American Bar Association 2010 Joint Fall CLE Meeting,
Toronto, ON, September 24, 2010
Primer on Tax Aspects and Mechanics
of Entity Conversion
Panelist:
Cassady V. Brewer
Lisa M. Rico
Morris, Manning & Martin, LLP
Gilmore, Rees & Carlson, P.C.
Atlanta, GA 30326
Wellesley Hills, MA 02481
[email protected]
[email protected]
404.504.7627
781.431.9788
Allen Sparkman
Sparkman Shaffer Perlick LLP
Denver, CO 80202
[email protected]
303.396.0230
Primer on Tax Aspects and Mechanics
of Entity Conversion
These materials were originally prepared by Cassady V.
Brewer as “Taxation of Business Transactions: Entity
Conversions” and updated by Lisa M. Rico for this
presentation.
Entity Conversions: Overview
This is an important area to understand because, if done
right, it can save you and your client much grief.
If done wrong, however, it can be a tax disaster.
Complexity stems in part from two sources:
• Promulgation of inter-entity conversion statutes
(e.g., LLC to corporation and vice versa).
• LLCs can be taxed in three different ways: (i)
disregarded; (ii) partnership; or (iii) corporation.
Entity Conversions: Overview
Tax lawyers and tax accountants tend to LOVE this area,
while business people and other lawyers HATE it, because it
illustrates a fundamental rule that keeps tax lawyers and
tax accountants gainfully employed:
FORM MEANS EVERTHING;
SUBSTANCE IS MEANINGLESS,
EXCEPT WHEN IT ISN’T . . . .
Background on “Conversion” Legislation
In many states (e.g., Delaware, Massachusetts, and
Georgia), its LLC Act permits conversion from domestic
corporation to domestic LLC.
Conversion Transactions: Why?
Straight conversion avoids transferring assets and
may involve little disruption of the business whereas
merger or other “conversion” transaction usually
involves asset transfers and some disruption of
business.
Further, in certain circumstances it may be
advantageous to have one type of income tax
treatment (e.g., S corporation), but a unique statelaw characteristic (e.g., restrictions on transfer
and/or forfeiture of interests) associated with an LLC.
Conversion Transactions: Why?
In all cases, the advisor must be mindful of the tax
implications that arise as part of the conversion.
If nothing else, remember this: Conversion from
LLC to corporation generally is nontaxable, but
conversion of a corporation (even an S corporation)
into an LLC almost always is taxable (despite the fact
that there will be no cash event out of which to pay
the tax).
Conversion to or from disregarded entity from or to
partnership either to add investors to entity or remove
members.
Conversion Transactions: Defined
Five basic types of “conversion” transactions:
1.
2.
3.
4.
5.
Juridical/“Formless”
Merger Into Newly-Formed Shell Entity
Tax-Only
Dissolution and Reformation Transactions
Pure Re-Domestication Transactions
As explained further below, we will focus on first three.
Number four is undertaken only in unusual circumstances.
Number five seldom has any income tax consequences.
Conversion Transactions: Defined
Juridical/“Formless” conversions are those
undertaken pursuant to state law inter-entity conversion
statutes.
Example: Delaware LLC elects to convert to a Delaware
or Delaware corporation.
Juridical/“formless” conversions generally have both tax
and state law implications.
Conversion Transactions: Defined
A merger into a newly-formed shell entity is both a
juridical and tax conversion and, as such, can have both
tax and state law implications.
Example: Merger of an existing Delaware LLC with and
into a newly-formed Delaware shell corporation.
Not “formless” because a second entity must be formed
and the original entity merged with and into the newlyformed entity.
Prior to the promulgation of the inter-entity conversion
statutes, this is the way most conversion transactions
were accomplished.
Conversion Transactions: Defined
Tax-only conversions most often involve LLCs and
have income tax but generally no state law implications.
For instance, as explained further below tax-only
conversions of LLCs may occur by either:
(i) filing IRS Form 8832, or
(ii) certain changes in ownership.
Often-used but deceptively simple example: The LLC S
corporation. See Reg. § 301.7701-3(c)(1)(v)(C).
Conversion Transactions: Defined
In dissolution and reformation conversions the actual
transaction steps are undertaken to convert an entity from
one form to another.
Example: Liquidation and dissolution of an LLC followed by
transfers of the assets from the former LLC members to a
newly-formed corporation.
These conversion transactions are highly-tax sensitive and,
moreover, are less often used unless there is a very
particular tax or possibly state law reason why the actual
dissolution and reformation steps must occur (as opposed to
using some other type of conversion technique).
Conversion Transactions: Defined
Pure re-domestication conversions simply involve
moving the state of organization of an entity without
changing its state law or tax form.
Example: Converting a Georgia LLC into a Delaware
LLC, or a Georgia corporation into a Delaware
corporation.
Re-domestication conversions generally have state law
implications but no income tax consequences provided
the form of the entity remains the same between the
two states.
Conversions: Underlying Tax Rules
To properly advise our clients and to take full advantage
of the various entity conversion techniques, it is
necessary to understand some fundamental tax rules.
Primarily, these are the so-called “Check the Box” rules,
and they are found in IRC § 7701 and the regulations
thereunder.
Conversions: Underlying Tax Rules
The “Check the Box” rules govern how an entity is
classified (i.e., treated as disregarded, as a partnership,
or as a corporation) for federal income tax purposes.
By default, the rules generally classify entities in the
most favorable category (i.e., disregarded or partnership
treatment) with the option to elect into corporate
treatment if desired.
But, as common sense would dictate, a corporation
formed under state law will be classified as a corporation
for income tax purposes as well.
CHECK THE BOX DEFAULT RULE CHART
All Entities
Eligible
Entities
Eligible Entities
Made in USA
Not Made in USA
Per Se
Corporations
1.
2.
3.
4.
Incs.
Listed Foreign Entities
Banks
Etc.
No Member Liable
Domestic Eligible Entities
Foreign Eligible Entities
Corporation*
(Whether 1 or more owners)
Any Member Liable
Single Owner
Disregarded for
Tax Purposes
Two or More Owners
Foreign Member
Liability Entity
Partnership
Single Owner
*But can elect on Form 8832
to be treated as a passthrough.
Disregarded for
Tax Purposes
Two or More Owners
Partnership
Some Tax Conventions
OR
OR
=
Individual
=
Corporation
=
Partnership
=
Disregarded
The Basics: An “Inc.” is a Tax Corporation
Too
Individual
100%
Corporation
Pursuant to Check the Box
regulations, normal
corporations formed under
state law automatically are
treated as corporations (i.e,
“associations”) for income tax
purposes. Reg. § 301.77013(a).
Single Member LLC Is Disregarded:
Reg. § 301.7701-3(b)(1)
Individual
100%
LLC
Single Member LLC Is Disregarded:
Reg. § 301.7701-3(b)(1)
Corporation
100%
LLC
Multiple Member LLC Is Partnership:
Reg. § 301.7701-3(b)(1)
Individual
Corporation
50%
50%
LLC
Purchase of Single Member LLC
LLC
r
o
f
sh
a
C
:
l
Lega Interest
Acquiror
Individual
100%
Tax
: Ca
s
Asse h for
ts
If the selling entity is a single member
LLC, then the transaction will be treated
for tax purposes as an asset sale, even if
the purchaser acquires the owner’s LLC
interest for state law purposes. Note
different treatment for gift of an interest
in a single member LLC under Pierre v.
Commissioner, 133 T.C. No. 2
(8/24/2009), which held for gift tax
purposes treated as transfer of an entity
rather than transfer of underlying assets.
Single Member LLC
Ordinary
Income
and/or
Capital Gain
Depending
On Assets
FYI: Allocation of
Purchase Price Key
Due to
Characterization
Issues
Tax-Only Conversions
Election on Form 8832 or Changes From
Single- to Multi-Member Status or Vice Versa
Tax-only conversions do not involve a change in the
entity under state law.
Tax-only conversions primarily involve LLCs.
Generally, will be tax-free, but possibly for different
reasons depending upon situation: Form 8832 election or
ownership change.
Tax-Only Conversions
Election on Form 8832
If electing corporate treatment on Form 8832, IRC § 351
applies, but as noted above liabilities in excess of basis can
cause gain. See Reg. § 301.7701-3(g)(1).
Can be retroactive as much as 75 days. See Form 8832.
Same subtle tax issues present.
Example: FEIN stays same. Reg. § 301.6109-1(h).
New tax year, accounting method changes, employment
tax credit, etc. are still concerns.
Single Member LLC Is Disregarded:
Reg. § 301.7701-3(b)(1)
Individual
100%
LLC
Unless Form 8832 Is Filed, Then Association
Individual
100%
LLC
Association
If file Form 8832, then can
elect “association” status
for income tax purposes.
“Associations” are taxed
as corporations for income
tax purposes.
Tax-Only Conversion Transactions from
Ownership Changes
Changes From
Single- to Multi-Member Status or Vice Versa
Tax-only conversions also occur when an LLC that
is disregarded or treated as a partnership changes
from a single-member LLC to a multi-member LLC
or vice versa.
See Rev. Rul. 99-5 and 99-6 for tax treatment.
Tax-Only Conversions: Rev. Rul. 99-5
Step 1:
$
A
B
50% Interest
100%
LLC
Tax-Only Conversions: Rev. Rul. 99-5
Step 2:
A
B
50%
50%
LLC
Tax-Only Conversions: Rev. Rul. 99-5
Purchase of less than 100% interest from sole
owner. Assumptions:
Neither LLC is liable for any
indebtedness, nor are the assets of the
LLCs subject to any indebtedness.
No election was made under Treas. Reg.
§ 301.7701-3(c).
How is this transaction treated if there is
indebtedness?
Treated as a purchase of assets from
existing owner of disregarded entity,
followed by a joint contribution to newlyformed partnership of (i) remaining
assets by existing owner and (ii)
purchased assets by purchaser.
Generally taxable only to seller of
interest under IRC § 1001; treated as
partial asset sale.
No gain or loss recognized under IRC §
721(a) to existing owner or purchaser.
Purchaser’s basis = amount paid.
Existing owner’s basis = basis in its
share of LLC assets. See IRC § 722.
Purchaser’s holding period begins on day
following deemed sale. See IRC §
1223(1).
See Rev. Rul. 99-5, 1999-1 C.B. 434.
FEIN stays same (assuming entity was
not using sole owner’s FEIN).
See Reg. § 301.6109-1(h) and Rev. Rul.
2001-61, 2001 C.B. 573.
Tax-Only Conversions: Rev. Rul. 99-5
Step 1:
A
B
$
100%
50% Interest
LLC
Tax-Only Conversions: Rev. Rul. 99-5
Step 2:
A
B
50%
50%
LLC
Tax-Only Conversions: Rev. Rul. 99-5
Investment into the disregarded LLC of either Treated as a contribution of (i) existing
cash or assets in exchange for a newlyassets “owned” by single owner and (ii)
issued interest to an additional owner.
cash or other assets owned by
Assumptions:
investor, in each case to a newlyformed partnership.
Neither LLC is liable for any indebtedness,
Generally not taxable; treated as
nor are the assets of the LLCs subject to any
formation of new partnership.
indebtedness.
No gain or loss recognized under IRC §
721(a).
No election was made under Treas. Reg. § Investor’s basis = amount paid.
301.7701-3(c).
Existing owner’s basis = basis in its
share of LLC assets. See IRC § 722.
Investor’s holding period begins on day
How is this transaction treated if there is
indebtedness?
following deemed sale. See IRC §
1223(1).
See Rev. Rul. 99-5, 1999-1 C.B. 434.
FEIN stays same (assuming entity was
not using sole owner’s FEIN).
See Reg. § 301.6109-1(h) and Rev.
Rul. 2001-61, 2001 C.B. 573.
Tax-Only Conversions: Rev. Rul. 99-6
Step 1:
$
A
B
50% Interest
50%
50%
LLC
Tax-Only Conversions: Rev. Rul. 99-6
Step 2:
A
B
100%
LLC
Tax-Only Conversions: Rev. Rul. 99-6
Purchase by one owner of all interests of
other owners. Assumptions:
Departing owner is treated as having
sold his/its partnership interest, while
the remaining owner is considered to
Neither LLC is liable for any indebtedness,
have acquired all of the assets of the
nor are the assets of the LLCs subject to any
partnership (i) by liquidating
indebtedness.
distribution with respect to the
partnership interest already owned and
No election was made under Treas. Reg.
(ii) by purchase with respect to the
§ 301.7701-3(c).
remaining assets of the partnership.
Partnership terminated under IRC §
708(b)(1)(A).
Generally taxable only to sellers of
interests; gain reported under IRC §
741.
Purchaser’s basis in purchased
interest= amount paid. See IRC § 1012
Purchaser’s holding period begins on
day following deemed sale. See IRC §
1223(1).
Purchaser must recognize gain or loss
on deemed liquidating distribution
under IRC § 731(a) to extent required.
Tax-Only Conversions: Rev. Rul. 99-6
Purchase by one owner of all interests of other
owners. Assumptions:
Neither LLC is liable for any indebtedness,
nor are the assets of the LLCs subject to any
indebtedness.
No election was made under Treas. Reg. §
301.7701-3(c).
How is this transaction treated if there is
indebtedness?
Purchaser’s basis in these assets
determined under IRC § 732(b) (carry
over basis – money distributed) and
purchaser’s holding period for these
assets includes the LLC’s holding
period under IRC § 735(b).
See Rev. Rul. 99-6, 1999-1 C.B. 432.
FEIN stays same (assuming entity was
not using sole owner’s FEIN).
See Reg. § 301.6109-1(h) and Rev.
Rul. 2001-61, 2001 C.B. 573.
Tax-Only Conversions: Rev. Rul. 99-6
Step 1:
B
$
A
$
50%
50%
LLC
C
Tax-Only Conversions: Rev. Rul. 99-6
Step 2:
B
C
A
100%
LLC
Tax-Only Conversions: Rev. Rul. 99-6
Purchase by third party of all interests.
Assumptions:
Neither LLC is liable for any indebtedness,
nor are the assets of the LLCs subject to any
indebtedness.
No election was made under Treas. Reg. §
301.7701-3(c).
Existing owners are treated as having
sold their partnership interests, while
the new owner is treated as having
acquired all of the assets of the
partnership by purchase.
Partnership terminated under IRC §
708(b)(1)(A).
Generally taxable to sellers of interests;
gain reported under IRC § 741.
Purchaser’s basis in purchased interest=
amount paid. See IRC § 1012
Purchaser’s holding period begins on
day following sale. See IRC § 1223(1).
See Rev. Rul. 99-6, 1999-1 C.B. 432.
FEIN stays same (assuming entity was
not using sole owner’s FEIN).
See Reg. § 301.6109-1(h) and Rev. Rul.
2001-61, 2001 C.B. 573.
Tax-Only Conversion Transactions from
Ownership Changes
Remember: Selling members will have tax concerns
(especially in conversion from multi-member LLC to
single-member LLC):
Cut-off of tax year and tax distributions for short-year
income.
Allocations and/or distributions with respect to short
year.
Indemnification for existing and contingent liabilities.
Biography
Lisa M. Rico is a partner in the Estate Planning Group at Gilmore, Rees & Carlson,
P.C., focusing on estate planning, probate and tax law. Ms. Rico's practice includes
estate, gift, generation-skipping transfer and income tax planning for high net
worth individuals, estate and trust administration, and the representation of
nonprofit organizations and charitable trusts. She also provides tax advice to
partnerships and other pass through entities.
LISA M. RICO
Partner
781 431-9788
[email protected]
20 Walnut Street
Wellesley Hills, MA
02481
Ms. Rico often lectures and has authored numerous materials on estate planning
issues, including family limited partnerships, estate liquidity and the generation
skipping transfer tax.
EDUCATION: LL.M., New York University School of Law, 1994, J.D., Western New
England College School of Law, cum laude, 1991 B.A., Western New England
College, magna cum laude, 1987.
ADMISSIONS: Massachusetts, Connecticut, New York, Maryland.
MEMBERSHIPS AND PROFESSIONAL ACTIVITIES: American Bar Association,
Massachusetts Bar Association, Taxation Law Section, Chair 2010-2011, Boston Bar
Association, Boston Estate Planning Council, Estate Planning and Administration for
Business Owners, Farmers and Ranchers Committee of Business Planning Group of
the ABA's Real Property Trust and Estate Law Section, Co-Chair, 2010-2011.