonly Owned Disregarded Entities

A B

100%99%

1% Y

Z

W

Merger

A B (1)X Stock

X

1% X StockW

(2)

Z

1% X Stock

YX(3)

P

LLC

LLC Note 100%$

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(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).

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2. Corporate Structures Involving Disregarded Entities

a. Example 5 – Multiple Disregarded Entities

(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 LLC-3, 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.

P

LLC-1 LLC-2

LLC-3

100% 100%

50% 50%

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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

(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

A Trust

A Trust

S-Corp Stock

LLC Interests

S-CorpLLCS-Corp

LLC

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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. 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 60-month 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.

B. 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

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must be taken in choosing the effective date of the change in classification.8

b. 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).

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).

8 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.

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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).

C. Treatment of Elective Classification Changes 9

1. 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

9 For purposes of this outline, unless otherwise specified, assume all corporations involved are solvent for all purposes.

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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 step-transaction 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).

2. An Association Elects to be Classified as a Partnership

a. 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.

b. Tax Consequences

(i) 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 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.

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(iii) If the corporation is treated as liquidating into an “80-percent 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.

c. 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 check-the-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).

3. A Partnership Elects to be Taxed as an Association

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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.

b. 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

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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. 2009-15, 2009-21 I.R.B. (May 7, 2009).

4. 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 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. Tax Consequences

(i) The association recognizes gain on the distribution of any appreciated assets. Section 336(a). The shareholder

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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.

5. 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).

b. 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.

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(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.

6. 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 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) 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.

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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.

D. 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.

(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).

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(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).

c. 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.

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.

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(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.

(ii) 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.

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(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.

3. 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. § 301.7701-3(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.

(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.” Browning-Ferris Indus., Inc. v. United States, 274 Fed. Appx. 904 (Fed. Cir. 2008).

(ii) This holding takes an overly narrow view of the check-the-box regulations. The default rules clearly treat the

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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.

4. 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.

(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.

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(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.

c. 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.

E. 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 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.

10 State tax issues are discussed below in section XI of this outline.

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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.

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b. Example 7 - Corporate Contribution of Assets to an LLC Classified as Either a Partnership or a Disregarded Entity Followed by Corporate Liquidation

(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,

A B A B

STEP 1:STEP 2:

LLC Interests

50% 50%

Assets

LLC

LLC Interests

LLC Interests

LLC

P P

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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

(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

A B

50% 50%

Assets

A B

LLC

STEP 1: STEP 2:

LLC Interests

LLC

P $1.00 $1.00

LLCInt.

LLCInt.

P’s LLC Int.

P’s LLC Int.

P

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contributed assets, increased by the amount of gain 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

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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 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, 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.

d. Example 9 - Merger of Corporation Into Multi-Member LLC

P

S-1

LLC

Merger

S-2

100% 100%

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(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 80-percent 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

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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. § 1.704-3(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 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.

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e. Example 10 - Merger of Corporation Into Single-Member LLC

(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 single-member 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).

P LLC Merger

100%

A

100%

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(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 § 29-1013; 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. § 301.7701-3(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).

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f. Example 11 – Merger of Wholly Owned Subsidiary Into Single- Member LLC

(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) 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. § 301.7701-3(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).

i.) 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).

P LLC Merger

100%100%

X

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(b) As discussed below in Section VI.A., Reg. § 1.368-2(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 single-member 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.

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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

(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

LLC Merger

A B

GP

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result in the recognition of gain to the LLC, the existing partnership, or its partners. Rev. Rul. 95-37 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.

(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.

F. Solvency of Electing or Converting Entity

1. In General

a. 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.

11 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.

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(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.

b. 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).

2. 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 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

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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 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.

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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 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

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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 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)).

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(e) 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).

3. 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 over-encumbered 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 over-encumbered 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. 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.

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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) 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).

b. If section 351 does not apply, the deemed transfer would presumably be either a taxable exchange or a taxable 301 distribution to the owner.

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

P

LLC

Sale of 100% LLC Interests

Cash

X

100%

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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 sale of the LLC interests as the sale of the LLC’s assets. See Rev. Rul. 70-140, 1970-1 C.B. 73.

c. 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. § 301.7701-3(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.

100%

P X

LLC S Merger

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2. Example 14 – Sale of All of the Membership Interests Through a Cash Merger

a. 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 state statute permitting such mergers). P exchanges LLC interests for cash from X.

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.

B. Sale of Less Than All of the Membership Interests

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1. Example 15 – Sale of Less Than All of the Membership Interests

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 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.

X

LLC

100%

50% of LLC

P

Cash

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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 pre-section 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 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 50-percent interest. Therefore, LLC’s entire basis in its goodwill is nonamortizable. See Reg. § 1.197-2(k), Ex.18.

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(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 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.

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2. Example 16 – Initial Public Offering of LLC Interests

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 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.

P

LLC

Public

50% LLC Interests

Cash

100%

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(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).

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VI. REORGANIZATIONS INVOLVING SINGLE-MEMBER LLC s

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. § 1.368-2(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

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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. § 1.368-2T(b)(1)(ii)):

(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.

(iii) 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.

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(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. 2000-5, 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. § 1.368-2T(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.

c. 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

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merger or consolidation.” Compare Old Temp. Reg. § 1.368-2T(b)(1)(ii) with Old Prop. Reg. § 1.368-2(b)(ii).

(a) 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 above-listed 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.

3. 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

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(a) 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.

b. 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.

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c. Example 17 – Merger Into LLC (Base Case)

(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

P T

LLC

100%

P Voting Stock

Merger

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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-the-box 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

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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) 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)).

4. 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. § 1.368-2T(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. § 1.368-2(b)(1)(iii), Ex. 8; Preamble to Old Temp. Reg. § 1.368-2T(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

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having to comply with the substantially all requirement of section 368(a)(2)(D).12

(iii) 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.

b. 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. § 1.368-2T(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, LLC-2, both of which are disregarded entities, and T merged into LLC-2, the conclusion should not change.

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.

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(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.

c. Example 18 – Sprinkling of Assets Among Transferee Unit

(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.

LLC1

P

100%

T

P Voting Stock and

cash

Merger LLC3

100%

LLC2

100%

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(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.

5. 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) 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.

(ii) Similarly, if T1 were a disregarded entity, it is not required to transfer all of its assets and liabilities and go out of existence.

b. 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

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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.

(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.

(ii) 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.

c. 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

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(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.

P T

Consolidation

Y

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(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. § 1.368-2(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

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 :

P

S

T

U

Amalgamation

P Voting Stock

P Voting Stock

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a) 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.

iii.) 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) 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. 4276-4294. 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.

6. Definition and Existence of Transferee and Transferor Units

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a. Example 21 – Merger into Disregarded Entity Owned by Partnership

(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.

b. 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.

LLC

100%

T

P Voting Stock

and cash

Merger

P

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(ii) Example 22 – Merger into LLC in Exchange for LLC Interests

(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.

P

100%LLC

Interests

Merger

TLLC

A P

LLC(P-Ship)

A

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(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. § 1.368-2(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).

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(iii) Example 23 – Merger of Corporate Partner into Partnership

(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.

50%P stock and

cash

Merger50%

P T

X(P-ship)

P

X(DE)

100%

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(c) 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.

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) 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. 99-6 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:

i.) 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 anti-mixing 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,

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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.

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7. Example 24 – Upstream 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 single-member 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).

100%

50% T Assets

Merger

P

LLC T S1

2

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(ii) 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 no-rule 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).

8. Two-Step Acquisitions of Target Corporation

a. Example 25 – Merger Into LLC Followed by Merger Upstream into P

(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

LLC

P T

P Voting Stock

and cash

Merger

STEP ONEMerger

STEP TWO

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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. § 1.368-2T(b)(1).

b. Example 26 – Acquisition of T Stock Followed by Alternative Transfers to P

(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) T ax 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

P

LLC

100%

T Stock

50% P Stock50% Cash

T

P

LLC

T SHs

T

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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

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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.) 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.

9. Example 27 – Forward Triangular Merger

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. § 1.368-2(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

P

T

LLC

Merger

S

P Voting Stock

- 96 -

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

(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).

T P

LLC

100%Merger

- 97 -

(c) 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.

b. Example 29 – Merger of Corporation into Multiple LLCs

(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

100%

P Voting Stock

Merger

100%

Merger

P

LLC-1 LLC-2 T

A

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directly to LLC-1 and a portion are transferred directly to LLC-2.

(ii) 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).

11. 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).

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b. Example 30 – Transaction Effected Pursuant to Foreign Law

(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.

P T

Merger

P Stock

USLLC

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c. Example 31 – Merger with Foreign Entity

(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. § 1.368-2T(b)(1)(iii).

(b) Therefore, T may merge into a foreign disregarded entity of P.

Merger

LLC1

USLLC2

Foreign

PUS

P voting stock and cashT

Foreign

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d. Example 32 – Drop and Check vs. Check and Drop

(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

PUS

CFC1 stock

CFC1Foreign

NewCFCForeign

CFC1Foreign CTB Election

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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.

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B. Example 33 - B Reorganization 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?

14 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).

TShareholders

T

LLC

P VotingStock

P

T Stock100%

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(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.

C. Example 34 - C Reorganization 15

1. 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.

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).

15 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.

P

T

LLC

TShareholders

P Voting Stock

T Assets andLiabilities

PVotingStock

100%

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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.

(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).

(iii) However, as discussed further below in Section X.A., the Service has looked to state law rights and obligations in holding that the conversion of a corporation into a single-member LLC did not result in a modification of debt owed by the corporation under Reg. § 1.1001-3. P.L.R.

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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).

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D. D Reorganization s 16

1. Example 35 – Acquisitive D Reorganization

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 subsidiary to Newco, followed by conversion of subsidiary into LLC and then a contribution of stock of a second wholly-owned

16 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).

100%

Merger

T

100%

P

A

T Stock

100%

100%

T

P

LLC

A

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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-to-foreign D reorganization is tax free under section 367(b).

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2. Example 36 – Divisive D Reorganization

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

C

Conversion

CC-LLC

D Shareholders D Shareholders

D D

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distribution of C stock qualifies as a tax-free divisive D reorganization. P.L.R. 200743007 (Jul. 10, 2007).

E. F Reorganization s 17

1. Example 37 – Basic F Reorganization

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-the-box 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 (May 27, 2003); P.L.R. 200422047 (May 28, 2004); F.S.A. 200237017 (June 7, 2002).

17 Section 368(a)(1)(F) treats as a reorganization a merge change in identity, form, or place of organization of one corporation, however effected.

P Shareholders

Check the Box Election

P Shareholders

PP-LPPCheck the Box Election

P Shareholders

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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.

2. Example 38 – Conversion as F Reorganization

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 tax-free 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).

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);

Convert/Check the Box

1% S Stock

1

2

P

SLLC S-LLC 1%

LLC99%

P

S-LLC

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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).

3. Example 39 - F Reorganization Preceding an Acquisition

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.

(ii) Step 2 : New T forms LLC, a new disregarded entity.

T Shareholders

T(Bus. A & B)

New T Stock

Bus. A

New T

LLC

1

2

Merger

3

T Shareholders

LLC(Bus. B)

Merger

New T(Bus. A)

P

LLCInterests

4

5

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(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.

b. 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).

Thus, this transaction is useful when a potential target

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would like to shed itself of contingent liabilities in preparation for an acquisition.

(ii) 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 tax-free 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.

(iii) 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 a disregarded entity. The Service has treated this

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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

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

(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

D

S-1Qualif. T/B

S-2Qualif. T/B

S-3Nonqualif.

S-4Nonqualif.

P Shareholders

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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.

(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.

(c) 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,

D

S-1Qualif. T/B

S-3Nonqualif.

S-4Nonqualif.

P Shareholders

Merger

S-2Qualif. T/B LLC

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1996-1 C.B. 696, Appendix A, § 2.09; Rev. Rul. 78-383, 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 single-member LLCs may reduce the use of the risk reduction business purpose set forth in Rev. Proc. 96-30.

(iv) 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.

2. Example 41 – Distribution of LLC Interests as a Spin-Off

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.

D

C

LLC

A B

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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.

(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. § 1.355-2(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).

i.) It is unclear what test is applied in determining whether continuity of interest is satisfied with respect to a spin-off.

ii.) 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

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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.

3. Example 42 – Avoiding the Requirements of Section 355

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 all of its assets and liabilities to its owner in complete liquidation).

LLC

P

C

D LLC

P

C

STEP 1 STEP 2

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(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.

4. Example 43 - Avoiding the Requirements of Section 355: Distribution of Assets

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

P

S-1(Bus. A &

B)Merge

S-2(Bus. A)

LLC-2

LLC-2Interests

Business A

LLC-2InterestsP

LLC S-2(Bus. A)

LLC(Bus. B)

LLC-2

1

2

3

4

5 6

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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

(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.

c. 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.

d. 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

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Service ignored the distribution and concluded that the conversion was a tax-free section 351 transaction.

5. Example 44– Section 355(e) Transaction

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 33-1/3% 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.

D

C

D

LLC

D Shareholders

100%

STEP 1

D Shareholders

STEP 2

C P

33-1/3 % 66-2/3 %

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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) 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. § 1.368-1(d)(4)(iii)(B), -1(d)(5), Ex. 9.

(ii) 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 50-percent 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.

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)

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(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.

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?

iii.) 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.

iv.) 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

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reference to section 381 transactions. Prop. Reg. § 1.355-8(c)(1).

VII. 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

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

LLC

Merger

P

S-2S-1

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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. § 301.7701-3(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 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.

B. 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.

2. Example 46 – SRLY Limitations

P

S-1

S-2

T Merger

LLC

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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.

C. 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. § 1.1502-13(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 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

P

S-2 S-1

S-3

LLC

50%

50%

Land

Cash

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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.

(i) 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 S-3 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).

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(ii) 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.

c. 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, 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

S-2

S-3

Newco

Newco Stock

S-1

Business Aand P Note

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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.

D. Deconsolidation of Two-Member Consolidated Group

1. In General

For a variety of reasons a two-member consolidated group may wish to 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%

Merger

S LLC

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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 single-member 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.

E. Avoid Triggering Restoration of Excess Loss Accounts

1. In General

Another concept that is unique to consolidated groups is that of an excess 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

18 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.

P

ELA 100%

Merger

S LLC

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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 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 LLC s IN CORPORATE TRANSACTIONS

A. Mergers Involving Multi-Member LLCs - The default classification for a multi-member 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

T 1%

S

99%

MergerLLC

TShareholders

- 133 -

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.

(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).

c. 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

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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 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

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,

P

A 1%

S

99%

MergerLLC

AShareholders

- 135 -

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.

(ii) Upon the distribution of A stock to the members, no additional gain or loss should be recognized by P, S, or LLC.

B. Example 53 – Multi-Member LLCs in the Consolidated Return Context

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.

A

S

P

S A B C

LLC

STEP 1P

STEP 2

SStock

Merger

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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).

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

Class A

40% 40%

Class A

Class B

20%

X YPublic

S

LLC

X Y

Class A Stock

Business

LLC

$ $

$

50% LLC Interest

50%LLC

Interest

S

Class A

$

50% 50%

Class A

Public

$

Class B Stock

20% LLC Interest

X

S

Y

LLC

1 1

2

3

4

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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 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. 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.

D. Change in Number of Members of Multi-Member LLC

1. Example 55 – Conversion of Multi-Member LLCs Into Single-Member LLCs

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.

LLC

A

50% 50%

$10,000

50% LLC Interest

B

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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 in the LLC. Thus, A must treat the transaction as a sale of a partnership interest. See Reg. § 1.741-1(b).

(ii) 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 50-percent 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).

2. Example 56 – Conversion of Multi-Member LLCs Into Single-Member LLCs in the Consolidated Return Context

LLC

50% 50%

$10,000

50% LLC InterestX Y

P

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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).

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(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).

E. 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

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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. 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. 105-34, by placing a moratorium on the issuance of regulations defining the term “limited partner” for purposes of the self-employment tax until July 1, 1998.

d. Thus, the treatment of LLC members for purposes of the self-employment tax is currently uncertain.

IX. 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

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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

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.

P

XLLC

Newco

100%

Assets

Pref’dStock Assets

Common Stock

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(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.

B. 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.

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2. Example 58 – Spin-off of an LLC

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 spin-off. 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.

LLC

Newco

100%

P

PShareholders

Assets N Stock

NewcoStock

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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

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.

P

$300 Basis 100%

Merger

S LLC

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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 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.

X. 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).

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(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.

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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) 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).

(ii) 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

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is discharged, presumably the owner has COD income, even if the LLC is insolvent.

(a) 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).

(iii) 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.

c. 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.

3. 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.

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(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).

d. 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 their intercompany debt and transfer an asset from Sub 1 to P tax free.

19 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.

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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

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?

(ii) If A exercises its conversion option and receives membership interests in LLC, LLC will no longer have a

P

A

LLC

Cash

Convertible Debt100%

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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.

3. 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. § 1.83-1(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.

C. 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 separate from the parent, the activities of the LLCs will be treated as an

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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

(i) 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 complex. An individual, C, also owns an apartment

LLC-1

LLC-2

A B

C

LLC-2

Interests in LLC-2

Apartment Complex

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complex. LLC-1 transfers its interest in LLC-2 to C in exchange for the apartment complex owned by C.

(ii) 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).

3. 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.

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(iii) 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. 99-6, and (ii) because LLC was disregarded, the taxpayer was treated as acquiring the replacement property directly. Accordingly, the arrangement qualified under section 1031.

b. 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).

E. 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.

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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. § 301.6109-1(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) 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.

2. 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).

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(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.

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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 self-employed for purposes of the self-employment tax).

(a) 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).

(iii) 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. 2009-242; Leedreau v. Commissioner, T.C. Summ. Op. 2009-195; E.C.C 201112014 (March 25, 2011).

(iv) 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

20 See also Med. Practice Solutions, LLC v. Commissioner, T.C. Memo. 2010-98 (2010), addressing subsequent tax periods.

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purposes. See F.A.A. 20093701F (July 27, 2009); E.C.C. 200946050 (July 17, 2009).

c. 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) As a result, successor liability does not attach to the disregarded entity’s assets. I.L.M. 200840001 (Aug. 28, 2008).

(ii) 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.

d. 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 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.

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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).

3. 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).

4. 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

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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).

G. 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.

b. The disregarded entity is also not required to file a separate Form 1023 exemption application. See P.L.R. 200134025 (May 22, 2001).

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XI. 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.

i. Washington taxes LLCs as partnerships; however, it should be noted that Washington does not have a personal income tax.

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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.

2. 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.

f. Wisconsin imposes a recycling surcharge tax on LLCs with more than $4 million in gross receipts.

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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.

(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.

h. 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. Assembly Bill 198 also limits refunds for taxes paid when the law was unconstitutional. See William Hays Weissman, What Is the

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Remedy for California’s Tax Problems?, 2007 STATE TAX TODAY 243-9 (Dec. 17, 2007).

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.

B. 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 single-member 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 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

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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

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. § 301.7701-3(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). 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 same tax treatment as if the state recognized the section 338(h)(10) election.

P

S

X

LLCMerger

100% LLC Interests

Cash100% 100%

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