Some Days Are Stones
It’s not always easy to find a topic about which to write a weekly blog post. I usually look for a ruling or decision that illustrates one of the recurring themes of the tax law, and then develop a lesson or message around it. Sometimes I’ll use a project on which I’m working.
Some weeks are more fruitful than others. This week was a relatively lean one.
That being said, I did come across a recent letter ruling issued by the IRS that was short on facts and legal analysis, and the outcome of which would be obvious to most, but which I thought might serve my purpose.
The taxpayer to which the ruling was issued asked the IRS to consider whether the conversion of a State law limited liability company (“LLC”) into a State law limited partnership would cause the LLC or its members to recognize taxable income or gain.
Now, some of you may say, “big whoop.” (I did say the result was obvious.)
Nevertheless, the ruling does offer an opportunity for some fruitful discussion based upon the significance of the factual representations on which the ruling was based.
LLC-1 was classified as a partnership for federal tax purposes. It had two managing members:
- Corp-1 was a state law limited liability company that was classified as a corporation for tax purposes;
- LLC-2 was a limited liability company that was disregarded as an entity separate from its owner for tax purposes;
- Corp-2 was classified as a corporation for tax purposes, and was the sole member of LLC-2; thus, Corp-2 was treated as the second member of LLC-1 for tax purposes.
The other membership interests in LLC-1 were non-managing member interests owned either indirectly by Corp-2 (including through subsidiaries of LLC-2), or by other investors.
LLC-1 planned to convert to a limited partnership in accordance with State law (the “Conversion”), after which it would continue to carry on the business operations it previously conducted as a limited liability company before the Conversion.
Creation of Disregarded Entities
Before the Conversion, Corp-1, LLC-2, and one of LLC-2’s wholly-owned subsidiaries (we are not told whether this subsidiary was itself a disregarded entity – i.e., a limited liability company – or a corporation) would each form a single-member limited liability company (three in all) that would be disregarded as an entity separate from its respective owner for federal tax purposes (the “Disregarded Entities”).
In connection with the Conversion, LLC-2 and LLC-2’s subsidiary would each contribute all of its interest in LLC-1 (including its managing-member interest) to its respective Disregarded Entity. Corp-1 would contribute a portion of its interest in LLC-1 to its Disregarded Entity.
As part of the Conversion, the three Disregarded Entities would become the State law general partners of LLC-1; for tax purposes, their “regarded” owners (Corp-1, LLC-2 and LLC-2’s subsidiary) would be treated as the general partners of post-Conversion LLC-1 (as compared to the two State law managing members of pre-Conversion LLC-1).
(The ruling did not give the business reason for the Disregarded Entities. There are several possibilities, including planning for creditors upon the conversion of the managing member interests into general partner interests.)
According to LLC-1, the limited partnership agreement that would replace its operating agreement would be substantively identical to the operating agreement; in other words, the economic arrangement among the members/partners, including the allocation of income, gain, loss, deduction, and credit among them would not be changed by virtue of the Conversion.
Consistent therewith, it was represented in the ruling that:
- the balances in each partner’s (formerly member’s) capital account immediately after the Conversion would be the same as they were immediately before the Conversion
- there would be no change in the partners’ existing equity;
- each partner’s total percentage interest in X’s profits, losses, and capital after the Conversion will be the same as that partner’s percentage interest in X’s profits, losses and capital before the Conversion, and the allocation of tax items will also remain unchanged
- there would be no change in how they shared these tax items after the Conversion;
- each partner’s share of liabilities of LLC-1 immediately after the Conversion would be the same as it was immediately before the Conversion
- there would be no deemed distribution or deemed contribution of cash to any partner, or any deemed sale of partnership interests between any partners; there would be no change in any partner’s share of value, gain, or loss associated with the partnership’s unrealized receivables or inventory items in connection with the Conversion
- thus, no partner would be treated as having exchanged an interest in so-called “hot assets” for a greater interest in other assets of the partnership, or vice versa, which could result in income or gain to such partner; and
- LLC-1 would retain the same method of accounting and accounting period.
Interestingly, LLC-1 represented to the IRS that it had not issued any profits interest in the two years preceding the date of the Conversion. You may recall that a person’s receipt of a profits interest in a partnership will generally not be treated as a taxable event; this result will not follow, however, if the partner disposes of the profits interest within two years of receipt.
LLC-1 also represented that the “Sec. 704(b) book basis” of its property (the fair market value of the property at the time of its contribution to LLC-1, adjusted for subsequent book depreciation) that secured nonrecourse debt exceeded the amount of such debt; in other words, there was no “partnership minimum gain” – the gain that the partnership would realize if it disposed of the property for no consideration other than full satisfaction of the liability.
The IRS’s “Analysis”
According to the Code, an existing partnership is considered as continuing if it is not terminated. A partnership is considered as terminated only if: (1) no part of any business, financial operation, or venture of the partnership continues to be carried on by any of its partners in a partnership; or (2) within a 12-month period, there is a sale or exchange of 50 percent or more of the total interest in partnership capital and profits (a “technical termination”).
The IRS has, on several occasions, published rulings in which it examined the federal income tax consequences of a conversion of one form of partnership interest into another form of partnership interest in the same partnership. In general, provided each partner’s total percentage interest in the partnership’s profits, losses, and capital would remain the same after the conversion, and the partnership’s business would continue, no gain or loss would be recognized by the partners as a result of their exchanging their interests in the partnership.
Similarly, the IRS has previously ruled that the conversion of a domestic partnership into a domestic limited liability company classified as a partnership for tax purposes is treated as a partnership-to-partnership conversion that is subject to the same principles as an exchange of interests within the same partnership. It has also stated that the same holdings would apply if the conversion had been of an interest in a domestic limited liability company that is classified as a partnership for tax purposes into an interest in a domestic partnership.
IRS regulations provide that a business entity that is not classified as a corporation per se (a so-called “eligible entity”) can elect its classification for federal tax purposes. An eligible entity with at least two members can elect to be classified as either an association or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner. The regulations also provide that unless the entity elects otherwise, a domestic eligible entity will be treated as a partnership if it has two or more members.
Without further discussion, the IRS concluded that the Conversion would not cause a “technical termination” of LLC-1’s status as a partnership for tax purposes, and that neither LLC-1 nor its members would recognize taxable income, gain, or loss upon the Conversion.
Although not stated in the ruling, the IRS could have added that: the taxable year of the pre-Conversion limited liability company did not close as a result of the Conversion, the post-Conversion partnership would continue to use the EIN of the converted limited liability company, the tax elections made by the converted limited liability company would remain in effect as would its depreciation methods, and the members’ bases in their membership interests would carry over to their partnership interests.
So What? Is That It?
The point is that there is a lot of thought and planning that goes into securing a “duh” ruling. The ruling becomes a foregone conclusion only because of the analysis, structuring and drafting that preceded it.
In the case of the ruling described herein, the failure of any of the representations set forth above may have resulted in a taxable event to one or more of the partners.
For that reason, it would behoove anyone who advises taxpayers and their business entities to become familiar with the kinds of representations that are made in connection with a “successful” ruling on a specific kind of transaction.
These representations highlight many of the issues that others have encountered in similar transactions over the years, and on which the IRS may be focusing. As such, they may provide a good starting point for an adviser’s consideration of, and planning for, his or her own client’s transaction.
 From “Some Days Are Diamonds” by Dick Feller, sung by John Denver.