PRACTISING LAW INSTITUTE

TAX PLANNING FOR DOMESTIC & FOREIGN

PARTNERSHIPS, LLCs, JOINT VENTURES &

OTHER STRATEGIC ALLIANCES 2013

December 2012

Use of Limited Liability Companies in

Corporate Transactions

Mark J. Silverman

Steptoe & Johnson LLP

Washington, D.C.

Copyright © 2012 Mark J. Silverman, All Rights Reserved

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Page

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.

Page

  1. INTRODUCTION......
  2. Check-the-Box Regulations......
  3. In General......
  4. Eligible Entities......
  5. Election......
  6. Waiting Period......
  7. Applicability of Check-the-Box Regulations to Elections by Foreign Entities......
  8. WHAT IS A DISREGARDED ENTITY?......
  9. In General......
  10. Determination of Single Owner......
  11. Assessment and Collection Issues......
  12. Liability for Tax
  13. Collection of Tax......
  14. Examples......
  15. Transactions Between Disregarded Entities and Their Owners
  16. Corporate Structures Involving Disregarded Entities
  17. treatment of classification changes......
  18. In General......
  19. Timing
  20. Treatment of Elective Classification Changes......
  21. In General
  22. An Association Elects to be Classified as a Partnership......
  23. A Partnership Elects to be Taxed as an Association
  24. An Association Elects to be a Disregarded Entity
  25. A Disregarded Entity Elects to be Classified as an Association
  26. Legal Effect of Deemed Transactions
  27. Treatment of Automatic Classification Changes......
  28. Partnership to a Disregarded Entity – Rev. Rul. 99-6
  29. Disregarded Entity to a Partnership – Rev. Rul. 99-5
  30. Conversion of an Ineligible Entity into an Eligible Entity
  31. Overlap between Automatic and Elective Classification Changes
  32. Treatment of Actual Conversions of An Existing Entity Into An LLC......
  33. Converting Existing Corporations Into LLCs
  34. Converting Existing Partnerships Into LLCs Classified as Partnerships
  35. Solvency of Electing or Converting Entity......
  36. In General......
  37. Deemed Incorporation of Insolvent Entity......
  38. SALE OF A SINGLE-MEMBER LLC......
  39. Sale of All of the Membership Interests......
  40. Sale of All of the Membership Interests to a Single Buyer
  41. Sale of All of the Membership Interests Through a Cash Merger
  42. Sale of Less than All of the Membership Interests......
  43. Sale of Less than All of the Membership Interests
  44. Initial Public Offering of LLC Interests
  45. REORGANIZATIONS INVOLVING SINGLE-MEMBER LLCs......
  46. A Reorganizations Involving Single-Member LLCs......
  47. Definition......
  48. History of Regulations
  49. General Definition of Statutory Merger or Consolidation......
  50. All of the Assets Requirement......
  51. Ceasing Separate Legal Existence Requirement......
  52. Definition and Existence of Transferee and Transferor Units
  53. Upstream Merger......
  54. Two-Step Acqusitions of Target Corporation......
  55. Forward Triangular Merger......
  56. Divisive Mergers Involving LLCs......
  57. Application of the Final Regulations in the Context of Foreign Entities......
  58. B Reorganization......
  59. C Reorganization......
  60. D Reorganizations......
  61. Acquisitive D Reorganization......
  62. Divisive D Reorganization......
  63. F Reorganizations......
  64. Basic F Reorganization......
  65. Partnership Formation as F Reorganization......
  66. F Reorganization Preceding an Acquisition
  67. Use of LLCs in Spin-Off Transactions......
  68. Spin-Off
  69. Distribution of LLC Interests as a Spin-Off
  70. Avoiding the Requirements of Section 355
  71. Avoiding the Requirements of Section 355: Distribution of Assets......
  72. Section 355(e) Transaction
  73. USE OF LLCs IN CONSOLIDATED RETURN CONTEXT......
  74. Selective Consolidation
  75. In General
  76. Selective Consolidation
  77. Avoiding SRLY Limitations......
  78. In General......
  79. SRLY Limitations
  80. Avoiding Intercompany Transaction Rules
  81. In General......
  82. Intercompany Sale
  83. Intercompany Debt
  84. Deconsolidation of Two-Member Consolidated Group
  85. In General......
  86. Deconsolidation Using a Single-Member LLC
  87. Avoid Triggering Restoration of Excess Loss Accounts
  88. In General......
  89. Avoiding Trigger of ELAs
  90. USE OF MULTI-MEMBER LLCs IN CORPORATE TRANSACTIONS......
  91. Mergers Involving Multi-Member LLCs......
  92. Merger of Target Corporation Into LLC
  93. Merger of LLC Into Acquiring Corporation
  94. Multi-Member LLCs in the Consolidated Return Context......
  95. Recognizing Losses Using Multi-Member LLCs......
  96. Change in Number of Members of Multi-Member LLC......
  97. Conversion of Multi-Member LLCs Into Single-Member LLCs
  98. Conversion of Multi-Member LLCs Into Single-Member LLCs in the Consolidated Return Context
  99. Treatment of Holder of Multi-Member LLC Interest as General or Limited Partner......
  100. Section 469 Passive Activity Loss Rules
  101. Self-Employment Tax
  102. DISADVANTAGES OF USING LLCs
  103. Certain LLCs Cannot Be Parties to Reorganizations......
  104. In General......
  105. Achieving Results Similar to a Tax-Free Reorganization
  106. Spinning Off a Lower Tier LLC......
  107. In General......
  108. Spin-off of an LLC
  109. Loss of Basis in the Stock of a Corporate Subsidiary......
  110. In General......
  111. Disappearing Basis
  112. OTHER ISSUES......
  113. Treatment of Indebtedness......
  114. Whose Debt Is It—the Disregarded Entity’s or the Owner’s?
  115. Cancellation of Debt (“COD”) Income
  116. Indebtedness to Owner of Disregarded Entity......
  117. Treatment of Outstanding Interests as Equity......
  118. Automatic Classification Change......
  119. Convertible Debt
  120. Granting Nonvested Equity Interests to Employees
  121. Start-Up v. Expansion Costs......
  122. Like-Kind Exchanges......
  123. In General
  124. Qualifying property......
  125. Acquiring Replacement Property......
  126. Personal Holding Companies......
  127. Employment Issues......
  128. Employer Identification Number (“EIN”)
  129. Employment and Withholding Taxes
  130. Employee Retirement Plans
  131. Incentive Stock Option Plans
  132. Filing Requirements......
  133. STATE TAX CONSIDERATIONS......
  134. State Treatment of LLCs......
  135. Achieving Consolidated Results In States That Prohibit Consolidation......
  136. Achieving Section 338(h)(10) Results in States That Do Not Recognize the Election......
  137. General
  138. Achieving Section 338(h)(10) Treatment for State Tax Purposes

Examples
1 / Contribution to Disregarded Entity...... / 23
2 / Distribution From Disregarded Entity...... / 24
3 / Debt Between a Disregarded Entity and its Owner...... / 25
4 / Transactions Between Commonly Owned Disregarded Entities...... / 25
5 / Multiple Disregarded Entities...... / 27
6 / Preservation of S Corporation Status...... / 28
7 / Corporate Contribution of Assets to an LLC Classified as Either a Partnership or a Disregarded Entity Followed by Corporate Liquidation / 45
8 / Formation of LLC by the Corporation and its Shareholders Followed by Liquidation of Corporation / 46
9 / Merger of Corporation Into Multi-Member LLC...... / 48
10 / Merger of Corporation Into Single-Member LLC...... / 51
11 / Merger of Wholly Owned Subsidiary Into Single-Member LLC...... / 53
12 / Partnership-to-LLC Conversion...... / 55
13 / Sale of All of the Membership Interests to a Single Buyer...... / 63
14 / Sale of All of the Membership Interests Through a Cash Merger...... / 64
15 / Sale of Less than All of the Membership Interests...... / 65
16 / Initial Public Offering of LLC Interests...... / 68
17 / Merger Into LLC (Base Case)...... / 75
18 / Sprinkling of Assets Among Transferee Unit...... / 79
19 / Consolidation...... / 81
20 / Forward Triangular Amalgamation...... / 83
21 / Merger of Disregarded Entity Owned by Partnership...... / 85
22 / Merger into LLC in Exchange for LLC Interests...... / 86
23 / Merger of Corporate Partner into Partnership...... / 88
24 / Upstream Merger...... / 91
25 / Merger Into LLC Followed by Merger Upstream...... / 92
26 / Acquisition of T Stock Followed by Alternative Transfers to P...... / 93
27 / Forward Triangular Merger...... / 95
28 / LLC Merger Into Corporation...... / 96
29 / Merger of Corporation into Multiple LLCs...... / 97
30 / Transaction Effected Pursuant to Foreign Law...... / 99
31 / Merger with Foreign Entity...... / 100
32 / Drop and Check vs. Check and Drop...... / 101
33 / B Reorganization...... / 103
34 / C Reorganization...... / 104
35 / Acquisitive D Reorganization...... / 107
36 / Divisive D Reorganization...... / 109
37 / Basic F Reorganization...... / 110
38 / Conversion as F Reorganization...... / 111
39 / F Reorganization Preceding an Acquisition...... / 112
40 / Spin-Off...... / 115
41 / Distribution of LLC Interests as a Spin-Off...... / 117
42 / Avoiding the Requirements of Section 355...... / 119
43 / Avoiding the Requirements of Section 355: Distribution of Assets...... / 120
44 / Section 355(e) Transaction...... / 122
45 / Selective Consolidation...... / 125
46 / SRLY Limitations...... / 127
47 / Intercompany Sale...... / 128
48 / Intercompany Debt...... / 130
49 / Deconsolidation Using a Single-Member LLC...... / 131
50 / Avoiding Trigger of ELAs...... / 132
51 / Merger of Target Corporation Into LLC...... / 133
52 / Merger of LLC Into Acquiring Corporation...... / 135
53 / Multi-Member LLCs in the Consolidated Return Context...... / 136
54 / Recognizing Losses Using Multi-Member LLCs...... / 137
55 / Conversion of Multi-Member LLCs Into Single-Member LLCs...... / 138
56 / Conversion of Multi-Member LLCs Into Single-Member LLCs in the ConsolidatedReturn Context / 139
57 / Achieving Results Similar to a Tax-Free Reorganization...... / 143
58 / Spin-off of an LLC...... / 145
59 / Disappearing Basis...... / 146
60 / Convertible Debt...... / 152
61 / 1031 Exchange...... / 154
62 / Achieving Section 338(h)(10) Treatment for State Tax Purposes...... / 167

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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]

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. SeeMcNamee 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’dper 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. SeeLittriello, 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).

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 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. SeeDel. 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).
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.
(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.

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).