It is not unusual to come across an IRS letter ruling that elicits the following reaction from many of its readers: “why did they expend the time and money to request this ruling?”

On the face of such a ruling, the IRS’s response may seem pretty obvious; even if the readers could not cite the specific authority to support their conclusion, their knowledge of general tax principles will generally lead them to the “right” answer. Under such circumstances, why would a taxpayer pay a significant user fee, not to mention accounting and legal fees, in preparing and submitting the ruling request? shutterstock_308642543

Whatever a taxpayer’s reasons for proceeding on this path (and there may be several valid ones), from the perspective of readers such as ourselves, it is often beneficial to see what other taxpayers are doing and to familiarize oneself with the IRS’s reasoning for its positions. After all, you never know when a similar situation may be presented to one of your clients.

It’s Just An F-Reorg

In one recent ruling, for example, the IRS considered one consequence to a corporation (“Corporation”) arising out of a so-called “F” reorganization.  An F reorganization is “a mere change in identity, form, or place of organization of one corporation, however effected.”

Like other types of corporate reorganizations, an F reorganization generally involves, in form, two corporations: one that transfers (or is deemed to transfer) assets, and another that receives such assets.

However, the Code describes an F reorganization as being undertaken with respect to “one corporation,” and an F reorganization is treated for most purposes of the Code as if the reorganized corporation were the same entity as the corporation in existence before the reorganization. Thus, the tax treatment accorded an F reorganization is more consistent with that of a single continuing corporation.

Qualified Small Business Stock

The taxpayer who requested the above ruling from the IRS was one of Corporation’s shareholders. Following its formation, Corporation issued common stock to eight stockholders, including the taxpayer (the “Initial Stockholders”). Corporation represented that it satisfied the requirements of Section 1202 of the Code. The taxpayer asked the IRS to confirm that the transactions described below would jeopardize neither the Corporation’s status as a “qualified small business” nor the status of the taxpayer’s shares as “qualified small business stock,” the gain from the sale of which could be excluded, in whole or in part, from the taxpayer’s gross income.

The Conversion Transaction

Pursuant to an agreement, Buyer purchased a portion of the Corporation stock owned by each Initial Stockholder. Also pursuant to that agreement, Corporation redeemed a portion of each Initial Stockholder’s Corporation stock (together, the “Transaction”). Thus, immediately after the Transaction, Buyer and Initial Stockholders owned all the stock of Corporation.

Immediately following the Transaction, Corporation converted into an LLC pursuant to State law. Corporation elected to continue to be taxed as a corporation for federal income tax purposes.

Now, you might ask, why would Corporation convert to an LLC as a matter of State law, yet elect to continue to be treated as a corporation for tax purposes?

Some States tax LLCs differently than they tax other business entities. For example, a State may not impose an entity-level tax on an LLC, but it may impose a franchise tax on a corporate entity. In addition, there may be non-tax legal reasons that make it advantageous to be organized as an LLC rather than as a corporation. For example, certain formalities of corporate governance may not be required under State law in the case of an LLC. The fact that an LLC may be member-managed as a matter of State law is another consideration that may persuade a corporation to convert into an LLC.

Although it may be better for a business, at least for state law purposes, to be organized as an LLC, it is unlikely that a conversion from corporate status to LLC status would be effected unless it could be accomplished on a non-taxable basis. However, the conversion of a corporation into an LLC is treated as a taxable liquidation of the corporation, at least where the LLC is treated as a partnership for tax purposes.

The IRS Rules

In the ruling, the LLC was described as being an association taxable as a corporation (not as a partnership) for income tax purposes. In other words, it had elected, under the “check the box” rules, to be treated as a corporation.  The taxpayer also represented that the conversion of Corporation into the LLC, pursuant to State law, qualified as an F reorganization; i.e., a mere change in the form of organization of one corporation, where the change in business form was effectuated with the assets remaining in corporate solution and avoiding the triggering of liquidation tax. On the basis of these representations, the IRS ruled that the transfers of the Corporation’s qualified small business stock would not be treated as a sale or exchange, and the successor “corporation” in the tax-free corporate reorganization (the LLC) would be treated as the same corporation as its predecessor (Corporation). Therefore, the IRS ruled that the status of the original issue common stock of Corporation as qualified small business corporation stock held by the Initial Stockholders was unaffected by the conversion.


As Hulk Hogan used to say, “take your vitamins, say your prayers, read the IRS’s letter rulings, and you will never go wrong.” (OK, I may have taken some poetic license. So what?) But seriously, what’s the point of this ruling?

“Of course,” you say, “the stock of Corporation continued to be treated as qualified small business corporation stock. The Transaction was an F reorganization, after all. The same corporate taxpayer that existed before the Transaction continued to exist after the Transaction.”

But that is the point. The Transaction was a tax-free F-reorganization because the LLC elected to be taxed as a corporation for tax purposes. That simple election enabled the Corporation to restructure itself and change its business form in a way that, presumably, was favorable and more desirable as a matter of State law, and it was able to do so without sacrificing any of its valuable tax attributes.

So, keep reading those letter rulings. You never know what may come out next.