Cross Species Conversions and Mergers

Transcription

1 Cross Species Conversions and Mergers 591 Cross Species Conversions and Mergers JOHN B. TRUSKOWSKI * The adoption by many states of both conversion statutes 1 statutes allowing one form of business organization, such as a limited liability company, to convert to another form of business organization, for example, a corporation, by simply filing a form with the appropriate state office and cross specie merger statutes 2 statutes allowing one form of business organization to merge with another form of business organization, such as a limited liability company with a corporation raises issues on how these conversions or mergers will be treated for federal income tax purposes. Parts I and II of this Article summarize these tax consequences, and Part III discusses in more detail some specific tax issues. This Article only considers limited liability companies (LLCs) with more than one member that are classified as partnerships for federal income tax purposes. However, to match the terminology used in the Code, regulations, rulings, and cases, this Article will generally refer to partnerships and partners rather than LLCs and members. I. Partnership to Corporation A. Specific Methods to Incorporate a Partnership Before we consider conversions and mergers, we must review the tax consequences of structured incorporation transactions. In Revenue Ruling , the Service ruled that regardless of how a partnership was actually incorporated, the tax consequences would be determined as an Assets Over transaction (described below). 3 However, in Revenue Ruling , the Service reversed course, recognizing that the tax consequences were not the same, and the Service ruled that taxpayers could choose the tax consequences of a partnership incorporation transaction by actually structuring the transaction in one of three ways: 4 * Of Counsel, Locke Lord LLP, Chicago, Illinois; Certified Public Accountant; University of Illinois, B.S. (Accountancy) 1967; University of Chicago Law School, J.D. (1970). Mr. Truskowski passed away before this article went to press. He was the immediate past chairman of the American Bar Association Section of Taxation's Committee on S Corporations. The Tax Lawyer thanks Laurence A. Hansen, a partner in Locke Lord LLP, for his assistance with the final steps of the editorial process for this article. 1 See, e.g., Delaware Limited Liability Company Act, Del. Code Ann. tit. 6, (2011). 2 See, e.g., Illinois Limited Liability Company Act, 37-20, 805 ILCS 180/37-20 (1998). 3 Rev. Rul , C.B Rev. Rul , C.B

2 592 section OF TAXATION 1. Assets Over, where the partnership contributes its assets and liabilities to a corporation and then liquidates, distributing the corporate stock to its partners. 2. Assets Up, where the partnership liquidates, distributing its assets and liabilities to its partners, and the partners then contribute those assets and liabilities to the corporation. 3. Interests Over, where the partners contribute their interests in the partnership to the corporation, and as the result of the corporation owning 100% of the interests in the partnership, the partnership terminates for tax purposes. 5 Although the tax consequences of these alternatives are similar, they are not identical. Revenue Ruling sets forth the general tax consequences of each transaction. 1. Assets Over For an Assets Over transaction where the partnership transfers its assets and liabilities to the corporation and then liquidates Revenue Ruling states that under section 351, 6 the partnership recognizes no gain or loss on the transfer of all of its assets to the corporation. 7 It also states that under section 358(a), the partnership s basis in the stock of the corporation is the same as its basis in the assets transferred to the corporation, reduced by the liabilities assumed by R [the corporation], which assumption is treated as a payment of money to X [the partnership] under section 358(d). Section 357(a) provides that the corporation s assumption of liabilities is not treated as money for purpose of section 351, thereby confirming the Ruling s conclusion that no gain or loss is recognized under section Section 357(c) provides that if the sum of the amount of the liabilities assumed by the corporation exceeds the total of the basis of the assets contributed to the corporation, then the excess is recognized as a gain from the sale or exchange of the assets contributed to the corporation. 9 Although Revenue 5 In the case of an LLC, if the LLC is not liquidated under the laws under which it was organized, it continues for Federal income tax purposes as a disregarded entity. I.R.S. Publication 3402 (Mar. 2010). 6 References to the Code, I.R.C. or section other than a section of this Article are to the Internal Revenue Code of 1986, as amended. 7 Rev. Rul , C.B I.R.C. 357(a)(2). 9 I.R.C. 357(c). Section 357(b)(1)(B) provides that if the purpose for the corporation s assumption of liabilities was tax avoidance and not a bona fide business purpose, then the liabilities assumed are considered money under section 351. For purposes of this Article, it is assumed that there is no tax avoidance purpose for the corporation s assumption of liabilities. I.R.C. 357(b)(1)(B).

3 Cross Species Conversions and Mergers 593 Ruling did not address section 357(c), Revenue Ruling did. This Ruling considered a limited partnership that had incurred nonrecourse liabilities in the ordinary course of its business. For valid business reasons, limited partners owning 35% of the partnership interests transferred those interests to a newly organized corporation in a transfer qualifying under section 351. The Ruling concluded that each transferring limited partner s share of the partnership s nonrecourse liabilities was considered as a liability to which the partnership interest was subject for purposes of section 357(c). Thus, each partner recognized gain under section 357(c) to the extent that the partner s share of the nonrecourse liabilities exceeded the basis in its partnership interest. Therefore, the tax consequences set forth below recognize the possibility of a recognized gain under section 357(c). The tax consequences of the corporation s assumption of liabilities are discussed in detail in Part III.A.1. The tax consequences of an Assets Over transaction are as follows: a. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on its receipt of assets and assumption of liabilities The basis in the assets in the hands of the corporation equals their basis in the hands of the partnership, increased by any gain recognized by the partnership such gain flows through to the partners and increases their basis in their partnership interests. 13 However, unless the election described in Part I.A.1.b.2 immediately below is made, the aggregate basis cannot exceed the fair market value of the assets The corporation s holding periods for the assets transferred to it includes the periods they were held by the partnership. 15 b. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on the transfer of its assets and liabilities to the corporation unless the corpora- 10 Rev. Rul , C.B I.R.C. 1032(a). 12 The Code speaks in terms of basis and adjusted basis. For simplicity, this Article uses the term basis to mean both basis and adjusted basis. 13 I.R.C. 362(a). 14 I.R.C. 362(e)(2). See infra Part III.B for a detailed discussion of basis. 15 I.R.C. 1223(2).

4 594 section OF TAXATION tion is an investment company, 16 or to the extent the amount of the liabilities transferred including liabilities secured by transferred assets 17 exceeds the tax basis of the assets transferred. 18 The distribution of the stock to the partners on liquidation of the partnership does not violate the control requirements of sections 351(a) and 368(c). 2. The partnership s basis in the stock it receives equals the basis in the assets transferred to the corporation, decreased by the liabilities assumed by the corporation, and increased by any gain recognized by the partnership. 19 If the aggregate basis of the assets transferred to the corporation exceeds their aggregate fair market value, the partnership and corporation can jointly elect to limit the partnership s basis in the stock to the fair market value of the assets, thereby avoiding the decrease in the assets basis noted in Part I.A.1.a.2 immediately above The holding period for stock received in exchange for capital and section assets includes the period the transferred assets were held by the partnership. 23 The holding period for stock received in exchange for all other assets begins on the day after the day on 16 I.R.C. 351(e) provides that transfers of property to an investment company are not tax free under Code section 351(a). An investment company is not specifically defined in Code section 351(e), although investment assets are. Regulation section (c) provides that a transfer of property will be considered to be a transfer to an investment company if (i) the transfer results, directly or indirectly, in diversification of the transferors interests, and (ii) the transferee is (a) a regulated investment company, (b) a real estate investment trust, or (c) a corporation more than 80% of the value of whose assets excluding cash and nonconvertible debt obligations from consideration are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts. For purposes of this Article, it is assumed that any corporation or partnership to which property is transferred is not an investment company. 17 For convenience, liabilities assumed by the transferee and liabilities secured by assets transferred to the transferee will be referred to as assumed liabilities or as liabilities assumed by the transferee. 18 I.R.C. 351(h)(1), 357(c)(1). 19 I.R.C. 358(a), (d). 20 I.R.C. 362(e)(2)(C). See infra Part III.B for a detailed discussion of basis. 21 A capital asset is defined in Code section 1221(a) as any property held by a taxpayer whether or not connected with its trade or business subject to certain statutory exceptions. The primary exceptions are stock in trade and depreciable property used in a trade or business. 22 Property is described in Code section 1231(b) as property used in a trade or business, of a character which is subject to the allowance for depreciation provided in Code section 167, held for more than 1 year, and real property used in a trade or business, held for more than 1 year.... Specifically excluded from Code section 1231(b) is property properly includible in inventory and property held primarily for sale to customers in the ordinary course of the taxpayer s trade or business. 23 I.R.C. 1223(1).

5 Cross Species Conversions and Mergers which they were contributed to the corporation. 24 No gain or loss is recognized by the partnership on the transfer of the stock to its partners on its liquidation. 25 c. Tax Consequences to Partners The corporation s assumption of the partnership s liabilities including receipt of property securing liabilities is treated as a deemed distribution to each partner equal to its share of those liabilities, as determined under section 752, thereby reducing each partner s basis in its partnership interest. 26 This deemed distribution could result in a partner recognizing gain if its share of these liabilities exceeds its basis in its partnership interest. The tax consequences of the corporation s assumption of the partnership s liabilities are discussed in detail in Part III.A.1. The partners recognize no gain or loss on receipt of the stock on the liquidation of the partnership. 27 Each partner s basis in the stock received on the liquidation of the partnership equals its adjusted basis in its partnership interest immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of its liquidation. 28 Each partner s holding period for the stock received includes the partnership s holding period for the stock, which generally includes the period the partnership held the assets contributed to the corporation Assets Up The tax consequences of an Assets Up transaction, where the partnership liquidates and the partners transfer assets and liabilities to the corporation, are similar to those for an Assets Over transaction, although the corporation s basis in the assets it receives may be different. These tax consequences are as follows: 24 Rev. Rul , C.B See Part III.C for a detailed discussion of holding periods. 25 I.R.C. 731(b). 26 I.R.C. 732(b). 27 I.R.C. 731(a). 28 I.R.C. 732(b). 29 I.R.C. 735(b), 1223(1); see also supra Part I.A.1.a.2. See infra Part III.C for a detailed discussion of holding periods.

6 596 section OF TAXATION a. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on the transfer of its assets and liabilities to its partners on its liquidation. 30 b. Tax Consequences to Partners In general, the partners recognize no gain or loss on receipt of the assets and assumption of the liabilities on the liquidation of the partnership, but they will recognize gain to the extent the amount of money distributed exceeds each partner s basis in its interest in the partnership immediately before the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation. 31 Each partner s basis in the assets received on the liquidation of the partnership equals the adjusted basis in its interest in the partnership immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation, decreased by the amount of money received. 32 Each partner s holding period for the assets received includes the period the partnership held those assets. 33 No gain or loss is recognized by the partners on the transfer of the assets and liabilities to the corporation unless the corporation is an investment company, 34 or except to the extent the amount of the liabilities transferred including liabilities secured by transferred assets exceeds the tax basis in the assets transferred. 35 Each partner s basis in the stock it receives equals its basis in the assets transferred to the corporation which is the basis in the interests in the partnership 36 decreased by the liabilities assumed by the corporation, including liabilities secured by assets transferred to the corporation, and increased by any gain recognized on the transfer of the assets to the corporation. 37 If the aggregate basis of the assets transferred to the corporation exceed their fair market 30 I.R.C. 731(b). 31 I.R.C. 731(a). 32 I.R.C. 732(b). See infra Part III.B for a discussion of the allocation of basis among the assets received. 33 I.R.C. 735(b). 34 See I.R.C. 357; see also supra text accompanying note I.R.C. 351, See supra Part I.A.2.b I.R.C. 358(a).

7 Cross Species Conversions and Mergers 597 value, the partners and corporation can jointly elect to limit the partner s basis in the stock to its fair market value, thereby avoiding a decrease in the basis in the assets For stock received in exchange for capital and section 1231 assets, each partner s holding period for the stock includes the holding period for the assets transferred to the corporation, which is the partnership s holding period for those assets. 39 For stock received in exchange for all other assets, each partner s holding period begins on the day after those assets were transferred to the corporation. 40 c. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on the receipt of the assets and the assumption of the liabilities The basis in the assets in the hands of the corporation equals their basis in the hands of the partners which is the basis in the partners interests in the partnership immediately prior to the liquidation 42 increased by any gain recognized by the partners. 43 However, unless the election noted in Part I.A.2.b.5 is made, the aggregate basis cannot exceed the fair market value of the assets The corporation s holding period for the assets transferred to it is the same as the holding period in the hands of the partners which, in general, includes the period the partnership held the assets. 45 Thus, the only difference between an Assets Over and an Assets Up transaction is the corporation s basis in the assets it receives. If there is a difference between the partners outside basis in their partnership interests and the partnership s inside basis in its assets, the transaction which results in the higher basis should be used in order to maximize the basis to the corporation. 3. Interests Over Determining the tax consequences of an Interests Over transaction where the partners transfer their partnership interests to the corporation and the 38 I.R.C. 362(e)(2)(C). This is noted below in Part I.A.2.c.2. See infra Part III.B for a detailed discussion of basis. 39 I.R.C. 1223(1); see discussion supra Part I.A.2.c Rev. Rul , C.B See infra Part III.C for a detailed discussion of holding periods. 41 I.R.C See supra Part I.A.2.b I.R.C. 362(a). 44 I.R.C. 362(e). See infra Part III.B for a detailed discussion of basis. 45 I.R.C. 1223(2).

8 598 section OF TAXATION partnership terminates as set forth in Revenue Ruling , requires a more detailed analysis as the result of a subsequent Revenue Ruling, 46 and an earlier Tax Court case 47 and Revenue Ruling, 48 neither of which were referred to in Revenue Ruling As with the Assets Over transaction, Revenue Ruling does not address the possibility of a recognized gain if the partnership has liabilities. It simply states that, under section 351, no gain or loss is recognized on the transfer of the partnership interests to the corporation. 49 As with the Assets Over transaction, the Ruling states that each partner s basis in the stock received equals its basis in its interest in the partnership reduced by Z s [the partnership] liabilities assumed by T [the corporation], the release from which is treated as a payment of money to Z s partners under sections 752(d) and 358(d). 50 Section 752(d) provides that on a sale or exchange of a partnership interest, liabilities are treated in the same manner as liabilities in connection with the sale or exchange of property not associated with partnerships. 51 Under Regulation sections (h) and (a)(1), when a partnership interest is sold, the selling partner s share of the partnership s liabilities is considered additional consideration received by the selling partner. No reference was made to these regulatory provisions or to section 357(c) in Revenue Ruling As noted with regard to Assets Over transactions, section 357(a) provides that the assumption of liabilities is not considered the receipt of money for section 351 purposes. 52 The question is whether section 357(c), requiring the recognition of gain if the amount of liabilities transferred to the corporation exceed the basis in the assets transferred, applies where a partnership interest is transferred to the corporation. As noted above, Revenue Ruling confirms that the partnership s liabilities are taken into account for section 357(c) purposes. 53 a. Tax Consequences to Partners. Whether the Revenue Ruling or Revenue Ruling approach applies, the tax consequences to the partners are the same. These tax consequences are fairly straightforward: 1. In general, no gain or loss is recognized by the partners on the transfer of their partnership interests to the corporation, unless the corporation is an investment company If the partnership has liabilities, the corporation s indirect assumption of the partnership s liabilities including receipt of property 46 Rev. Rul , C.B. 432; see also supra Part I.A.2.b McCauslen v. Commissioner, 45 T.C. 588 (1966). 48 Rev. Rul , C.B See I.R.C Rev. Rul , C.B I.R.C. 752(d). 52 See I.R.C. 357(a). 53 See Rev. Rul , C.B I.R.C. 351; see also supra note 9.

9 Cross Species Conversions and Mergers 599 securing liabilities could subject the partners to tax, if the partner s share of the liabilities exceeds the partner s basis in the partnership interest Each partner s basis in the stock it receives equals the basis in the partnership interest transferred to the corporation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the portion of the partnership s taxable year during which the interest in the partnership was owned, 56 decreased by its share of the partnership s liabilities, and increased by any gain recognized on the transfer to the corporation. 57 If the aggregate basis of the interests transferred to the corporation exceed their fair market value, the partners and corporation can jointly elect to limit the partners basis in the stock to its fair market value, thereby avoiding a decrease in the basis in the assets In general, the holding period for the stock received by each partner includes the period the partnership interest was held by the partner. However, for stock received in exchange for a partner s interest in section 751 assets 59 that are neither capital nor section 1231 assets, the holding period begins on the day after the partnership interests were transferred to the corporation. 60 b. Tax Consequences to the Corporation. The corporation s tax consequences may be less clear. Revenue Ruling states correctly that the partnership terminates when all of its interests are owned by the corporation. 61 As a result of such termination, the corporation owns all of the partnership s assets. The Ruling concludes that the corporation s basis for the assets received equals the basis of the partners in their partnership interests allocated in accordance with section 732(c), and the corporation s holding period for the assets includes the period the partnership held the assets. No specific statutory citations are given for these particular conclusions, although sections 362(a) and 1223(1) are described generally at the beginning of the Ruling. However, for this alternative the Ruling states [o]n the transfer of 55 I.R.C. 357(c). See infra Part III.A.1 for a detailed discussion of this issue. 56 Since the partnership terminates as the result of the corporation owning all of the interests in the partnership, the partnership s books would be closed as of the day of the contribution to the corporation and all of the partnership s income, gains, losses, deductions, and credits for the short year ending on that date would be allocated to the partners in accordance with the partnership or operating agreement. 57 I.R.C. 358(a), (d). 58 This is noted below in Part I.A.3.b.1.b. See Code section 362(e)(2)(C) and infra Part III.B for a detailed discussion of basis. 59 Section 751 assets are unrealized receivables and inventory items that have appreciated substantially in value. 60 See Rev. Rul , C.B See infra Part III.C for a detailed discussion of holding periods. 61 See Rev. Rul , C.B. 88.

10 600 section OF TAXATION the partnership interests to the corporation, Z [the partnership] terminated under section 708(b)(1)(A) of the Code. Section 708(b)(1)(A) provides that a partnership terminates if 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. Since neither the earlier Tax Court case nor Revenue Ruling which are discussed next is cited, these conclusions would seem to be based on treating the partnership as existing momentarily after the corporation acquires ownership of all of the interests in the partnership. Assuming the momentary existence of the partnership following the transfer of all of the partnership interests to the corporation, the steps and tax consequences would be as follows: 1. The partnership exists as a partnership for federal income tax purposes immediately after the corporation acquires ownership of all of the partnership interests. 62 a. No gain or loss is recognized by the corporation. b. The corporation s basis in the partnership interests equals the part- ners basis in those interests, increased by any gain recognized by the partners. 63 However, unless an election 64 is made, the basis cannot exceed the fair market value of the partnership interests. 65 c. The corporation s holding period for the partnership interests includes the period the interests were held by the partners The partnership terminates, distributing its assets and liabilities to the corporation. a. The corporation recognizes no gain or loss on termination of the partnership unless the amount of money received exceeds the corporation s basis for the partnership interests. 67 The corporation s basis in the assets is the basis in the partner- ship interests, which is the same as the partners basis in their partnership interests, but limited to the fair market value of the interests, 68 plus any gain recognized. 69 b. 62 I.R.C I.R.C. 362(a). 64 This is noted above in Part I.A.3.a I.R.C. 362(e). See infra Part III.B for a detailed discussion of basis. 66 I.R.C. 1223(2). 67 I.R.C Because the corporation owns 100% of the partnership, liabilities of the partnership are not relevant the decrease in the corporation s share of partnership liabilities, which is treated as a distribution under section 752(b), equals the increase in the corporation s liabilities on liquidation of the partnership, which is treated as a contribution to the partnership under section 752(a). 68 See supra Part I.A.3.b.1.b. 69 I.R.C See Part III.B for a discussion of basis.

11 c. Cross Species Conversions and Mergers 601 The corporation s holding period for the assets includes the period the assets were held by the partnership. 70 An earlier Tax Court case and Revenue Ruling characterize the transaction differently where a partnership terminated following acquisition by one partner of all of the interests in a partnership, which is similar to what occurs in an Interests Over transaction. McCauslen v. Commissioner 71 involved the determination of gain from the sale of partnership property following one partner s acquisition of all of the interests in the partnership. McCauslen and his brother formed an equal partnership to conduct a nursery business. When the brother died, McCauslen purchased his brother s interest. This resulted in a termination of the partnership. McCauslen continued the nursery business as a sole proprietorship. Two months later, McCauslen sold a greenhouse and greenhouse equipment previously owned by the partnership. Although the sale occurred within six months of McCauslen s purchase of his brother s interest, the sale occurred more than six months after the partnership had acquired the property that was sold. The issue was the holding period for the property sold. 72 The holding period for long-term capital gain treatment at that time was only six months. The Tax Court held that since the purchase of the brother s interest terminated the partnership, McCauslen actually bought the partnership assets relating to his brother s interest, rather than receiving the assets as the result of a distribution from the partnership on its termination. 73 Thus, the holding period for the portion of the assets acquired indirectly from his brother began when the brother s interest was purchased, rather than when the partnership had purchased those assets. In essence, the purchase of the brother s interest was treated similar to an Asset Up transaction the assets were deemed to be distributed up to the brother s estate, which then sold them to McCauslen. Note that this case does not address the tax consequences to the brother s estate which sold the interest. There is no indication that the sale, from the estate s standpoint, would also be treated as a sale of the partnership s assets. Rather, the Tax Court refers to section 741, noting that a partnership interest is a capital asset which may be sold or exchanged. 74 Therefore, if the issue had been before the Tax Court, it is likely it would have decided that, from the estate s standpoint, this was a sale of a partnership interest, not a sale of a portion of the partnership s assets. Revenue Ruling involved similar facts. D and E were equal partners in a two-man partnership. Pursuant to an agreement between them, when D died, E bought D s interest and continued the business as a sole 70 I.R.C. 735(b) T.C. 588 (1966). 72 Id. at Id. at Id. at Rev. Rul , C.B. 168.

12 602 section OF TAXATION proprietorship. The Ruling stated: Although it is recognized that one partner in a two-man partnership may sell his partnership interest to his partner (sec (b) of the regulations), such a transaction is viewed as though one partner acquired by purchase, the assets attributable to the partnership interest sold by the other partner. No distribution of property by the partnership occurred with respect to such assets. However, the purchasing partner is considered to have received as a distribution in kind, through liquidation of his partnership interest, those assets attributable to his own former interest in the partnership. 76 As to the deceased partner, this Ruling seems to confirm that the estate transferred its partnership interest to E, and not its proportionate share of the partnership s assets. 77 If this approach were applied to an Interests Over transaction, the corporation would be deemed to have received the partnership s assets in exchange for the stock and assumption of liabilities, following a deemed liquidation of the partnership and distribution of those assets and liabilities to the partners. The only difference between an Interest Over transaction and the situations described in McCauslen and Revenue Ruling is that in an Interests Over transaction a third party the corporation acquires all the partnership interests, and not an existing partner. Is this significant enough to require a different result? This question is answered in the negative in Revenue Ruling This Ruling considered two situations involving the conversion of a multi-owner LLC taxed as a partnership into a disregarded entity. In Situation 1, A and B are equal members in an LLC. A sells his interest to B, and the LLC continues to conduct its business. In Situation 2, C and D, also equal members in an LLC, sell their membership interests to E, an unrelated party. Again, after the sale the LLC continues to conduct its business. After citing the various Code authorities governing partnerships, the Revenue Ruling then cites McCauslen and Revenue Ruling , noting the conclusions in each that although the surviving partner purchased the deceased partner s interest, he was deemed to have purchased the assets attributable to the interest. 79 The Ruling first recognizes that since in both Situation 1 and Situation 2 the LLCs end up with only one owner, they terminate under section 708(b)(1)(A). Revenue Ruling also concluded that in an Interests Over transaction the partnership terminates under section 708(b)(1)(A). 80 With respect to Situation 1, the Ruling holds that the selling member (A) must treat the transaction as the sale of a partnership interest, 76 Id., C.B. at Id. 78 Rev. Rul , C.B Id. 80 Rev. Rul , C.B. 88.

13 Cross Species Conversions and Mergers 603 citing Regulation section (b). 81 It then continues that under McCauslen and Revenue Ruling , to determine the tax consequences to B the purchasing member the partnership is deemed to make a liquidating distribution of all of its assets to A and B, and following this distribution, B is treated as acquiring the assets deemed to have been distributed to A [the selling member].... Thus, B s basis for the assets attributable to A s one-half interest in the LLC is the price paid for the interest, and B s holding period for those assets begins on the day after the sale. Similarly, in Situation 2, C and D are treated as having sold their interests in the LLC to E in accordance with section As to E, however, the Ruling states: For purposes of classifying the acquisition by E, the CD partnership is deemed to make a liquidating distribution of its assets to C and D. Immediately following this distribution, E is deemed to acquire, by purchase, all of the former partnership s assets. Compare Rev. Rul , C.B. 88 (Situation 3), which determines the tax consequences to a corporate transferee of all interests in a partnership in a manner consistent with McCauslen, and holds that the transferee s basis in the assets received equals the basis of the partnership interests, allocated among the assets in accordance with 732(c). 83 Thus, E s basis for the assets is the purchase price paid to C and D, and its holding period for those assets begins on the day after the sale. Contrary to the quoted language, the conclusions in Revenue Ruling may not be consistent with McCauslen. Revenue Ruling does not describe the Interests Over transaction from the corporation s standpoint as a liquidating distribution of the partnership s assets to its partners, followed by a transfer of those assets to the corporation that is, an Assets Up transaction. Rather, it treats the transaction as it was structured a transfer of the partnership interests to the corporation, followed by its termination. 84 Thus, under the Revenue Ruling approach, the purchaser s basis for the assets received on termination of the partnership is the price paid for the partnership interests, and the holding period begins on the day after the day those assets are deemed to have been purchased. Although this seems to dictate different tax consequences than those set forth in Revenue Ruling , generally, the tax consequences under Revenue Ruling are the same as those described in Revenue Ruling , because the tax consequences of the transfer of the partnership interests to the corporation are governed by section 351. However, an exception applies where the money received by the corporation exceeds the corporation s basis in the partner- 81 Rev. Rul , C.B Id. 83 Id., C.B. at Rev. Rul , C.B. 88.

14 604 section OF TAXATION ship, which is taxable under the Revenue Ruling approach but not under the Revenue Ruling approach. Under the Revenue Ruling approach, as to the corporation, the steps and tax consequences would be as follows: 1. a. The partnership liquidates, distributing its assets and liabilities to its partners. Solely for purposes of determining the corporation s tax conse- quences under step 2 immediately below, each partner s basis in the assets received on the deemed liquidation of the partnership equals the basis in its interest in the partnership immediately prior to the liquidation, after taking into account the allocation of any income, gains, losses, expenses, and distributions for the short taxable year of the partnership ending on the date of the liquidation, decreased by the amount of money received, and increased by any gain recognized by the partner. 85 The impact of liabilities on this calculation is discussed in Part III.A.1. Solely for purposes of determining the corporation s tax conse- quences under step 2 immediately below, each partner s holding period for the assets received includes the period the partnership held the assets. 86 b. c. The corporation is not impacted by this deemed liquidation. 2. The partners transfer the assets and liabilities to the corporation. a. No gain or loss is recognized by the corporation on the receipt of the assets and the assumption of the liabilities. 87 b. The basis in the assets in the hands of the corporation equals their basis in the hands of the partners which is the basis in the partners interests in the partnership immediately prior to the deemed liquidation 88 increased by any gain the partners would have recognized on the deemed contribution to the corporation. 89 However, unless the election noted above is made, the basis cannot exceed the fair market value of the assets I.R.C. 732(b). 86 I.R.C. 735(b). 87 I.R.C See supra Part I.A.3.b.1.b. 89 I.R.C. 362(a). 90 I.R.C. 362(e).

15 Cross Species Conversions and Mergers 605 c. The corporation s holding period for the assets transferred to it is the same as the holding period in the hands of the partners which includes the period the partnership held its assets. 91 c. Tax Consequences to Partnership. The partnership recognizes no gain or loss on its termination. 4. Summary The following table summarizes the general tax consequences of the three methods of incorporating a partnership. Each consequence is the final tax consequence after all steps have been completed. Partners gain or loss Partners basis in stock Partners holding period for stock Corporation s gain or loss Assets Over Assets Up Rev. Rul None, unless share of liabilities exceeds basis in partnership interest Same as basis in partnership interest* Generally includes period partnership held assets** None, unless money received exceeds basis in partnership interest or share of liabilities exceeds basis in assets**** Same as basis in partnership interest decreased by share of liabilities assumed by corporation* Generally includes period partnership held assets** None, unless share of liabilities exceeds basis in partnership interest**** Same as basis in partnership interest, decreased by share of liabilities, and increased by any gain recognized* Generally includes period partnership interest held** None None None, unless money received exceeds basis in partnership interest Interest Over Rev Rul None, unless share of liabilities exceeds basis in partnership interest**** Same as basis in partnership interest, decreased by share of liabilities, and increased by any gain recognized* Generally includes period partnership interest held** None 91 This includes the period the partnership held its assets. I.R.C. 1223(2); see also text accompanying note 66.

16 606 section OF TAXATION Corporation s basis for assets Corporation s holding period for assets Partnership s gain or loss Basis in hands of partnership plus any recognized gain, but limited to FMV of assets Includes period assets held by partnership None**** unless liabilities exceed basis of assets*** Partners basis in partnership interests, but limited to FMV of interests Generally includes period assets held by partnership Partners basis in partnership interests plus any gain recognized, but limited to FMV of interests Includes period assets held by partnership None None None Partners basis in partnership interests plus any gain recognized, but limited to FMV of interests Includes period assets held by partnership *After taking into account the allocation of any income, gains. losses, expenses, and distributions for the portion of the partnership s taxable year during which the interest in the partnership was owned. Also, if basis exceeds the fair market value of the assets or interests, the transferor and corporation can elect to limit basis to such far market value, thereby avoiding the limitation on basis in the hands of the corporation. **The difference in holding periods for stock received in exchange for capital and section 1231 assets and stock received in exchange of all other assets is discussed in Part III.C. ***Any gain or loss flows through to the partners in accordance with the partnership or operating agreement, increasing or decreasing the partner s basis for its partnership interest. ****This assumes the corporation is not an investment company. B. The Check-the-Box Regulations On December 18, 1996, the Treasury Department issued final regulations under section 7701 permitting taxpayers to elect the tax classification of certain business organizations the check-the-box regulations. 92 Generally, an unincorporated U.S. entity, such as a limited partnership or multi-member LLC, will be classified for federal income tax purposes as a partnership unless it elects to be taxed as a corporation. Although these regulations are generally considered in the context of choosing the tax form of an eligible business organization at the time it is organized that is, a domestic multi-member LLC being treated as a partnership upon formation or electing to be taxed as a corporation from the time of its formation 93 the check-the-box regulations also apply to elections to change tax status after the business organization has been organized and operating. For example, a multi-member LLC that has been in business for a 92 Reg to A discussion of why a domestic LLC would want to be taxed as a corporation is beyond the scope of this Article.

17 Cross Species Conversions and Mergers 607 number of years and has been taxed as a partnership can elect to be taxed as a corporation. 94 Regulation section (g)(1)(i) specifically provides that if a business entity taxed as a partnership, such as a multi-member LLC, elects to be taxed as a corporation, the following events are deemed to occur: 1. The partnership contributes all of its assets and liabilities to the corporation in exchange for stock in the corporation, and 2. The partnership liquidates, distributing all of the stock to its partners. These deemed events are an Assets Over transaction, the tax consequences of which were discussed in Part I.A.1 above. C. Conversions from Partnership to Corporation Form In Revenue Ruling , 95 the Service ruled that a conversion of an entity classified as a partnership for federal income tax purposes to a corporation under a state law formless conversion statute is treated as an Assets Over transaction. This treatment is the same as a check-the-box election by a partnership to be taxed as a corporation. Therefore, the tax consequences are the same as those described in Part I.A.1 above. Where a partner s basis in its interest in the partnership its outside basis is greater than that partner s share of the partnership s basis in its assets its inside basis an Assets Up transaction can result in a higher basis in the assets in the hands of the corporation. Therefore, if this higher basis is desired, rather than converting an LLC into a corporation, the incorporation transaction should be specifically structured as an Assets Up transaction. D. Merger of a Partnership into a Corporation Although a merger of an LLC and a corporation may be a merger under state law, it does not constitute a merger for federal income tax purposes. Section 368(a)(1)(A) defines a reorganization to mean a statutory merger or consolidation. The regulations expand on this definition, requiring that the participants in the statutory merger be corporations. 96 Thus, a merger of an LLC into a corporation or a corporation into an LLC is not a merger under section 368(a)(1)(A), and therefore is not a tax-free reorganization under sections 354, 355, and 356. Unlike conversions, the Service has issued no formal guidance on how a merger of a partnership into a corporation is to be treated. In a private let- 94 An election can be effective for up to 75 days prior to its filing and up to 12 months after its filing. When an election is made, generally another election cannot be made for 60 months. Reg (c)(iv). 95 Rev. Rul , C.B Reg

18 608 section OF TAXATION ter ruling, however, the Service applied the Assets Over approach. 97 Therefore, until formal guidance is issued by the Service, the tax consequences of a merger of a partnership into a corporation should be determined as an Assets Over transaction described in Part I.A.1 above. 98 As in a conversion, where a partner s outside basis is greater than that partner s inside basis, an Assets Up transaction can result in a higher basis in the assets in the hands of the corporation. Therefore, if this higher basis is desired, rather than merging the LLC into the corporation, the incorporation transaction should be specifically structured as an Assets Up transaction. II. Corporation to Partnership A. Specific Methods to Change from Corporate to Partnership Form The Service has not issued a Revenue Ruling similar to Revenue Ruling on the tax consequences of a change from the corporate to partnership form of business a disincorporation. However, there would seem to be the same three methods of doing so: 1. Assets Over, where the corporation contributes its assets to a partnership and then liquidates, distributing the partnership interests to its shareholders. 2. Assets Up, where the corporation liquidates, distributing its assets to its shareholders, and the shareholders then contribute those assets to the partnership. 3. Interests Over, where the shareholders contribute their stock in the corporation to the partnership, and the corporation then liquidates. Assuming the Service were to similarly rule that the method selected dictates the tax consequences, those tax consequences should be as follows. 1. Assets Over There are two variations of an Assets Over transaction, depending upon how the partnership is formed. In one variation, the corporation forms the partnership and becomes its sole partner at the time it transfers its assets and liabilities to the partnership. Because a partnership requires more than one partner, the partnership would likely be disregarded until it has more than one partner. If the entity is an LLC, a single-member LLC is treated as a disregarded entity. Thus, in either case, for tax purposes the corporation should still be treated as the owner of those assets, and no tax consequences would result from the transfers to the partnership. When the interests in the partnership are transferred to the shareholders, the entity becomes a partnership for federal income tax purposes. 97 P.L.R (Mar. 4, 1994). 98 Informal consultation suggests that this should be the correct approach.

19 Cross Species Conversions and Mergers 609 In Revenue Ruling , 99 the Service set forth the tax consequences when a single-member LLC becomes a partnership in two situations. In Situation 1, the sole member of an LLC (A) sells one-half of its LLC interest to an unrelated third party (B). With respect to this Situation, the Service ruled that B s purchase of a one-half interest in the LLC is treated as the purchase of a 50% interest in each of the LLC s assets, which are treated as held directly by A. Immediately thereafter, A and B are treated as contributing their respective interests in those assets to the LLC in exchange for interests in the LLC. Under section 1001, A recognizes gain on this deemed sale to B of A s 50% interest in each of the LLC s assets. By analogy, the formation of the single-partner partnership or single-member LLC by the corporation, followed by the distribution of the interests in the partnership or LLC to the corporation s shareholders, should be treated as a transfer of the assets which are deemed to be owned by the corporation to its shareholders, followed by the contribution of those assets by the shareholders to the partnership. This is the same as the Assets Up transaction discussed next. As discussed in Part II.B below, the regulations provide that if an eligible entity that is taxed as a corporation elects to be taxed as a partnership, the following events are deemed to occur: (i) the corporation liquidates, distributing all of its assets and liabilities to its shareholders; and (ii) the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. 100 These deemed events are also an Assets Up transaction, the same as described in Revenue Ruling Thus, until further guidance is provided by the Service, it would seem reasonable to apply the Assets Up rules to this variation of an Assets Over transaction. In the other variation, the shareholders form the partnership, making nominal capital contributions in proportion to what their ownership percentages will be when all of the transfers are complete. In this variation, the partnership will not be a disregarded entity but a partnership for federal income tax purposes from its formation, to which the corporation makes a capital contribution. Thus, neither Revenue Ruling nor the check-the-box Regulations should apply. Without further guidance from the Service, it would seem reasonable to apply an Assets Over analysis similar to that set forth in Revenue Ruling The tax consequences of this variation, where the partnership is not disregarded, are as follows: a. Tax Consequences to Corporation. 1. No gain or loss is recognized by the corporation on the transfer of its assets and liabilities to the partnership unless the partnership 99 Rev. Rul , C.B Reg (g)(1)(ii).

20 610 section OF TAXATION would be treated as an investment company as defined in section 351 if the partnership were incorporated. 101 The corporation s basis in the partnership interest it receives equals the amount of money and the basis in the assets transferred to the partnership. 102 However, this basis must be adjusted if any liabilities are assumed by the partnership. 103 For partnership interests received in exchange for capital and section 1231 assets, the holding period for the interests received by the corporation includes the period the transferred assets were held by the corporation. 104 For partnership interests received in exchange for all other assets, the holding period begins the day after these assets were transferred to the partnership. 105 On liquidation of the corporation, the corporation will recognize gain or loss as if it had sold the partnership interests distributed to its shareholders for their fair market value. 106 b. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on its receipt of assets and assumption of liabilities The basis in the assets in the hands of the partnership equals their basis in the hands of the corporation, increased by any gain recognized by the corporation. 108 The partnership s holding periods for the assets transferred to it includes the periods they were held by the corporation. 109 c. Tax Consequences to Shareholders. 1. Each shareholder will recognize gain or loss on receipt of the partnership interest on liquidation of the corporation equal to the 101 I.R.C. 721(a). For simplicity purposes, a partnership which would be an investment company under section 351 if it were incorporated will be referred to as an investment partnership. For purposes of this Article, it is assumed that any partnership to which property is transferred would not be an investment partnership. 102 I.R.C See infra Part III.A.2 for a detailed discussion of liabilities. 104 I.R.C. 1223(1). 105 Rev. Rul , C.B See infra Part III.C for a more detailed discussion of holding periods. 106 I.R.C I.R.C I.R.C I.R.C. 1223(2).

21 Cross Species Conversions and Mergers 611 fair market value of the interest received minus the basis in the corporation s stock owned by the shareholder Each shareholder s basis in the partnership interests received on the liquidation of the corporation equals its fair market value Each shareholder s holding period for its partnership interest received on the liquidation of the corporation commences on the day after the receipt of the interest. 112 When the corporation contributes its assets and liabilities to the partnership, it will receive a significant interest in the partnership clearly more than 50%. When the corporation liquidates and distributes these interests to its shareholders, more than 50% of the interests in capital and profits will be transferred. Thus, the partnership will terminate under section 708(b)(1)(B). 113 However, as discussed in Part III.E, this termination should not alter the tax consequences described above. Compared to the incorporation of a partnership, which can generally be accomplished without tax consequences, a disincorporation transaction has tax consequences to both the corporation and its shareholders. As discussed in Parts III.C and D below, these tax consequences cannot be avoided by structuring the disincorporation transaction as either a conversion or merger under state law. 2. Assets Up The tax consequences of an Assets Up transaction where the corporation liquidates and the shareholders form the partnership should be as follows: a. Tax Consequences to Corporation. 1. On liquidation of the corporation, it will recognize gain or loss as if it had sold the assets distributed to its shareholders for their fair market values. 114 b. Tax Consequences to Shareholders. 1. Each shareholder will recognize gain or loss on receipt of the corporation s assets in an amount equal to the amount of money and the fair market value of the assets received, minus the liabilities assumed, and minus the basis in the corporation s stock owned by the shareholder I.R.C I.R.C Rev. Rul , C.B The termination rule applies even though the transfer is to other partners in the partnership. Reg (b)(2). 114 I.R.C I.R.C See supra Part III.A.2 for a detailed discussion of liabilities.

22 612 section OF TAXATION Each shareholder s basis in the assets received equals their fair market value. 116 Each shareholder s holding period for the assets received on the liquidation of the corporation commences on the day after the receipt of those assets. 117 In general, no gain or loss is recognized by the shareholders on the transfer of the assets and liabilities to the partnership, unless the partnership is an investment partnership. 118 Depending on the nature of the liabilities transferred to the partnership, gain could be recognized by the shareholders on the transfer of the liabilities to the partnership. 119 Each shareholder s basis in the partnership interest it receives equals the basis in the assets transferred to the partnership which is their fair market value 120 decreased by the liabilities assumed by the partnership, including liabilities secured by assets transferred to the corporation, and increased by the shareholder s share of those liabilities in the hands of the partnership. 121 The holding period for the partnership interest includes the holding period for the assets transferred to the corporation. 122 c. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on its receipt of assets and assumption of liabilities The basis in the assets in the hands of the partnership equals their basis in the hands of the shareholders, 124 increased by any gain recognized by the partners on the transfer of the assets to the partnership. 125 The partnership s holding period for the assets transferred to it is the same as the holding period in the hands of the shareholdrs I.R.C Rev. Rul , C.B I.R.C Liabilities are discussed in detail infra Part III.A This is their fair market value. See supra Part II.A.2.b I.R.C. 721(b), I.R.C. 1223(1). The holding period would have commenced on the day after the liquidating distribution from the corporation. See infra Part II.A.2.b I.R.C This is their fair market value. See supra Part II.A.2.b I.R.C I.R.C. 1223(2). The holding period would have commenced the day after the liquidating distribution to the shareholders. See supra Part II.A.2.b.7.

23 Cross Species Conversions and Mergers 613 As in an Assets Over transaction, both the corporation and shareholders recognize gain or loss. Note that the partnership s basis for the assets has been stepped-up to their fair market values, whereas in an Assets Over transaction, the basis is a carryover basis from the corporation. Also, the holding period starts over in an Assets Up transaction, while there is a tacking of holding periods in an Assets Over transaction. 3. Interests Over The tax consequences of the Interests Over structure where the shareholders capitalize the partnership with corporate stock and the corporation then liquidates should be as follows: a. Tax Consequences to Shareholders. 1. No gain or loss is recognized by the shareholders on the transfer of their corporate stock to the partnership, unless the partnership is an investment partnership Gain or loss will flow through to the shareholders when the partnership recognizes gain or loss on the liquidation of the corporation. 128 Each shareholder s basis in the partnership interest it receives equals the basis in the stock contributed to the partnership. 129 Each shareholder s basis in the partnership interest will be increased for any gain or decreased for any loss flowing through to the shareholder from the partnership on the liquidation of the corporation. 130 Each shareholder s basis in its interest in the partnership will be increased for its share of the liabilities assumed by the partnership on the liquidation of the corporation. 131 The holding period for the partnership interests received by the shareholders includes the period the transferred stock was held by the shareholders. 132 b. Tax Consequences to Partnership. 1. No gain or loss is recognized by the partnership on its receipt of the corporate stock I.R.C See infra Part II.A.3.b I.R.C See infra Part II.A.3.b I.R.C See I.R.C. 1223(1). 133 See I.R.C. 721(a).

24 614 section OF TAXATION The basis in the stock in the hands of the partnership equals their basis in the hands of the shareholders, increased by any gain recognized by the partners on the transfer of the stock to the partnership. 134 The partnership s holding period for the stock transferred to it includes the periods they were held by the shareholders. 135 The partnership will recognize gain or loss on receipt of the corporation s assets on liquidation of the corporation equal to the fair market value of the those assets, minus the liabilities assumed, and minus the partnership s basis for the corporation s stock owned by the partnership. 136 The basis in the assets in the hands of the partnership equals their fair market value as of the date the corporation liquidates. 137 The partnership s holding period for assets received on the liquidation of the corporation commences on the day after the assets were distributed to the partnership during the corporation s liquidation. 138 c. Tax Consequences to Corporation. On liquidation of the corporation, the corporation will recognize gain or loss as if it had sold the assets distributed to the partnership for their fair market values Summary The following table summarizes the general tax consequences of the three methods of disincorporating a corporation. Each consequence is the final tax consequence after all steps have been completed. 134 See I.R.C See I.R.C. 1223(2). 136 See I.R.C. 331(a) (b). 137 See I.R.C. 334(a). 138 See Rev. Rul , C.B See I.R.C. 336(a).

25 Cross Species Conversions and Mergers 615 Shareholders gain or loss Shareholders basis in partnership interest Shareholders holding period Corporation s gain or loss Partnership s gain or loss Partnership s basis for assets Partnership s holding period for assets Assets Over Corporation forms Partnership Gain or loss recognized on liquidation of corporation Fair market value of share of assets transferred to partnership Commences the day after assets received on liquidation of corporation Gain or loss recognized on liquidation of corporation Shareholders form Partnership Assets Up Interests Over Gain or loss recognized on liquidation of corporation Fair market value of partnership interest Commences the day after interests received on liquidation of corporation Gain or loss recognized on liquidation of corporation* Gain or loss recognized on liquidation of corporation* Fair market value of share of assets transferred to partnership plus share of liabilities Commences the day after assets received on liquidation of corporation Gain or loss recognized on liquidation of corporation Gain or loss flows through to shareholders on liquidation of corporation* Basis in stock plus any gain or minus any loss flowing through on liquidation of corporation plus share of liabilities Includes period stock held by shareholders Gain or loss recognized on liquidation of corporation None None None Gain or loss flows through to shareholders on liquidation of corporation Fair market value Corporation s Fair market Fair market of assets basis for assets value of assets value of assets Commences the day after assets received by shareholders on liquidation of corporation Includes period assets held by corporation *Assumes the partnership is not an investment partnership. Commences the day after assets received by shareholders on liquidation of corporation Commences the day after assets received on liquidation of corporation B. The Check-the-Box Regulations Regulation section (g)(1)(ii) specifically provides that if a busi-

26 616 section OF TAXATION ness entity taxed as a corporation elects to be taxed as a partnership such as a multi-member LLC the following events are deemed to occur: 1. The corporation liquidates, distributing all of its assets and liabilities to its shareholders; and 2. The shareholders contribute all of the distributed assets and liabilities to a newly formed partnership. These deemed events are an Assets Up transaction, the tax consequences of which were discussed in Part II.A.2 above. C. Conversion from Corporate to Partnership Form The Service has not issued a Revenue Ruling similar to Revenue Ruling , addressing the tax consequences of a conversion of an entity classified as a corporation for federal income tax purposes to a partnership under a state law formless conversion statute. However, since Revenue Ruling applied the approach set forth in the regulations on a conversion from partnership to corporate form, it would seem reasonable to assume that the Service would also apply the approach in the regulations on a conversion from corporate to partnership form. Therefore, the tax consequences of a conversion of an entity classified as a corporation for federal income tax purposes to an entity classified as a partnership under a state law formless conversion statute should be determined as an Assets Up transaction described in Part II.A.2 above. D. Merger of a Corporation into a Partnership As in the case of a merger of an entity taxed as a partnership into a corporation, the Service has issued no formal guidance on how a merger of a corporation into a partnership is to be treated. In private letter rulings, however, the Service has applied both the Assets Over and Assets Up approaches. 140 Nevertheless, until formal guidance is issued by the Service, the tax consequences of a merger of a corporation into a partnership should be determined as an Assets Up transaction described in Part II.A.2 above. 141 III. Specific Tax Issues A. Liabilities To preserve the federal income tax construct that a partnership including an LLC taxed as a partnership is an aggregate of its partners, section 752(a) provides that each partner s basis for its interest in the partnership is increased by its share of the partnership s liabilities and by any increase in its individual liabilities by assuming a partnership liability. Conversely, under sec- 140 See, e.g., P.L.R (Aug. 27, 2002); P.L.R (Jan. 3, 1997). 141 As in the case of a merger of a partnership into a corporation, informal consultation suggests that this should be the correct approach.see supra note 98.

27 Cross Species Conversions and Mergers 617 tion 752(b), any decrease in a partner s share of the partnership s liabilities, or any decrease in its individual liabilities by the partnership s assumption of an individual liability, is considered a distribution of money to the partner by the partnership. The incorporation of a partnership or the disincorporation of a corporation may have tax consequences if either the partnership or corporation has liabilities that are assumed by the successor entity. Although the determination of a partner s share of a partnership s liabilities is beyond the scope of this Article, a general understanding of how liabilities affect an incorporation or disincorporation transaction is necessary, both to determine if there are tax consequences to the incorporation or disincorporation transaction and to determine whether an alternative structure could be used to minimize or eliminate those tax consequences. Preliminarily, the impact of liabilities on a disposition of assets securing those liabilities needs to be reviewed. In Crane v. Commissioner, the U.S. Supreme Court held that the amount realized on a disposition of encumbered property includes the amount of a liability assumed by the purchaser. 142 In Tufts v. Commissioner, the Court followed the Crane doctrine, treating a nonrecourse debt as a true debt. 143 More importantly, it held that even if the amount of the debt exceeds the fair market value of the property, the full amount of the debt must be taken into account in computing the amount realized. 144 Regulation section (a)(1) adopts this result, providing that the amount realized from a sale or other disposition of property includes the amount of liabilities from which the transferor is discharged as a result of the sale or disposition. 1. Partnership to Corporation Liabilities can impact an incorporation transaction in two ways. First, the deemed distribution resulting from the corporation s assumption of liabilities can result in the partners recognizing a gain, as illustrated starting with Example A Second, if the amount of the liabilities assumed exceed the basis of the properties transferred to the corporation, the partners will recognize a gain equal to such excess. 146 Section 357(c) applies on a gross basis. If the sum of the amount of the liabilities assumed exceeds the total of the adjusted basis of the property transferred, then the excess is taxable. 147 Thus, the comparison is between the total liabilities assumed and the basis of all property transferred. a. Example A C transfers the following assets to a corporation U.S. 1, 11, 13 (1947) U.S. 300, 317 (1983). 144 Id. 145 See infra Part III.A.1.a, Ex. A I.R.C. 357(c). 147 I.R.C. 357(c)(1). 148 Reg (a).

28 618 section OF TAXATION (Newco) in a transaction qualifying under section 351: Basis Nonrecourse Debt Asset 1 $10,000 $0 Asset 2 10,000 30,000 Total $20,000 $30,000 On a gross basis, since the nonrecourse debt $30,000 exceeds the total basis of both assets $20,000 C recognizes a gain of $10,000. If Asset 1 had a basis of $20,000, no gain would be recognized by C the nonrecourse debt of $30,000 would not exceed the total basis of both assets. This is true even though the debt secured by Asset 2 exceeds its basis by $20,000. Section 357(c) refers to liabilities assumed. Section 357(d) defines this term. In general, a recourse liability is assumed if, based on all facts and circumstances, the corporation has agreed to, and is expected to, satisfy such liability. 149 A nonrecourse liability is assumed if it is secured by any property transferred to the corporation. 150 A special rule applies to a nonrecourse liability which is also secured by property not transferred to the corporation. 151 A detailed discussion of section 357(d) is beyond the scope of this Article. 152 The income recognized is considered as a gain from the sale or exchange of a capital asset or of property which is not a capital asset, as the case may be. 153 Where more than one property is transferred to the corporation, the regulations provide that any gain recognized is allocated among the properties in proportion to their fair market values. 154 This can lead to some interesting results. b. Example A-2. Assume the same facts as in Example A-1. Assume, further, that the fair market value of Asset 1 is $10,000 and of Asset 2 is $30,000. Therefore, the $10,000 gain is allocated 25% $10,000/$40,000 to Asset 1 and 75% $30,000/$40,000 to Asset 2. Note that the actual appreciation in the assets was: 149 I.R.C. 357(d)(1)(A). 150 I.R.C. 357(d)(1)(B). 151 I.R.C. 357(d)(2). 152 See generally Karen C. Burke, Contributions, Distributions and Assumption of Liabilities: Confronting Economic Reality, 56 Tax Law. 383 (2003); L. Sheppard, Tinkering with Assumption of Liabilities, 84 Tax Notes (TA) 1348 (Sept. 7, 1999); Boris I. Bittker & James C. Eustice, Federal Income Taxation of Corporations and Shareholders 3.06 (7th ed. 2006). 153 I.R.C. 357(c)(1). 154 See Reg (b).

29 Cross Species Conversions and Mergers 619 Asset 1 Asset 2 Fair market value $10,000 $30,000 Basis 10,000 10,000 Appreciation $0 $20,000 Even though there is no appreciation in Asset 1, $2,500 25% of $10,000 of the recognized gain is allocated to it, while only $7,500 75% of $10,000 is allocated to Asset 2. If Asset 2 is a capital asset and Asset 1 is not, $2,500 of the recognized gain is shifted from a capital gain to ordinary income. The best way to consider the impact of liabilities on incorporation transactions is through examples. For Examples A-3 through A-6, assume: A and B organized LLC, each making an initial capital contribution of $50, LLC borrowed $900,000 on a nonrecourse basis. The loan requires annual payments of interest at 7% and a balloon payment of principal and interest at the end of 10 years. A and B each assume $450,000 of the nonrecourse debt. 3. LLC purchased a building on leased land for $1,000,000. The lease has a remaining term of 40 years. 4. The building is leased on a triple net basis. The rents received are sufficient to pay all expenses but not to generate any positive cash flow. Therefore, a $25,000 loss is realized each year, which equals the $25,000 depreciation deduction $1,000,000 divided by 40 years. 5. At the end of year six, LLC s balance sheet is as follows assuming the building has neither appreciated nor depreciated in value: Book Basis Fair Market Value Building $1,000,000 $1,000,000 Accumulated depreciation (150,000) 0 Total Assets $ 850,000 $1,000,000 Nonrecourse debt $ 900,000 $ 900,000 Capital: A (25,000) 50,000 B (25,000) 50,000 Total Liabilities and Capital $ 850,000 $1,000,000 At the beginning of year seven, 6. A and B decide to convert the LLC into a corporation (Newco).

30 620 section OF TAXATION a. Example A-3: Incorporation Transactions in General. To understand how liabilities affect the tax consequences of a partnership incorporation transaction, the starting point is a review of the basic rules on how sections 351, 357, 358, and 362 operate in a nonpartnership context. For this purpose, assume the same facts as above except that A is the sole owner of the building. Thus, at the end of year six, his basis in the building is $850,000. He transfers the building, subject to the nonrecourse debt, to Newco for stock. If A had sold the building, subject to the nonrecourse debt, for $100,000 the excess of the value of the building over the nonrecourse debt in accord with Crane and Tufts, he would recognize a gain of $150,000: Cash received $ 100,000 Nonrecourse debt assumed 900,000 Total proceeds $1,000,000 Less: basis (850,000) Recognized gain $ 150,000 Transfer of the building to Newco generally defers this gain under section 351. However, section 357(c) provides that gain is recognized to the extent the liabilities assumed by the corporation exceed the basis in the property transferred to the corporation. A liability which would result in a tax deduction when paid, or a liability described in section 736(a), 155 is excluded when determining the amount of liabilities under section 357(c). 156 However, this exception does not apply to the extent that the incurrence of the liability resulted in the creation of, or an increase in, the basis of property. 157 In this example the liabilities assumed $900,000 exceed basis $850,000 by $50,000. Therefore, A recognizes a gain of $50,000. Under section 358(a), A s basis in the Newco stock is the same as its basis in the building, decreased by the amount of money and the fair market value of any property received in addition to the Newco stock, and increased by the gain recognized. For basis purposes, relief from the nonrecourse debt is treated as money received. 158 Thus A s basis in the Newco stock is zero: 155 I.R.C. 736(a) deals with payments to a retiring or deceased partner. 156 I.R.C. 357(c)(3)(A). 157 I.R.C. 357(c)(3)(B). 158 I.R.C. 358(d).

31 Cross Species Conversions and Mergers 621 Basis in building $ 850,000 Less: nonrecourse debt 900,000 $ (50,000) Plus: gain recognized 50,000 Basis in Newco stock $ 0 This zero basis preserves the deferred $100,000 gain $150,000 realized gain minus $50,000 recognized gain. Since the stock has a value of $100,000 $1,000,000 value of building minus $900,000 nonrecourse debt a sale of that stock would result in a realized gain of $100,000: Value of Newco stock $ 100,000 Less: basis 0 Gain $ 100,000 Under section 362, Newco s basis in the building is $900,000, the basis in A s hands $850,000 plus the $50,000 gain recognized by A. Further, under section 1223(2), Newco s holding period for the building includes the six years it was held by A. b. Example A-4: Assets Over. In an Assets Over transaction, LLC transfers the building, subject to the nonrecourse debt, to Newco in exchange for Newco stock. LLC then liquidates, distributing the Newco stock equally to A and B. Because the amount of the nonrecourse debt $900,000 exceeds LLC s basis for the building $850,000 section 357(c) requires LLC to recognize a gain of $50,000. This gain is allocated equally to A and B and increases each of their basis in their interests in LLC by $25,000. In addition, the transfer of the building subject to the nonrecourse debt is a reduction in each of A s and B s share of that debt, which is treated as a distribution of money to A and B. 159 Section 731 provides that gain is recognized by a partner on a distribution from a partnership to the extent the amount of money distributed exceeds the partner s adjusted basis in its interest in the partnership. 160 The issue is how basis is determined under these particular circumstances. Is the basis first increased to reflect the recognized gain on the incorporation of Newco, or is the distribution considered first? The answer can have significant tax consequences to A and B. Just prior to the incorporation transaction, A s and B s basis in their interests in LLC are $425,000 each, calculated as follows: 159 See I.R.C. 752(b). 160 See I.R.C. 731(a)(1).

32 622 section OF TAXATION Capital contribution $ 50,000 $ 50,000 Share of nonrecourse debt 450, ,000 A B $500,000 $500,000 Less: losses years 1-6* (75,000) (75,000) Basis $425,000 $425,000 *$12,500 per year for 6 years. If the distribution is considered first, the $450,000 deemed money distribution to each of A and B one-half of the $900,000 nonrecourse debt exceeds each of A s and B s $425,000 basis, resulting in a $25,000 gain each. Then, A and B must each recognize another $25,000 gain their distributive shares of the $50,000 gain recognized by LLC on the incorporation of Newco. However, if the gain realized by LLC is considered first, the transfer of the nonrecourse debt has no tax consequences to either A or B, and each recognizes only the $25,000 gain from the incorporation transaction: Basis from above $ 425,000 $ 425,000 Plus: gain from incorporation 25,000 25,000 A B $ 450,000 $ 450,000 Less: nonrecourse debt (450,000) (450,000) Basis $ 0 $ 0 Section 731(a)(1) provides that gain shall not be recognized to such partner, except to the extent that any money distributed exceeds the adjusted basis of such partner s interest in the partnership immediately before the distribution Further, the regulations under section 731 provide, in part that [t]he determination of the adjusted basis of a partnership interest is ordinarily made as of the end of a partnership taxable year. 162 This language implies, if not dictates, that no adjustments to basis are made with respect to distributions during a partnership s taxable year. 163 If LLC liquidates on the same day that it transfers its assets to Newco, LLC s taxable year would end on that day. Therefore, A s and B s basis would first be increased to $450,000 by their $25,000 allowable share of the gain on 161 I.R.C. 731(a)(1) (emphasis added). 162 Reg (a)(1). 163 See id.

33 Cross Species Conversions and Mergers 623 the incorporation of Newco. Since the deemed $450,000 distribution does not exceed basis, no gain or loss is recognized by either A or B. Even if the liquidation is deferred, the Regulations provide relief. The Regulations under section 731 also provide that advances or drawings of money or property against a partner s distributive share of income shall be treated as current distributions made on the last day of the partnership taxable year with respect to such partner. 164 In Revenue Ruling , the Service ruled that deemed distributions of money resulting from a partner s reduction in its share of a partnership s liabilities are treated as advances or drawings under the above-cited Regulation to the extent of the partner s distributive share of income for the partnership taxable year. 165 Since A and B each recognize a $25,000 gain on the incorporation of Newco, $25,000 of the deemed distribution from Newco s assumption of the nonrecourse debt is treated as an advance or drawing. Therefore, only $425,000 of the deemed distribution $450,000 minus $25,000 is treated as a current distribution against which A s and B s basis of $425,000 is applied. Since the distribution does not exceed their basis, no gain is recognized on the deemed distribution. Although A s and B s basis is reduced to zero by this deemed distribution, it is increased by the $25,000 gain on the incorporation of Newco at the end of LLC s taxable year. Since the remaining $25,000 of the deemed distribution is the same as the $25,000 basis, no additional gain is recognized by either A or B. On the liquidation of LLC, no further gain or loss is recognized since A and B only receive Newco stock. Each of their basis in the Newco stock will be $0, the basis in their interests in LLC immediately before the liquidation, after taking into account the $25,000 gain and the deemed $450,000 money distribution to each of them. A s and B s holding period for the Newco stock includes the six years they held their interests in LLC. Newco s basis in the building is $900,000, which is LLC s basis in the building $850,000 plus the $50,000 gain recognized by LLC. Further, Newco s holding period for the building includes the six years LLC owned the building. Therefore, the tax results to A and B, together, and Newco are the same as if A were the sole owner of the building, preserving the construct that a partnership is an aggregate of its partners. c. Example A-5: Assets Up. In an Assets Up transaction, LLC liquidates, transferring the building subject to the nonrecourse debt equally to A and B. A and B then transfer their interests in the building subject to the nonrecourse debt to Newco in exchange for Newco stock. Under section 752, the transfer of the building subject to the nonrecourse debt to A and B reduces each of A s and B s basis in their interests in 164 Reg (a)(1)(ii). 165 Rev. Rul , C.B. 195.

34 624 section OF TAXATION the LLC by $450,000 their shares of that debt. 166 However, section 752 also provides that an increase in a partner s individual liabilities by reason of the assumption by the partner of partnership liabilities is considered a contribution of money by such partner to the partnership. 167 Section 752(c) provides that for purposes of section 752, a liability to which property is subject shall, to the extent of the fair market value of such property, be considered as a liability to the owner of the property. 168 Thus, on the liquidation of LLC, both A and B are considered to have received a $450,000 distribution of money from the LLC and to have made a contribution of $450,000 in money to the LLC. As in Example A-4, the issue is how basis is determined under these particular circumstances. Is the basis first increased to reflect the deemed capital contribution, or is the deemed money distribution considered first? If the distribution is considered first, since A s and B s share of the nonrecourse debt $450,000 each exceeds each of their basis in their interests in LLC $425,000 A and B would each recognize a gain of $25,000. However, if the contribution is considered first, A s and B s basis would each be increased by $450,000 to $875,000, and then decreased by the $450,000 deemed distribution to $425,000, so no gain would be recognized. Fortunately, the regulations provide: If, as a result of a single transaction, a partner incurs both an increase in the partner s share of the partnership liabilities (or the partner s individual liabilities) and a decrease in the partner s share of the partnership liabilities (or the partner s individual liabilities), only the net decrease is treated as a distribution from the partnership and only the net increase is treated as a contribution of money to the partnership. 169 Since the deemed distribution and deemed capital contribution by A and B are the same amounts, there is no impact on their basis in their interests in LLC. Thus, as of the liquidation of LLC, their basis in their interests in LLC is $425,000, as calculated above. Under section 732(b), A s and B s basis in their equal interests in the building are the same as each of their basis in their interest in LLC, or $425,000. A s and B s holding period includes the six years they held their interest in LLC. When the building, subject to the nonrecourse debt, is transferred by A and B to Newco, section 357(c) requires each of A and B to recognize a gain of $25,000, because the amount of the nonrecourse debt transferred by each of them $450,000 exceeds the basis in their one-half interest in the building $425,000. Each of their basis in the Newco stock is $0 the $425,000 basis in the building transferred to Newco, plus the $25,000 recognized gain 166 See I.R.C. 752(d). 167 I.R.C. 752(a). 168 See I.R.C. 752(c). 169 Reg (f).

35 Cross Species Conversions and Mergers 625 on such transfer, minus the $450,000 debt deemed assumed by Newco. This is the same amount of gain and basis as in an Assets Over transaction. A s and B s holding period for the Newco stock includes the period they held the building, which includes the six years they held their interests in LLC. Newco s basis in the building is $900,000, the basis in the building in the hands of A and B $850,000 plus the $50,000 gain recognized by A and B. Further, Newco s holding period for the building includes the six years A and B are deemed to have held the building. Therefore, as in Example A-4, the tax consequences to A and B, together, and Newco are the same as if A were the sole owner of the building. d. Example A-6: Interests Over. In an Interests Over transaction, A and B transfer their interests in LLC to Newco in exchange for Newco stock. LLC terminates for federal income tax purposes because all of the interests in LLC are owned by one member, Newco. If LLC is not liquidated under state law, it continues as a disregarded entity. It is not clear from Revenue Ruling how partnership liabilities impact the tax consequences of an Interests Over transaction. To understand the issue, start with the tax consequences of the sale of an interest in a partnership having liabilities, a portion of which are allocated to the selling partner. Referring to the basic facts set forth above, assume A sells its interest in LLC for its $50,000 fair market value one-half of LLC s equity value of $100,000, the $1,000,000 fair market value of the building minus the $900,000 nonrecourse debt. Under Regulation sections (h) and (a)(1), the amount realized by A includes both the $50,000 actually received and $450,000, its share of the $900,000 nonrecourse debt. Therefore, A s gain would be $75,000: Cash proceeds $ 50,000 Share of debt 450,000 Total amount realized $500,000 Less: Basis (425,000) Gain $ 75,000 However, an Interests Over transaction is governed by sections 351, 357 and 358. If this indirect assumption of liabilities is considered additional consideration received under section 1001, should it be considered additional consideration under section 357? We know from section 357(a) that an assumption of liabilities is not considered money for purposes of section However, section 357(c) provides for recognition of gain to the extent the amount of the liabilities assumed by the corporation exceed the transferor s basis for the 170 See I.R.C. 357(a)(2).

36 626 section OF TAXATION assets contributed to the corporation. 171 As noted in Part I.A.1, Revenue Ruling ruled that on a transfer of a partnership interest in a partnership that had incurred nonrecourse liabilities, the transferring partner s share of those nonrecourse liabilities was considered a liability to which the partnership interest was subject for purposes of section 357(c). 172 Therefore, as in the Assets Over and Assets Up transactions, A and B would each recognize a $25,000 gain on the transfer of their interests in LLC to Newco: Share of nonrecourse debt $ 450,000 Less: basis in LLC (425,000) Gain $ 25,000 A s and B s basis in their Newco stock would be $0: Basis in LLC $ 425,000 Plus: gain recognized 25,000 $ 450,000 Less: share of debt (450,000) Basis in Newco stock $ 0 A s and B s holding period in the Newco stock includes the six years the interests in LLC were held. From Newco s standpoint, its basis in the interest in LLC is the same as the transferees basis in LLC $850,000 plus the gain recognized on the transfer $50,000 or a total of $900,000. Newco s holding period for the interest in LLC includes the six years A and B held their interests in LLC. On termination of LLC, Newco s basis in the building is $900,000, the same as its basis in its interest in LLC. Newco s holding period for the building includes the six years it is deemed to have held its interest in LLC. e. Summary of Examples A-4 through A-6. The following table summarizes the tax consequences in Examples A-4 through A See I.R.C. 357(c)(1). 172 See supra note 10 and accompanying text.

37 Cross Species Conversions and Mergers 627 Gain recognized by A and B (each) A s and B s basis in Newco stock (each) Example A-4 Assets Over Example A-5 Assets Up Example A-6 Interests Over $25,000 $25,000 $25,000 $0 $0 $0 A s and B s holding period 6 years 6 years 6 years for Newco stock (each) Newco s basis in the building $900,000 $900,000 $900,000 Newco s holding period for the building 6 years 6 years 6 years 2. Corporation to Partnership The impact of liabilities in these transactions is not as significant as in partnership to corporation transactions. As with partnership to corporation transactions, the best way to consider the impact of liabilities is through examples. For Examples A-7 through A-9, assume: 1. A and B organized a corporation, Newco, each making an initial capital contribution of $50, Newco borrowed $900,000 on a nonrecourse basis. The loan requires annual payments of interest at 7%, and a balloon payment of principal and interest at the end of 10 years. 3. Newco purchased a building on leased land for $1,000,000. The lease has a remaining term of 40 years. 4. The building is leased on a triple net basis. The rents received are sufficient to pay all expenses, and to generate a positive cash flow of $25,000 each year. Newco realizes neither income nor loss, because the $25,000 of cash flow each year is reduced by a $25,000 depreciation deduction $1,000,000 divided by 40 years. 5. At the end of year six assuming the building has neither appreciated nor depreciated in value Newco s balance sheet is as follows:

38 628 section OF TAXATION Book Basis Fair Market Value Cash $ 150,000 $ 150,000 Building 1,000,000 1,000,000 Accumulated depreciation (150,000) 0 Total Assets $1,000,000 $1,150,000 Nonrecourse debt $ 900,000 $ 900,000 Capital stock 100, ,000 Retained earnings 0 150,000 Total Liabilities and Net Worth $1,000,000 $1,150, At the beginning of year seven, A and B decide to convert Newco into a limited liability company (LLC). a. Example A-7: Assets Over. Assume A and B form LLC with a capital contribution of one cent each. In an Assets Over transaction, Newco transfers the building, subject to the nonrecourse debt, to LLC in exchange for an interest in LLC. Newco then liquidates, distributing the LLC interests and cash equally to A and B. 173 Under section 721, Newco recognizes no gain or loss on the transfer of the building, subject to the nonrecourse debt, to LLC. Under section 722, Newco s basis in its interest in LLC is the same as its basis in the building, or $850,000, and under section 1223(1), its holding period for the LLC interest includes the six years it held the building. Under section 723, LLC s basis for the building is $850,000, the same as Newco s basis. Further, under section 1223(1), LLC s holding period for the building includes the six years Newco held the building. The transfer of the building, subject to the nonrecourse debt, to LLC reduces Newco s individual liabilities, which is treated as a distribution of money from LLC to Newco. 174 Section 752(a) provides that an increase in a partner s share of partnership liabilities is considered a contribution of money by such partner to the partnership. Based on the de minimis contributions by A and B to LLC, Newco s share of the nonrecourse debt should be 100%. Thus, on the transfer to LLC, Newco is considered to have received a $900,000 distribution of money from LLC and to have made a contribution of $900,000 in money to LLC. As discussed in Example A-4, the regulations provide that, with respect to liabilities, if a partner has both a distribution and contribution as the result of a single transaction, only the net decrease is treated as a distribution from the 173 For simplicity purposes, it is assumed that the cash is not transferred to LLC. This provides funds to both Newco and A and B to pay any taxes that might be due. 174 See I.R.C. 752(b).

39 Cross Species Conversions and Mergers 629 partnership, and only the net increase is treated as a contribution of money to the partnership. 175 Since the deemed distribution and deemed capital contribution by Newco are the same amounts, Newco recognizes no gain or loss on the transfer of the building to LLC, and there is no impact on its basis in its interest in LLC. On the liquidation of Newco, it is deemed to have sold its interest in LLC for its fair market value. That fair market value should be $100,000 the $1,000,000 value of the building minus the $900,000 nonrecourse debt. In accordance with the Crane and Tufts rules, Newco should also be treated as receiving money in the amount of the nonrecourse debt, or $900, Thus, Newco realizes and recognizes a gain of $150,000 on its liquidation, calculated as follows: Value of LLC interest $ 100,000 Nonrecourse debt 900,000 Total received $1,000,000 Less: basis (850,000) Recognized gain $ 150,000 Assuming a combined federal and state income tax rate of 40%, Newco owes taxes of $60,000. Thus, on its liquidation, Newco distributes $45,000 of cash one-half of $150,000 minus the $60,000 of taxes and an LLC interest valued at $50,000 to each of A and B. A and B each recognize a gain of $45,000 on the liquidation of Newco, calculated as follows: Cash received $ 45,000 Value of interest in LLC 50,000 Total received $ 95,000 Less: basis in Newco stock (50,000) Recognized gain $ 45,000 Since A and B held the Newco stock for more than one year, this is a longterm capital gain. Each of A s and B s basis in the partnership interest is its fair market value or $50,000 plus each of their share in the nonrecourse debt or $450,000 for a total of $500,000. The holding period for the interests commences the day after Newco liquidated. 175 Reg (f). 176 See Tufts v. Commissioner, 461 U.S. 300, 317 (1983); Crane v. Commissioner, 331 U.S. 1, 14 (1947).

40 630 section OF TAXATION Thus, in an Assets Over transaction, Newco recognizes a gain of $150,000, and A and B each recognizes a gain of $45,000. b. Example A-8: Assets Up. In an Assets Up transaction, Newco liquidates, transferring cash and the building subject to the nonrecourse debt equally to A and B, and A and B then transfer their interests in the building subject to the nonrecourse debt to LLC in exchange for interests in LLC. On the liquidation of Newco, it is deemed to sell the building for its fair market value of $1,000,000. Therefore, Newco realizes and recognizes a gain of $150,000, calculated as follows: Value of building $1,000,000 Less: basis (850,000) Recognized gain $ 150,000 Assuming the same 40% combined federal and state tax rate, Newco owes taxes of $60,000 40% of $150,000. This leaves $90,000 to be distributed to A and B. Therefore, A and B each receives $45,000 in cash and a one-half interest in the building worth $50,000 $1,000,000 value minus $900,000 nonrecourse debt. To calculate A s and B s gain on the liquidation of Newco, we first need to address how liabilities are handled on the purchase of assets secured by a liability. As noted earlier, when property secured by a liability is sold subject to that liability, the liability is treated as additional consideration received, even if the amount of the liability exceeds the fair market value of the property. 177 From the buyer s standpoint, any liability secured by the property purchased is considered additional consideration paid for the property purchased. 178 For example, if A were to have purchased the building from Newco for its $100,000 net value, its purchase price and basis would be $1,000,000: Cash paid $ 100,000 Nonrecourse debt 900,000 Total purchase price/basis $1,000,000 Therefore, when Newco liquidates, A and B should be deemed to have paid $900,000 or $450,000 each for the property received from Newco on its liquidation. Thus, A s and B s recognized gain on the liquidation of Newco is $45,000 each, calculated as follows: 177 See supra note Crane, 331 U.S. at 14.

41 Cross Species Conversions and Mergers 631 Cash received $ 45,000 One-half value of building 500,000 $545,000 Less: share of nonrecourse debt (450,000) $ 95,000 Less: basis in Newco stock (50,000) Recognized gain $ 45,000 Since A and B held the Newco stock for more than one year, this is a longterm capital gain. A s and B s basis in the building is $500,000 each one-half of its $1,000,000 fair market value and their holding period commences on the day after the building was distributed to them by Newco. Neither A nor B recognizes gain or loss on the contribution of the building to LLC. A s and B s basis in LLC would be $500,000 each, the same as each of their basis in the building, and their holding periods would include the holding period for the building which commenced the day after the building was distributed by Newco to A and B. When A and B transfer the building subject to the nonrecourse debt to LLC, there is both a decrease in their individual liabilities and an increase in their shares of partnership liabilities of $450,000 each. As in Example A-5, since the changes in liability result from the same transaction and the amounts are exactly the same, there are no tax consequences to either A or B and no adjustment to the basis in their interests in LLC. LLC s basis in the building is $1,000,000, the same as A s and B s basis in the building. LLC s holding period includes the period the building was held by A and B, which commenced on the day after the building was distributed to A and B on the liquidation of Newco. Thus, in an Assets Up transaction, Newco recognizes a gain of $150,000, and A and B each recognizes a gain of $45,000 the same as in an Assets Over transaction. However, compared to an Assets Over transaction, LLC s basis in the building has been stepped-up to its fair market value of $1,000,000, but its holding period begins anew on the day after the building was distributed by Newco to LLC. c. Example A-9: Interests Over. In an Interests Over transaction, A and B transfer their stock in Newco to LLC in exchange for interests in LLC. Newco then liquidates. The transfer of the Newco stock is not taxable to either A or B. Since the liabilities are still in Newco, there is no impact on A or B. Each of their basis in their interest in LLC is $50,000, the same as the basis in their Newco stock, and their holding period for the LLC interests includes the six years they held the Newco stock. LLC s basis in the Newco stock is $100,000, the same as A s and B s basis, and its holding period includes the six years A and B held the Newco stock. As in example A-8, on the liquidation of Newco, it is treated as selling the

42 632 section OF TAXATION building for its fair market value of $1,000,000. With a basis of $850,000, the realized and recognized gain is $150,000. At a combined federal and state tax rate of 40%, the tax is $60,000. Thus, $90,000 of cash is received by LLC on the liquidation of Newco. LLC s realized and recognized gain is $90,000: Cash received $ 90,000 Value of building 1,000,000 $1,090,000 Less: nonrecourse debt (900,000) $ 190,000 Less: basis in Newco stock (100,000) Recognized gain $ 90,000 This gain flows through equally to A and B or $45,000 each and increases their basis in LLC by a like amount. Since LLC s holding period includes the six years A and B held the Newco stock, this gain is a long-term capital gain. As the result of the liquidation, LLC now has a debt of $900,000. Under section 752(a), each of A and B increase their basis in LLC by their one-half share of that debt or $450,000. For parity with examples A-5 and A-6, assume LLC distributes the $90,000 cash received from Newco equally to A and B. To determine whether there are any tax consequences to this distribution, A s and B s basis in LLC must be determined. After the liquidation, each of their basis is $545,000: Basis on formation of LLC $ 50,000 $ 50,000 Plus: share of nonrecourse debt A B 450, ,000 Plus: share of gain 45,000 45,000 Basis before distribution $545,000 $545,000 With a distribution of only $45,000 each, there are no further tax consequences, other than a reduction in their $545,000 basis to $500,000. LLC s basis for the building is its fair market value of $1,000,000, and its holding period begins on the day after the day the building was distributed to LLC on the liquidation of Newco. As in an Assets Over or Assets Up transaction, Newco recognizes a gain of $150,000, and A and B each recognizes a gain of $45,000. However, compared to an Assets Over transaction, LLC s basis in the building has been stepped-up to its fair market value of $1,000,000, but its holding period begins anew on the day after the building was distributed by Newco to LLC.

43 Cross Species Conversions and Mergers 633 d. Summary of Examples A-7 through A-9. The tax consequences of each alternative are as follows: Recognized gain to A and B (each) Example A-7 Assets Over Example A-8 Assets Up Example A-9 Interests Over $ 45,000 $ 45,000 $ 45,000* Recognized gain to Newco $ 150,000 $ 150,000 $ 150,000 LLC s basis for building $ 850,000 $1,000,000 $1,000,000 LLC s holding period for building A s and B s basis for LLC interests (each) A s and B s holding period for LLC interests (each) * Flow through from LLC 6 years 0 years 0 years $ 500,000 $ 500,000 $ 500,000 0 years 0 years 6 years e. Example A-10. As the summary chart shows, there are differences in basis and holding periods depending on which transaction is used to disincorporate Newco. Does this mean more gain is recognized depending on which transaction is used? Generally, the answer is no. Assume that immediately after the disincorporation transaction, LLC sells the building subject to the nonrecourse debt for its fair market value of $1,000,000 and then liquidates. LLC actually receives $100,000, the net amount of the $1,000,000 fair market value and the $900,000 nonrecourse debt. i. Assets Over Transaction. As concluded in Example A-7, LLC s basis in the building is $850,000. Since LLC receives $100,000 of cash and the nonrecourse debt is considered additional consideration received, LLC s gain on the sale is $150,000: Cash received $ 100,000 Nonrecourse debt 900,000 Total received $1,000,000 Less: basis (850,000) Recognized gain $ 150,000

44 634 section OF TAXATION This gain flows through equally to A and B. This gain would be a long-term capital gain as LLC s holding for the building includes the period the building was held by Newco. 179 Also as concluded in Example A-7, A s and B s basis in their interests in LLC before the sale are $500,000 each. As the result of the sale, their basis is increased by their share of the recognized gain $75,000 each and reduced by $450,000, their share of the nonrecourse debt to which the sold building was subject. Thus, at the time LLC liquidates, each of their basis in LLC is $125,000: Basis after disincorporation $500,000 Plus: recognized gain 75,000 $575,000 Less: reduction in LLC s liabilities (450,000) Basis at time of liquidation $125,000 On the liquidation of LLC, A and B each receives $50,000 and recognizes a loss of $75,000: Cash received $ 50,000 Less: basis (125,000) Recognized gain ($ 75,000) Because A s and B s holding period for their interests in LLC includes the six years they held the Newco stock, this loss is a long-term capital loss. Assuming the liquidation occurs in the same taxable year as the sale of the building, this loss offsets the $75,000 gain flowing through from LLC, so no net gain or loss is recognized by either A or B on the sale of the building and liquidation of LLC. However, if LLC liquidates in a taxable year after the year the building is sold, A and B would pay tax on the long-term capital gain flowing through from LLC in the year of the sale, and they might be able to deduct the $75,000 long-term capital loss in a later year. Capital losses may be deducted to offset capital gains plus $3, Therefore, if nether A nor B has any capital gains in the year LLC liquidates, only $3,000 of the recognized longterm capital loss could be deducted in that year. The $72,000 excess would carry over indefinitely to future years, subject to the same capital gains plus $3,000 annual limit. If A and B have little or no capital gains in future years, they would be forced to deduct the carried-over, long-term capital loss over a period of years up to a maximum of 25 $75,000 divided by $3, To simplify this discussion, it is assumed that no part of the gain would be taxable under section I.R.C. 1211(b).

45 Cross Species Conversions and Mergers 635 ii. Assets Up Transaction. As concluded in Example A-8, LLC s basis for the building is $1,000,000, and A s and B s basis in their interest in LLC are $500,000 each. Since LLC receives $100,000 of cash and the nonrecourse debt is considered additional consideration received, LLC realizes no gain or loss on the sale: Cash received $ 100,000 Nonrecourse debt 900,000 Total received $1,000,000 Less: basis (1,000,000) Recognized gain $ 0 Similarly, neither A nor B realize any gain or loss on the liquidation of LLC following the sale of the building. As the result of the sale, their basis is reduced by $450,000 their share of the nonrecourse debt to which the sold building was subject. Thus, at the time LLC liquidates, each of their basis in LLC is $50,000: Basis after disincorporation $500,000 Less: reduction in LLC s liabilities (450,000) Basis at time of liquidation $ 50,000 Thus, on liquidation of LLC, A and B recognize no gain or loss: Cash received $50,000 Less: basis (50,000) Recognized gain $ 0 Since A and B recognize neither gain nor loss, the fact that the liquidation of LLC may occur in a taxable year following the taxable year of the sale is irrelevant. iii. Interests Over Transaction. As concluded in Example A-9, LLC s basis in the building is $1,000,000, and A s and B s basis in their interests in LLC are $500,000 the same as in an Assets Up transaction. Therefore, the tax consequences are the same as an Assets Up transaction neither LLC nor A and B realize or recognize any gain or loss on the sale of the building and the liquidation of LLC. iv. Summary. In summary, the overall tax consequence to A and B under the three transactions are as follows:

46 636 section OF TAXATION Assets Over Assets Up Interests Over A s and B s taxable gain on disincorporation $45,000 $45,000 $45,000 transaction (each) LLC s gain on sale of building $75,000 $0 $0 flowing through to A and B (each) A s and B s loss on liquidation of ($75,000) $0 $0 LLC (each) Overall gain (each) $45,000 $45,000 $45,000 Thus, the net tax consequences are the same. However, in an Assets Over transaction, adverse tax consequences could result if the LLC does not liquidate in the same taxable year that it sells the building. B. Basis Issues Section 1012 sets forth the basic basis rule, providing that the basis of property is its cost. Sections 1013 to 1022 provide special basis rules, such as the basis in property acquired by gift 181 or inheritance. 182 Overriding basis rules are contained in Subchapters C corporate distributions and adjustments K partnerships and P capital gains and losses. 183 In the context of the transactions considered in this Article, these overriding rules govern property transferred to or by partnerships and to or by corporations. 1. Basis Rules Applicable to Partners and Partnerships a. Distributions by Partnerships. Section 732 sets forth the rules for determining the basis in property distributed by a partnership to a partner. There are two rules, depending on the transaction by which the distribution is made a distribution other than in liquidation of the partner s interest in the partnership a nonliquidating distribution and a distribution in liquidation of a partner s interest in the partnership a liquidating distribution. Although an incorporation or disincorporation transaction could involve either of these types of distributions, a liquidating distribution will always occur in an incorporation transaction, since the partnership always liquidates or terminates for tax purposes. For a nonliquidating distribution, section 732(a) provides that the basis in property, other than money, distributed to a partner is the partnership s basis in the property immediately before the distribution. However, the basis cannot exceed the partner s basis in its interest in the partnership, reduced 181 I.R.C I.R.C I.R.C , ,

47 Cross Species Conversions and Mergers 637 by the amount of any money distributed. 184 Where multiple properties are distributed and the limitation applies, it is necessary to allocate the limited basis among the properties received. The decrease in basis is allocated first to the properties with unrealized depreciation, in proportion to each property s unrealized depreciation, but only to the extent of such unrealized depreciation. 185 Any remaining decrease in basis is allocated to all properties received in proportion to their separate basis after the adjustment for unrealized depreciation. 186 This methodology is discussed below. i. Example B-1. A is a member in LLC with a $16,000 basis in its interest in LLC. On June 30, 2011, LLC distributes the following property to A, not in liquidation of its interest in LLC: Property LLC s Basis Fair Market Value Unrealized Depreciation Asset X $10,000 $9,000 $1,000 Asset Y 11,000 12,000 N.A. Total $21,000 $21,000 Because A s basis in its interest in LLC $16,000 is less than LLC s basis in the properties distributed $21,000 the required decrease of $5,000 is allocated as follows: A s basis in LLC $16,000 Basis to Allocate Asset X Asset Y To properties per LLC s basis 21,000 $10,000 $11,000 Decrease to be allocated ($5,000) Allocation of decrease: First to unrealized depreciation 1,000 (1,000) Second, in proportion to basis* 4,000 (1,800) (2,200) Totals $0 $7,200 $8,800 *Based on basis after allocating unrealized depreciation: $9,000 basis divided by $20,000 total basis times $4,000 = $1,800, and $11,000 basis divided by $20,000 total basis times $4,000 = $2,200. For a liquidating distribution, section 732(b) provides that the basis in 184 I.R.C. 732(a). 185 I.R.C. 732(c)(1)(A). 186 I.R.C. 732(c)(1)(B).

48 638 section OF TAXATION property, other than money, distributed to a partner is equal to the partner s basis in its interest in the partnership, reduced by the amount of any money received as part of the same distribution. Where multiple properties are distributed, the basis must be allocated among the properties received, as discussed below. For this purpose, a partner s basis is adjusted for all items of income, gain, loss, deduction, and distributions other than the liquidating distribution for the year in which the liquidating distribution is received. 187 Where a partner s outside basis is different from its share of the partnership s inside basis in its properties, there can be either an increase or decrease in basis to the properties distributed. 188 ii. Example B-2. Member B owns an interest in LLC with a basis of $12,000. B withdraws from LLC, receiving cash of $2,000 and real property with a fair market value of $14,000 and a basis to LLC of $6,000. B s basis in the real property is $10,000: Basis in LLC $12,000 Less: cash received (2,000) Basis in real property $10,000 B s basis in the real property is stepped-up from the LLC s basis of $6,000 to $10,000. If LLC s basis in the real property had been $15,000, there would have been a step-down from that $15,000 to $10,000. As discussed in Part II.A, if there is a difference between a partner s outside basis and its share of the partnership s inside basis for its properties, the specific form of transaction resulting in the higher basis should be used to maximize the basis of property in the hands of the former partners. Section 732(c) sets forth specific rules on the allocation of basis where multiple properties are received. Under section 732(c)(1)(A), basis is first allocated to any unrealized receivables and inventory items as defined in sections 751(c) and (d), respectively in an amount equal to the partnership s basis in those properties. If the basis to be allocated is less than the partnership s basis in these properties, the difference (the decrease) is allocated first to the properties with unrealized depreciation, in proportion to each property s unrealized depreciation, but only to the extent of such unrealized depreciation. 189 Any remaining decrease is allocated to all properties received in proportion to their separate basis after the adjustment for unrealized depreciation. 190 Where the basis to be allocated exceeds the partnership s basis in unrealized receivables and inventory items, or where there were no unrealized receivables 187 I.R.C. 732(b) (c). 188 I.R.C. 732(c)(2) (3). 189 I.R.C. 732(c)(3). 190 I.R.C. 732(c)(1)(B); see also supra Example B-1.

49 Cross Species Conversions and Mergers 639 or inventory items distributed, the excess is allocated to the remaining properties received in the following order: 1. First, by assigning to each property its basis to the partnership. 2. Second, to the extent any decrease in basis is required because the remaining basis to be allocated is less than the partnership s basis in the remaining properties as set forth above. 3. Third, to the extent of any increase in basis required because the remaining basis to be allocated exceeds the partnership s basis in the remaining properties to the remaining properties with unrealized appreciation, in proportion to, but only up to such unrealized appreciation. 4. Last, to the remaining property in proportion to their fair market values. 191 iii. Example B-3. C is a member in LLC with a basis in its interest of $650. LLC distributes the following properties to C in liquidation of its interest in LLC: Property LLC s Basis Fair Market Value Unrealized Appreciation Inventory items $100 $200 N.A. Asset X Asset Y N.A. Under sections 732(b) and (c), C s $650 basis in its interest in LLC is allocated among the properties received as follows: 191 I.R.C. 732(c)(2).

50 640 section OF TAXATION Basis to Allocate C s basis in LLC interest $650 First, to inventory items (100) $100 $550 Inventory Items Asset X Asset Y Next, to LLC s basis in X and Y (150) $50 $100 $400 Next, unrealized appreciation (350) 350 $50 Next, in proportion to FMV* (50) Totals $0 $100 $440 $110 *Asset X: $400 FMV divided by $500 total FMV times $50 = $40 and Asset Y: $100 FMV divided by $500 total FMV time $50 = $10. From the partnership s standpoint, a distribution of property, whether a liquidating or nonliquidating distribution, has no impact on the partnership. Under section 731(b), it recognizes no gain or loss as the result of the distribution. Further, the distribution has no impact on its basis in the properties retained by the partnership. b. Contributions to Partnerships. Section 722 provides that on a contribution of property to a partnership, the contributing partner s basis in its partnership interest increases by the contributing partner s basis in the property contributed to the partnership, plus any gain recognized by the contributing partner. Under section 721(b), gain can only be recognized if the partnership is an investment partnership. Since a partner s interest in a partnership is considered one property, there are no allocation issues at the partner level. i. Example B-4. D contributes Property X, with a basis of $10,000 and a fair market value of $13,000, to LLC for a 5% interest in LLC. If LLC is not an investment partnership, D recognizes no gain or loss on the contribution of Property X to LLC, and D s basis in its interest in LLC is $10,000, D s basis in Property X. However, if LLC is an investment partnership, D recognizes a $3,000 gain on the contribution of Property X to LLC $13,000 fair market value minus $10,000 basis and D s basis in its interest in LLC is $13,000, which is the $10,000 basis in Property X plus the $3,000 recognized gain. From the partnership s standpoint, section 723 provides that the basis in property contributed to a partnership is the basis in the hands of the contributing partner, increased by any gain recognized by the partner on the contribution of that property to the partnership. The gain recognition and

51 Cross Species Conversions and Mergers 641 basis increase language was added to sections 721 and 723 in The regulations under section 723 have not been amended to reflect this legislative change. Further, the Service has issued no guidance on how this gain is to be allocated among the properties contributed to the partnership. However, since the effect of section 721(b) is to make the transfer to the partnership a taxable event and is similar to the approach to allocate an increase for a nonliquidating distribution, it would seem reasonable to allocate the increase among the assets in accordance with the gains recognized on the transfer. Note in this regard that even if the partnership is an investment partnership, no losses are recognized, only gains. ii. Example B-5. Assume the same facts as in Example B-4. If D recognizes no gain on the contribution of Property X to LLC, LLC s basis in Property X is $10,000 D s basis in Property X. If D recognizes a $3,000 gain, LLC s basis in Property X is $13,000, which is D s $10,000 basis in Property X plus D s recognized gain of $3,000. iii. Example B-6. Assume E makes a capital contribution of the following properties to LLC, an investment partnership: Property Basis Fair Market Value Gain (Loss) Stock X $50,000 $80,000 $30,000 Stock Y 60,000 50,000 (10,000) Stock Z 80,000 90,000 10,000 $190,000 $220,000 $30,000 Since LLC is an investment partnership, E s contribution to LLC is taxable, but only as to gains. Therefore, E recognizes a gain of $40,000 the $30,000 gain for Stock X and the $10,000 for Stock Z. E s basis in its interest in LLC is $230,000: Basis in stock $190,000 Recognized gain 40,000 Basis in LLC $230,000 The $10,000 loss in Stock Y is deferred. It will be taken into account on a subsequent sale of the interest in LLC. For example, if E sells its interest in LLC for its $220,000 fair market value, E will recognize the $10,000 deferred loss: 192 Tax Reform Act of 1976, Pub. L. No , 2131(b), 90 Stat. 1520, 1922.

52 642 section OF TAXATION Sale proceeds $220,000 Basis in LLC 230,000 Recognized loss ($10,000) From LLC s standpoint, its basis in the stock would be E s basis of $190,000 plus E s $40,000 recognized gain, or a total of $230,000. Since the increase in basis is the gain recognized on the contribution of Stocks X and Z, the basis increase should be allocated to Stocks X and Z based on the gain recognized by E with respect to each: Income to Allocate Stock X Stock Y Stock Z E s basis $50,000 $60,000 $80,000 Gain $40,000 Allocation ($40,000) 30, ,000 Basis to LLC $80,000 $60,000 $90, Basis Rules Applicable to Shareholders a. Distributions by Corporations. In an Assets Over disincorporation, the corporation transfers its assets to the partnership and then liquidates, transferring the partnership interests to its shareholders. In an Assets Up disincorporation, the corporation liquidates, transferring its assets to its shareholders. In both of these disincorporation transactions, the shareholders recognize gain or loss on the liquidation of the corporation. 193 Therefore, under section 1016, the basis in the assets received by the shareholders are their fair market values. 194 In an Interests Over disincorporation, shareholders transfer their stock in the corporation to the partnership, and the corporation then liquidates. The partnership recognizes gain or loss on the liquidation which flows through to its partners so its basis in the assets received will also be the fair market value of those assets. 195 b. Transfer of Assets to a Corporation. i. In General. In conversions from a partnership to a corporation, assets will be transferred to a corporation by the partnership in an Assets Over or Interests Over transaction, or by the partners in an Assets Up transaction. In an Assets Over transaction assuming the corporation is not an investment company the partnership recognizes no gain or loss on the 193 I.R.C. 331(a). 194 See I.R.C. 1016(c)(1)(A). 195 I.R.C. 1016(c)(1)(A).

53 Cross Species Conversions and Mergers 643 transfer of the assets to the corporation, except to the extent money or property other than corporate stock is received boot or the liabilities assumed by the corporation exceed the partnership s basis in the assets transferred. 196 Similarly, in an Assets Up transaction, the partners recognize no gain or loss on the transfer of the assets to the corporation, except to the extent of any boot received, or if the liabilities assumed by the corporation exceed the partners basis in the assets transferred again, assuming the corporation is not an investment company. 197 In a corporation formation transaction qualifying under section 351, the basis in the stock received equals the basis in the property transferred to the corporation, decreased by the fair market value of any boot received, decreased by the amount of any money received, decreased by any liabilities assumed by the corporation, 198 and increased by any gain recognized by the transferor. 199 If boot is received, the basis in the boot is its fair market value. 200 The reduction in basis for liabilities assumed by the corporation applies even if no gain is recognized by the transferor as the result of the assumption of liabilities. 1. Example B-7. Assume LLC transfers real property to a corporation, Newco, in a transaction qualifying under section 351. The real property has a basis of $80,000, a fair market value of $100,000, and is subject to a $70,000 nonrecourse liability. Since the liability of $70,000 does not exceed the $80,000 basis in the real property, LLC recognizes no gain on the transfer. However, the liability is taken into account in determining LLC s basis in the Newco stock it receives: Basis in real property $80,000 Less: liabilities assumed 70,000 $10,000 Plus: gain recognized 0 Basis in Newco stock $10,000 This approach preserves the gain the transferor would have recognized had it sold the property. 2. Example B-8. Assume the same facts as in Example B-7. The net value of the real property is $30,000 $100,000 fair market value minus the 196 I.R.C. 351(a) (c). In any conversion from partnership to corporate form, it is unlikely that any boot will be received by the transferor of property to the corporation. 197 I.R.C. 351(a) (c). 198 Section 357(d) sets forth the rules for determining when a liability is assumed for purposes of section 357(c). 199 I.R.C. 358(a). 200 I.R.C. 358(a)(2).

54 644 section OF TAXATION $70,000 liability. If LLC had sold the real property subject to the liability, LLC s gain on the sale would have been $20,000 because relief of a liability is additional consideration on the sale of property subject to that liability: Sale proceeds $ 30,000 Plus: liabilities assumed 70,000 Total received $100,000 Less: basis 80,000 Gain $ 20,000 Since the stock has a value of $30,000 Newco s sole asset is real property with a fair market value of $100,000 which is subject to a $70,000 liability a sale of the stock for $30,000 would net the same gain: Sale proceeds $ 30,000 Less: basis 10,000 Gain $ 20,000 A similar preservation of gain occurs where the amount of the liability exceeds the basis in the property. 3. Example B-9. Assume the same facts as in Example B-8, except the basis in the real property is only $60,000. Since the liability of $70,000 exceeds the basis of $60,000, LLC recognizes a $10,000 gain on the transfer. The liability is also taken into account in determining LLC s basis in the Newco stock it receives: Basis in real property $60,000 Less: liabilities assumed 70,000 ($10,000) Plus: gain recognized 10,000 Basis in Newco stock $ 0 If LLC had sold the real property subject to the liability, LLC s gain on the sale of the real property would have been $40,000:

55 Cross Species Conversions and Mergers 645 Sale proceeds $ 30,000 Plus: liabilities assumed 70,000 Total received $100,000 Less: basis 60,000 Gain $ 40,000 A sale of the stock for $30,000 the net value of the real property would result in a $30,000 gain: Sale proceeds $ 30,000 Less: basis 0 Gain $ 30,000 Adding the $10,000 gain recognized by LLC on the incorporation of Newco results in the same $40,000 overall gain. ii. Allocation of Basis. Because only stock is received other than any boot there would appear to be no need to allocate basis under section 358(a). For example, if 20 different properties with a total basis of $317,000 are transferred to a corporation in a nonrecognition transaction qualifying under section 351, the transferor s basis in the stock received is $317,000. There would seem to be no need to analyze the specific properties from which this basis is derived. Nevertheless, since each share of stock has a basis, there are two methods that could apply an averaging method and a tracing method. Under the averaging method, the entire basis would be allocated equally to each share received. However, under the tracing method, the basis of each share is traced to the property transferred for that share, which depends on the relative fair market values of all of the properties transferred Example B-10. Assume LLC transfers the following property to a corporation, Newco, in exchange for 100 shares of Newco s stock in a transaction qualifying under section 351: Basis FMV Asset 1 $10,000 $20,000 Asset 2 20,000 20,000 The total basis in the 100 shares received is $30,000. Under the averaging method, this would be allocated equally to each share, so each share would 201 See Howard J. Rothman et al., Transfers to Controlled Corporations: In General, 758 Tax Mgmt. Port. (BNA) A-91 (2012).

56 646 section OF TAXATION have a basis of $300 $30,000 divided by 100. However, under the tracing method, since the two assets have equal value, half of the 100 shares were received for Asset 1 and half for Asset 2. Thus, the shares received for Asset 1 would have a basis of $200 each $10,000 divided by 50 shares and the shares received for Asset 2 would have a basis of $400 each $20,000 divided by 50 shares. The Service takes the position that the averaging method, and not the tracing method, applies to a section 351 transaction. 202 Section 358(b)(1) provides that [u]nder regulations prescribed by the Secretary, the basis determined under subsection (a)(1) shall be allocated among the properties permitted to be received without recognition of gain or loss. Regulation section (b) provides that where stock or securities are received in a section 351 transaction, the basis in the property transferred as adjusted for boot liabilities assumed, and any recognized gain is allocated among all of the stock and securities received in proportion to the fair market values of the stock of each class and the securities of each class. 203 No reference is made to the property transferred for the stock. Further, allocation is based on the fair market value of the classes of stock received, not the fair market values of the properties transferred which is the key to applying the tracing method. Proposed regulations issued in 2009 confirm application of the averaging method. 204 Proposed regulation section (g) deals with section 351 transactions, providing in general that where more than one share of stock is received, the aggregate basis in the property transferred as adjusted for any boot liabilities assumed, or gain recognized shall be allocated among all of the shares of stock received in proportion to the fair market values of each share of stock. If only one class of stock is received, each share must have the same fair market values. Where shares of more than one class are received, allocation is based on the fair market values of the shares received not the fair market values of the property transferred. Where stock of another corporation is also transferred to the corporation, the proposed regulations prescribe special rules which do allocate basis based on the fair market values of the stock transferred. 205 However, it only applies to the stock received in exchange for the stock transferred to the corporation in the section 351 transaction. The allocation of the remaining basis uses the averaging method. 202 See Reg (b). 203 This regulation was adopted in 1955 when section 351 allowed the tax-free receipt of both stock and securities. Section 351(a) was amended in 1989 to treat securities as boot. Thus, this portion of the regulations would only apply if different classes of stock are received in a section 351 transaction. Omnibus Budget Reconciliation Act of 1989, Pub. L. No , 7203(a), 103 Stat. 2106, Prop. Reg , 74 Fed. Reg (Jan. 21, 2009). 205 Id.

57 Cross Species Conversions and Mergers Example B Assume LLC transfers the following property to a corporation (Newco) in exchange for 110 Newco shares in a transaction qualifying under section 351: Basis FMV Asset Asset shares of X ,100 Since LLC recognizes no gain or loss on the exchange, and since stock was transferred to Newco, the $850 basis is allocated among the shares received in proportion to the fair market values of the property transferred to Newco. Since the fair market value of the X shares is 50% of the total, 50% of the 110 shares or 55 shares have a total basis of $250, or $4.55 each $250 divided by 55. The $600 basis in Assets 1 and 2 is allocated to the remaining 55 shares received pro rata, so each share has a basis of $10.91 $600 divided by 55. Although the tracing method is used to allocate basis for shares received in exchange for stock, the averaging method is used for shares received for all other property. 3. Basis Rules Applicable to Corporations a. Distributions by Corporations. Since a disincorporation involves the liquidation of the corporation, there are no basis consequences to the corporation regardless of the form of the disincorporation. b. Transfer of Assets to a Corporation. i. In General. From the corporation s standpoint, section 362(a) provides that the corporation s basis for the properties received is the same as their basis in the hands of the transferor, increased by any gain recognized by the transferor. However, there are two statutory exceptions to this rule, which are discussed below. First, however, the allocation of basis must be considered. ii. Allocation of Basis. Where only one property is transferred to the corporation, its basis in the hands of the corporation is the same as its basis in the hands of the transferor. 207 However, where multiple properties are transferred, neither the Code nor regulations provide for how the basis of each property is to be determined. There are two possible methods for allocating basis. One method is to preserve the transferor s basis in each property. 206 Prop. Reg (h), Ex. 16, 74 Fed. Reg (Jan. 21, 2009). 207 I.R.C. 362(a).

58 648 section OF TAXATION 1. Example B-12. Assume LLC transfers the following two assets to a corporation (Newco) in a transaction qualifying under section 351: Basis FMV Asset 1 $10,000 $20,000 Asset 2 20,000 20,000 Since no gain is recognized, Newco s aggregate basis in Assets 1 and 2 is $30,000. Under the preservation of basis method, Newco s basis in Asset 1 and 2 would be $10,000 and $20,000, respectively, the same as LLC s basis in each asset. The other method uses an aggregate approach. 2. Example B-13. Assume the same facts as in example B-12. Under the aggregate method, the aggregate basis of Assets 1 and 2 $30,000 is allocated between Asset 1 and 2 based on their fair market values. Since the fair market values of Assets 1 and 2 are the same, the $30,000 aggregate basis is allocated equally to Asset 1 and 2 or $15,000 each. The Seventh Circuit adopted the preservation approach, 208 as did the Tenth Circuit. 209 This method more clearly follows the statutory language, which states that the basis shall be the same as it would be in the hands of the transferor Further, it eliminates any gains or losses if the assets are immediately sold by the corporation. In Example B-12, a sale of the assets at fair market value results in a realized gain of $10,000 for Asset 1, but no realized gain or loss for Asset 2. However, in Example B-13, such a sale would result in a realized gain of $5,000 for Asset 1 and $5,000 for Asset 2. Although the overall gain is the same, the character could be different. For example, if Asset 2 is a section asset and Asset 1 is a capital asset, only $5,000 of the gain in Example B-13 may be a capital gain the $5,000 gain on the sale of Asset 2 could be recaptured as ordinary income under section The aggregate method requires an appraisal of the assets, which is not needed under the preservation method. Also, it may be necessary to allocate basis to property not reflected on the transferor s books, such as goodwill. If such property is a nonamortizable intangible, this can shift basis from depreciable or amortizable property to nondepreciable or nonamortizable property. For these reasons, it is more logical to use the preservation of basis method. 208 P.A. Birren & Sons, Inc. v. Commissioner, 116 F.2d 718 (7th Cir. 1940). 209 Gunn v. Commissioner, 25 T.C. 424 (1955), aff d per curiam sub nom. Perrault v. Commissioner, 244 F.2d 408 (10th Cir. 1957). 210 I.R.C. 362(a). 211 Section 1245 provides that with respect to section 1245 property generally depreciable personal property used in a trade or business a portion of the gain on a sale equal to the depreciation previously taken on the section 1245 property is recaptured as ordinary income.

59 Cross Species Conversions and Mergers 649 Where only one property is transferred to a corporation and gain is recognized, the increase in basis resulting from the recognized gain is allocated to that single property. 212 However, if multiple properties are transferred, neither the Code nor regulations provide for how the increase in basis is to be allocated among those properties. The Service has ruled that where gain is recognized in a boot transaction, each property must be considered separately and the boot must be allocated among the properties in proportion to their fair market values. 213 Since boot is not related to any particular property, it may not be logical to apply a similar rule where gain is recognized because the amount of the liabilities assumed by the corporation exceeds the basis in the property transferred to the corporation. 3. Example B-14. Assume LLC transfers the following assets to a corporation (Newco) in a transaction qualifying under section 351: Basis FMV Asset 1 $50,000 $80,000 Asset 2 10,000 20,000 Also assume Asset 1 is subject to a $70,000 nonrecourse debt. Since the amount of the debt $70,000 exceeds the total basis of the assets transferred to Newco $60,000 the $10,000 excess is recognized as a gain by LLC. Under section 362(a), Newco s basis in the assets is $60,000 LLC s basis in the assets plus $10,000 LLC s recognized gain or $70,000. Using the approach in Revenue Ruling , the $10,000 increase in basis would be allocated between Asset 1 and Asset 2 based on their fair market values. 214 Since the fair market value of Asset 1 is 80% of the fair market value of both assets, 80% of the gain or $8,000 would be allocated to Asset 1, resulting in a basis in Asset 1 of $48,000 $40,000 plus $8,000 and the remaining 20% $2,000 would be allocated to Asset 2, resulting in a basis in Asset 2 of $12,000 $10,000 plus $2,000. However, since the recognized gain results from the nonrecourse debt secured only by Asset 1, it may be more logical to increase the basis in Asset 1 by the full amount of the gain, resulting in a basis in Asset 1 of $60,000 $50,000 plus $10,000 gain. Of course, if more than one asset is secured by a liability assumed by the corporation, then an allocation among those assets, as in Revenue Ruling , would be required. A fair market value allocation can also result in allocation to property that has depreciated in value. For example, assume the same facts as in Example B-14, except that the fair market value of Asset 2 is only $5,000. The 212 I.R.C Rev. Rul , C.B Id.

60 650 section OF TAXATION fair market value allocation method would allocate $588 of the gain $5,000/$85,000 times $10,000 to Asset 2 even though a sale of Asset 2 would have resulted in a realized loss of $5,000 $5,000 fair market value minus $10,000 basis. 215 iii. Limitation Under Section 362(d). Section 362(d) limits the increase in basis where gain is recognized as the result of the corporation s assuming a liability of the transferor, or if the property transferred to the corporation is subject to a liability. In either case, the basis of the property cannot be increased above its fair market value Example B-15. Assume LLC s sole asset is real property with a fair market value of $90,000, a basis of $80,000, and subject to a nonrecourse debt of $100,000. LLC transfers the real property to a corporation (Newco) in a transaction qualifying under section 351. However, because the nonrecourse debt $100,000 exceeds LLC s basis in the real property $80,000 the $20,000 excess is recognized as a gain by LLC. Under section 362(a), Newco s basis in the real property would be $100,000, which is LLC s $80,0000 basis in the real property, plus the $20,000 recognized gain. However, under section 362(d), since the basis $100,000 exceeds the fair market value of the real property $90,000 the basis increase for the recognized gain is limited to $10,000, resulting in a basis in the real property of only $90,000. The primary purpose of this limitation was to counter tax shelter schemes involving debts secured by multiple properties and to tax indifferent taxpayers. 217 However, it has interesting results in a straight-forward incorporation transaction. Consider Example B-15. If LLC had transferred the real property to the lender in full satisfaction of the nonrecourse debt, LLC would have recognized a $20,000 gain: Sale proceeds $ 0 Plus: nonrecourse debt 100,000 Total proceeds $100,000 Less: basis 80,000 Gain $ 20,000 Following transfer of the real property to Newco, LLC s basis in its Newco stock is zero: For a more detailed discussion of this issue, see Howard J. Rothman et al., supra note 201, at A-97 to A I.R.C. 362(d). 217 See supra note See supra note 17.

61 Cross Species Conversions and Mergers 651 Basis in real property $ 80,000 Less: nonrecourse debt 100,000 ($ 20,000) Plus: recognized gain 20,000 Basis in Newco stock $ 0 If the limitation under section 362(d) did not apply and the real property presumably neither appreciates nor depreciates in value, a transfer of the real property by Newco to the lender in full satisfaction of the nonrecourse debt would result in no gain or loss: Sale proceeds $ 0 Plus: nonrecourse debt 100,000 Total proceeds $100,000 Less: basis 100,000 Gain $ 0 Since there are no liquidation proceeds to distribute to LLC, and since LLC s basis in its Newco stock is zero, no further gain is recognized by LLC. Thus, the overall gain recognized by LLC and Newco is $20,000 the same as if LLC had transferred the real property to the lender. However, with the section 362(d) limitation, Newco s basis is limited to $90,000 the real property s fair market value. Thus, on Newco s transfer of the real property to the lender in full satisfaction of the nonrecourse debt, Newco recognizes a $10,000 gain: Sale proceeds $ 0 Plus: nonrecourse debt 100,000 Total proceeds $100,000 Less: basis 90,000 Gain $ 10,000 Adding this to the $20,000 gain recognized by LLC on the incorporation of Newco results in an overall gain of $30,000 $10,000 more than if section 362(d) did not apply, and $10,000 more than if LLC had transferred the real property to the lender. Section 362(d) also raises an issue of the transfer of net value to the corporation. The limitation on the increase in basis of a property relates to any gain recognized to the transferor as the result of the assumption of a liability. 219 Example B-15 posits the simplest situation the transfer of one property whose fair market value is less than the amount of the debt assumed by the corporation. Thus, the transferor is not transferring any net value to the corporation. 219 I.R.C. 362(d).

62 652 section OF TAXATION What if LLC also transfers $10,000 cash to Newco so the total value of the assets transferred to Newco equals the amount of the nonrecourse debt? Section 357(c) still applies, since the amount of the debt $100,000 still exceeds the basis of the assets transferred to Newco $90,000 so gain is recognized, but only in the amount of $10,000. Recall that section 357(c) applies on a gross basis the assumed debt must exceed the basis of all assets transferred to the corporation, not just the assets securing the debt. 220 Under section 358(a), LLC s basis in the Newco stock is still zero: Basis in real property $ 80,000 Cash 10,000 $ 90,000 Less: nonrecourse debt 100,000 ($ 10,000) Plus: recognized gain 10,000 Basis in Newco stock $ 0 Under section 362(a), the increase in basis is therefore only $10,000. Since the increased basis of $90,000 $80,000 basis plus $10,000 recognized gain does not exceed the fair market value of the real property, section 362(d) does not apply. Assume the $10,000 is paid to the lender to reduce the nonrecourse debt to $90,000. Newco s transfer of the real property in full satisfaction of the nonrecourse debt would, therefore, result in no gain or loss. Since there are no assets to distribute to LLC and LLC has no basis for its Newco stock, it recognizes no gain or loss. Thus, the overall recognized gain is $20,000, the same as if LLC had transferred the real property to the lender in full satisfaction of the nonrecourse debt. What if Newco is not required to pay the $10,000 to the lender? In this case Newco realizes a $10,000 gain: Nonrecourse debt $ 100,000 Less: basis $ 90,000 Gain $ 10,000 Ignoring any taxes payable by Newco, distribution of the $10,000 to LLC results in LLC recognizing a $10,000 gain because it has no basis for its Newco stock. Thus, the overall gain is still $30,000: 220 See supra note 35.

63 Cross Species Conversions and Mergers 653 Gain recognized by LLC on incorporation $ 10,000 Gain recognized by Newco 10,000 Gain recognized by LLC on liquidation of Newco 10,000 Total overall gain $ 30,000 Thus, contributing additional assets to avoid section 362(d) does not really reduce the adverse tax consequences of section 362(d) unless the additional assets are used to pay down the debt. Proposed regulations issued in 2005 would require net value to be exchanged. 221 This net value requirement would apply to transfers after the proposed regulations are adopted as final. 222 If these proposed regulations were to apply to Example B-14, section 351 would not apply and the transfer of the real property to Newco would be a taxable sale or exchange because there would be no net value transferred to Newco. LLC would recognize a gain of $20,000 assuming Newco has no other assets, and therefore is insolvent: Value of stock received $ 0 Nonrecourse debt 100,000 Total proceeds $ 100,000 Less: basis 80,000 Recognized gain $ 20,000 This is the same gain recognized under section 357(c). However, Newco s basis in the real property would be $100,000, the amount of the nonrecourse debt. iv. Limitation Under Section 362(e). Section 362(e), enacted in 2004 and applicable to transfers to corporations after October 22, 2004, prevents the duplication of net built-in losses. Two types of situations are covered by section 362(e). Section 362(e)(1) applies to certain transactions otherwise governed by section 362(a) or (b), 223 while section 362(e)(2) applies to incorporation transactions under section 351. Either subsection could apply to the incorporation of a partnership. A duplication of losses occurs due to the interaction of sections 362 and 358. For example, assume LLC transfers an asset with a basis of $100 and a fair market value of $90 to a corporation (Newco) in a transaction qualifying under section 351. Under section 362(a), Newco s basis in the asset is $100, and under section 358(a), LLC s basis in the Newco stock is also $100. If Newco sells the asset for its $90 fair market value, it realizes a loss of $10. If 221 Prop. Reg (a)(iii), 20 Fed. Reg. 11,903 (Mar. 10, 2005). 222 Id. 223 I.R.C. 362(b) applies to reorganization transactions.

64 654 section OF TAXATION the $90 sale proceeds are distributed to LLC in a liquidation of Newco, LLC also realizes a $10 loss. Thus, the total realized losses are $20. If instead LLC had simply sold the asset for $90, it would have realized a loss of $10. Thus, but for section 362(e), there is a duplication of losses a $10 loss at the corporate level and another $10 loss at the shareholder level. Section 362(e)(1) only applies to property where gain or loss with respect to such property is not subject to tax in the hands of the transferor immediately before the transfer, but is subject to tax in the hands of the corporation immediately after the transfer (section 362(e)(1) property). This provision applies to property imported into the United States. 224 The purpose is to prevent a built-in loss from accruing while the property was not subject to U.S. taxation, thereby reducing any gain from the sale of that property after it becomes subject to U.S. taxation. 225 If section 362(e)(1) applies, it looks at the totality of the section 362(e) (1) property transferred to the corporation. If all of the section 362(e)(1) property, in the aggregate, would have a basis in the hands of the corporation in excess of the aggregate fair market value of that property, then the basis of each item of section 362(e)(1) property is its fair market value Example B-16. Assume LLC, a foreign limited liability company not subject to U.S. taxation, owns the following assets: Basis FMV Asset 1 $ 90 $ 60 Asset $200 $180 LLC transfers these assets to a domestic corporation (Newco) in a transaction qualifying under section 351. Since the aggregate basis $200 is more than the aggregate fair market value $180 Newco s basis in each asset is its fair market value. Thus, Newco s basis in Asset 1 is $60 and the basis in Asset 2 is $120. Because this fair market value basis rule applies to all properties, it applies to Asset 2 even though its basis is less than its fair market value. However, under section 358(a), LLC s basis in the Newco stock is $200 its basis in Assets 1 and 2. Section 362(e)(2) applies where section 362(e)(1) is not applicable. It also applies on an aggregate basis to transactions qualifying under section Under section 362(e)(2), if the aggregate basis of the property transferred to the corporation exceeds the aggregate fair market value of such property, then the aggregate basis in that property is limited to the aggregate fair market 224 I.R.C. 362(e). 225 I.R.C. 362(e)(1). 226 I.R.C. 362(e)(2)(A). 227 I.R.C. 362(e)(2)(A).

65 Cross Species Conversions and Mergers 655 value of the property. 228 If the limitation applies, the aggregate reduction in basis is allocated among the properties with built-in losses in proportion to those built-in losses Example B-17. Assume the same facts as in Example B-16, except that LLC is a domestic limited liability company subject to U.S. taxation. Since the aggregate basis $200 exceeds the aggregate fair market value $180 the basis in Assets 1 and 2, which would otherwise be $200 under section 362(a), is limited to $180. The $20 reduction is allocated to the properties having a built-in loss, in proportion to those built-in losses. Since only Asset 1 has a built-in loss, the entire $20 reduction is allocated to Asset 1, reducing its basis from $90 to $70. The basis in Asset 2 is not affected. Thus, Newco s basis in Asset 1 and 2 is $70 and $110, respectively. As in Example B-16, LLC s basis in the Newco stock it receives is $200, its basis in Assets 1 and 2. If the assets are then sold by Newco for their fair market values, Newco would recognize gains and losses as follows: Asset 1 Asset 2 Sales proceeds $ 60 $120 Basis Gain (loss) ($ 10) $ 10 Disregarding any taxes payable by Newco, if Newco distributes the $180 sale proceeds, LLC realizes a $20 loss. Thus, the net result to Newco and LLC is a $20 loss. This is the same loss LLC would have realized had it sold Assets 1 and 2 for their fair market values, rather than contributing them to Newco. The limitation under section 362(e)(2) will not apply if both the transferor and transferee elect to limit the transferor s basis in the stock it receives to its fair market value Example B-18. Assume the same facts as in Example B-17. If Newco and LLC elect to limit LLC s basis in the Newco stock it receives to $180 the fair market values of Assets 1 and 2, the only assets owned by Newco then Newco s basis in Assets 1 and 2 would be $90 and $110 respectively, LLC s basis in those assets. If the assets are then sold by Newco for their fair market values, Newco would recognize gains and losses as follows: 228 I.R.C. 362(e)(2)(A)(iii). 229 I.R.C. 362(e)(2)(B). 230 I.R.C. 362(e)(2)(C).

66 656 section OF TAXATION Asset 1 Asset 2 Sales proceeds $ 60 $120 Basis Gain (loss) ($ 30) $ 10 Disregarding any taxes payable by Newco, if Newco distributes the $180 sale proceeds, LLC realizes no gain or loss. The net result to Newco and LLC is a $20 loss, the same as in Example B-17. C. Holding Period Issues The holding period for a property is important if the property is a capital asset or an asset described in section 1231(b) (capital section 1231 assets). If a capital 1231 asset is held for more than one year, any gain or loss will be a long-term capital gain or loss. 231 For individuals, estates, and trusts, longterm capital gains are currently taxed at a maximum rate of 15%, 232 while any other gains are currently taxed at a rate as high as 35%. 233 Categorization of a gain or loss as a capital gain or loss is also critical for partnerships and S corporations. Any capital gain or loss recognized by these entities flows through to their owners, retaining their character as a capital gain or loss. If a partner or S corporation shareholder is an individual, estate, or trust, then any longterm capital gain flowing through to such partner or shareholder is currently taxed at a maximum rate of 15%. 234 In general, the holding period for a property begins on the day after the property is acquired. 235 This general rule applies no matter how the property was acquired, including a nontaxable transaction. However, there are a number of special rules providing for either a substituted or inherited holding period. Some of these special rules only apply to capital section 1231 assets, while others apply to all assets. 1. Partners and Partnerships a. Distributions by Partnerships. Section 735(b) provides that a partner s holding period for assets distributed by a partnership includes the period the partnership held those assets. This inherited basis applies on a propertyby-property basis. 236 Further, the character of the asset is not relevant. Thus, this inherited basis rule applies to both capital section 1231 assets and noncapital section 1231 assets. 231 I.R.C. 1231(a)(1). 232 I.R.C. 1(h). 233 I.R.C. 1(i). 234 I.R.C. 1(h). 235 Rev. Rul , C.B I.R.C. 735(c).

67 Cross Species Conversions and Mergers 657 b. Contributions to Partnerships. Under section 1223(1), the holding period for an interest in a partnership received in exchange for capital section 1231 assets transferred to the partnership includes the period those properties were held by the transferor. For a partnership interest received in exchange for any other assets, the holding period begins on the day after those other assets are transferred to the partnership. 237 Where only one property is transferred, the holding period is easily determined. i. Example C-1. A transfers one capital asset to LLC for a 10% interest in LLC. A held the capital asset for three years. A s holding period for the 10% interest in LLC includes the three years A held the capital asset. What if more than one property is transferred to a partnership? Unlike stock in a corporation, where each share is a separate asset and can have a separate basis and holding period, an interest in a partnership has a unified basis. 238 For example, even if a partner owns both a general and limited partnership interest, for basis purposes it has only one unified interest. Notwithstanding this unified basis rule, the Service issued regulations in 2000 which provide for the fragmentation of an interest in a partnership for holding period purposes. 239 Under Regulation section (a), fragmentation is required when a partner acquires different interests at different times, or acquires an interest in a single transaction where there are different holding periods under section In either of these situations: The portion of a partnership interest to which a holding period relates shall be determined by reference to a fraction, the numerator of which is the fair market value of the portion of the partnership interest received in the transaction to which the holding period relates, and the denominator of which is the fair market value of the entire partnership interest (determined immediately after the transaction). 240 Although reference is made to the fair market values of the interest, the examples in the regulation illustrate that these fair market values are based on the fair market values of the properties transferred to the partnership. 241 ii. Example C B contributes the following properties to LLC for a 50% interest in LLC: 237 Rev. Rul , C.B Rev. Rul , C.B Reg (a). 240 Reg (b)(1). 241 Reg (f), Exs Reg (f), Ex. 1.

68 658 section OF TAXATION Basis Fair Market Value Holding Period Noncapital asset $5,000 $5,000 2 years Capital asset 5,000 10,000 2 years B s basis for the entire 50% interest in LLC is $10,000 B s total basis in the properties transferred to LLC. The fair market value of B s 50% interest in LLC is $15,000 presumably the fair market value of the properties transferred to LLC. Based on these fair market values, B received one third of the 50% interest in exchange for the $5,000 noncapital asset, and two-thirds in exchange for the capital asset. Therefore, B s holding period for one third of the 50% interest received in exchange for the noncapital asset begins on the day after the capital contribution, and B s holding period for two thirds of the 50% interest received in exchange for the capital asset includes the two years the capital asset was held by B. iii. Example C-3. Assume the same facts as in Example C-2. Six months after B s capital contribution to LLC, B sells the entire 50% interest for $15,000. Assume LLC has no inventory or unrealized receivables and had no income or loss for the six-month period. B will realize a $5,000 capital gain $15,000 sale proceeds minus $10,000 basis for B s interest in LLC. Since one-third of B s interest in LLC has a six-month holding period the six months B held the interest in LLC one-third of the gain is a short-term capital gain. Since the remaining two-thirds interest has a holding period of two and a half years the two-year inherited holding period plus the six months B held the interest in LLC two-thirds of the gain is a long-term capital gain. Note that although there is a fragmentation of holding periods, there is no fragmentation of basis. The entire 50% interest in LLC has a unified $10,000 basis. Thus, if only half of the 50% interest were sold for $7,500, half of the $10,000 basis would be applied, resulting in a $2,500 capital gain. As in Example C-3, one-third of this gain would be short-term and two-thirds would be long-term. This fragmentation rule also applies where an existing partner makes an additional capital contribution to the partnership. Special rules apply where there are both additional cash contributions to the partnership and cash distributions from the partnership. 243 These rules are beyond the scope of this Article. In the context of the disincorporation transactions considered in this Article, regardless of the method used to convert the corporation to a partnership, there will only be the initial capital contributions to the LLC, either by the corporation in an Assets Over transaction or by the shareholders in an Assets 243 Reg (b)(2).

69 Cross Species Conversions and Mergers 659 Up or Interests Over transaction. Nevertheless, there can be differences in holding periods, depending on the method used. In an Assets Over disincorporation, the corporation transfers all of its assets to the LLC. It is likely that a variety of assets will be transferred to the LLC, so the fragmentation rule will need to be applied to the interests received in the LLC, as in Example C-2. In an Assets Up disincorporation, the corporation liquidates, distributing all of its assets to its shareholders, who then transfer all of those assets to the LLC. Since the liquidation of the corporation is a taxable event, the shareholders holding period for those assets begins on the day after the liquidating distribution. Thus, no fragmentation is required. Although there is a carryover holding period in the capital section 1231 assets contributed to the LLC, fragmentation would assign only a slightly longer holding period to the capital section 1231 assets since this contribution will occur shortly after the corporate liquidation. For example, if the corporate liquidation occurs on July 6, and the assets are contributed to the LLC on July 10, the capital section 1231 assets will have a holding period commencing July 7 the day after the liquidating distribution from the corporation, which holding period carries over to the LLC while all other assets will have a holding period commencing July 11 the day after the contribution of those assets to the LLC. In an Interests Over disincorporation, the shareholders transfer their corporate stock to the LLC. Assuming each shareholder has the same holding period for all of its stock, the fragmentation rule would not apply. Each shareholder s holding period for the interests received in the LLC would include the period it held the corporate stock transferred to the LLC. However, if any shareholder has different holding periods for shares of stock transferred, then the fragmentation rule may be applied. However, if all of the stock has a holding period in excess of one year the current holding period for long-term capital gain treatment then it may not be necessary to fragment the holding periods. Even if the entire interest is assigned a holding period equal to the shortest holding period for the stock transferred, disposition of any part of the interest would yield a long-term capital gain or loss. iv. Example C-4. Assume C and D each own 200 shares of Newco, Inc., constituting all of the issued and outstanding stock of Newco. Assume C acquired 100 shares four years ago and 100 shares six months ago. All 200 shares owned by D were acquired four years ago. In an Interests Over transaction, each of C and D transfer all of their Newco stock to LLC for a 50% interest in LLC. Since D had the same holding period for all of her Newco stock, her holding period for her 50% interest in LLC includes the four years she held the Newco stock. However, since C has a different holding period for some of her Newco stock, fragmenting is necessary. Assuming each Newco share has the same fair market value, since one-half of the Newco shares transferred to LLC had a holding period of four years, one-half of C s interest in LLC will include the four years those Newco shares were held. Since the other half of the Newco shares had a holding period of only six months, the other

70 660 section OF TAXATION half of C s interest in LLC will only include the six months those Newco shares were held. v. Example C-5. Assume the same facts as in Example C-4, except C s holding period for half of the Newco shares is two years, rather than six months. Since all of the shares have been held for more than one year, fragmentation may not be necessary unless the holding period for long-term capital gain treatment increases to more than two years. If not, any sale of all or any portion of C s interest in LLC would qualify for long-term capital gain treatment, since the block of shares with the shortest holding period has been held for more than one year. From the LLC s standpoint, under section 1223(2), its holding period includes the period each asset was held by the person transferring it to the LLC. This rule applies regardless of the nature of the assets transferred. 244 vi. Example C-6. Assume the same facts in Example C-2. Although a portion of B s interest will have a new holding period, LLC s holding period for both assets will include the two years those assets were held by B. 2. Holding Period Rules Applicable to Shareholders a. Distributions by Corporations. As discussed earlier, in any disincorporation transaction, gain or loss is recognized on the liquidation of the corporation. 245 Therefore, each shareholder s holding period for any property received on the liquidation commences the day after the property is received. 246 Nevertheless, depending on the disincorporation transaction, the shareholders holding period for the LLC interests could be different. In an Assets Over transaction, the corporation receives interests in the LLC, the holding period of which was discussed in Part III.C.1.b above. However, when the corporation liquidates and distributes those interests to its shareholders, since the liquidation is a taxable event, the shareholders holding period for the interests in the LLC commence on the day after the liquidating distribution. In an Assets Up transaction, the corporation liquidates, distributing all of its assets to its shareholders. Since this is a taxable event, the holding period for those assets commences the day after the liquidating distribution. As discussed in Part III.C.1.b above, the holding period for the LLC interests includes the period the assets were held, which period commenced the day after the liquidating distribution. In an Interests Over transaction, the shareholders transfer their corporate stock to the LLC for an interest in the LLC. As discussed in Part III.C.1.b above, the shareholder s holding period for the LLC interests received includes the period the stock was held. 244 I.R.C. 1223(2). 245 I.R.C. 336(a). 246 Rev. Rul , C.B. 168.

71 Cross Species Conversions and Mergers 661 b. Transfer of Assets to a Corporation. In a transaction qualifying under section 351, the holding period for stock received in exchange for capital section 1231 assets includes the period the transferor held those assets. 247 The holding period for stock received in exchange for all other assets begins on the day after they were contributed to the corporation. 248 Because each share of stock is a separate asset, each share is assigned a holding period based on the asset exchanged for that share. In an incorporation transaction, a number of assets will be contributed to the corporation. They can be capital section 1231 assets as well as noncapital section 1231 assets. Further, if multiple capital section 1231 assets are transferred, they can have different holding periods, although a section 1231 asset must have been held for more than one year. Where multiple asset are contributed to the corporation, holding periods are assigned based on the fair market value of the asset transferred to the corporation. 249 i. Example C-7. E transfers the following properties to a corporation (Newco) in exchange for 100 shares of Newco stock in a transaction qualifying under section 351: Fair Market Value Holding Period Capital asset $300,000 4 years Other assets 100,000 2 years Since the fair market value of the capital asset is 75% of the total fair market value of all of the assets transferred to Newco, 75% of the Newco stock or 75 shares are received in exchange for the capital asset. Thus, the holding period for 75 shares includes the four years the capital asset was held by E. The holding period for the remaining 25 shares commences the day after the other assets were contributed to Newco. A similar allocation is required where more than one capital section 1231 asset is transferred to the corporation and the holding periods are different. 250 Again, assignment of holding periods is based on the relative fair market values of the capital section 1231 assets transferred. 251 ii. Example C-8. F transfers the following capital assets to a corporation (Newco) in exchange for 150 shares of Newco stock in a transaction qualifying under section 351: 247 I.R.C. 1223(1). 248 Rev. Rul , C.B Rev. Rul , C.B Id. 251 Id.

72 662 section OF TAXATION Fair Market Value Holding Period Capital asset 1 $100,000 4 years Capital asset 2 200,000 6 months Because the fair market value of capital asset 1 is one-third of the total fair market value of all assets transferred to Newco, one-third of the Newco shares or 50 shares have an initial holding period of four years. The remaining 100 shares have an initial holding period of six months. 3. Holding Period Rules Applicable to Corporations a. Distributions by Corporations. The distribution of property by a corporation has no impact on the corporation s holding periods for any assets it retains. In any disincorporation transaction, the corporation eventually liquidates, so no assets are retained. b. Transfer of Assets to a Corporation. Under section 1223(2), regardless of the assets transferred and regardless of the transaction by which LLC s assets are transferred to the corporation, the corporation s holding period for such assets includes the period those assets were held by the LLC. D. Partnership Termination Issues In the case of an Assets Over disincorporation transaction where the shareholders form the partnership with nominal capital contributions, there is a further complication. Under this variation, when the corporation contributes its assets and liabilities to the partnership, it will obtain a significant interest in the partnership clearly more than 50%. When the corporation liquidates and distributes these interests to its shareholders, more than 50% of the interests in capital and profits will be sold or exchanged, so the partnership will terminate under section 708(b)(1)(B). The regulations provide that if a partnership terminates because at least 50% of the interests in capital and profits are sold or exchanged, the following are deemed to occur: 1. The partnership contributes all of its assets and liabilities to a new partnership in exchange for an interest in the new partnership; and 2. Immediately thereafter, the terminated partnership distributes interests in the new partnership to the purchasing partners in this case, the shareholders and the other remaining partners also in this case, the shareholders in proportion to their interest in the terminated partnership, in liquidation of the terminated partnership. 252 An example in the regulations addresses only a few of the tax consequences 252 Reg (b)(4).

73 Cross Species Conversions and Mergers 663 of a termination under section 708(b)(1)(B). 253 Specifically, it states that the tax basis in the terminated partnership s assets in the hands of the new partnership is the same as the basis in the hands of the terminated partnership. Further, each partner s capital account in the new partnership is the same as its capital account in the terminated partnership. Nothing is said about the tax consequences to either the terminated partnership or the partners. However, applying the general principals of Subchapter K of the Code, there should be no change to the tax consequences resulting from this termination. 1. Tax Consequences to Corporation Because the termination occurs after the corporations liquidates and transfers the interests in the partnership to its shareholders, it is not affected by the termination. Thus, its tax consequences to the corporation are as described in Part II.A. 2. Tax Consequences to Partnership Under section 721, no gain or loss is recognized by the old partnership on its receipt of assets and assumption of liabilities from the corporation. 254 Similarly, under section 721, no gain or loss is recognized by the new partnership on the deemed transfer of the old partnership s assets and liabilities to the new partnership. 255 Under section 723, the old partnership s basis in the assets equals their basis in the hands of the corporation, increased by any gain recognized by the corporation. Similarly, under section 723, the new partnership s basis in the assets equals their basis in the hands of the old partnership, which is their basis in the hands of the corporation, increased by any gain recognized by the corporation. Under section 1223(2), the old partnership s holding periods for the assets transferred to it by the corporation includes the periods they were held by the corporation. Similarly, under section 1223(2), the new partnership s holding periods for the assets deemed transferred to it by the old partnership includes the periods they were held by the old partnership, which includes the periods they were held by the corporation. 3. Tax Consequences to Shareholders Under section 331, each shareholder will recognize gain or loss on receipt of the partnership interest on liquidation of the corporation equal to the fair market value of the interest received, minus the basis in the corporation s stock owned by the shareholder. Under section 731, no gain or loss is 253 Id. 254 I.R.C. 721(a). 255 I.R.C. 721(a).

74 664 section OF TAXATION recognized on the receipt of interest in the new partnership on the deemed liquidation of the old partnership. 256 Under section 1012, each shareholder s basis in the partnership interests received on the liquidation of the corporation equals its fair market value. Under section 732(b), each former shareholder s basis in the interests in the new partnership received on the deemed liquidation of the old partnership equals the shareholder s basis in the interest in the old partnership, which is its fair market value at the time of the liquidation of the corporation. Under Revenue Ruling , each shareholder s holding period for its interest in the old partnership received on the liquidation of the corporation commences on the day after the receipt of the interest. 257 Under section 735, each shareholder s holding period for its interest in the new partnership deemed received on the liquidation of the old partnership includes the period in which the interest in the old partnership was held, which commenced the day after the receipt of the interests in the old partnership. 258 Thus, the termination of the partnership under section 708(b)(1)(B) has no effect on the tax consequences of an Assets Over disincorporation transaction where the partnership is organized by the shareholders, rather than the corporation. IV. Conclusion Although many state statutes allow for conversions of one form of business entity into another form by simply filing a document with the appropriate state office or allow for one form of business entity to merge with a different form of business entity the tax consequences of these simple conversions and mergers are not as simple. Converting from a partnership form of business to a corporate form can usually be accomplished on a tax-free basis. Nevertheless, the actual tax consequences will depend on how the conversion occurs. To the contrary, conversion from the corporate form of business to the partnership form will have tax consequences, both to the corporation and to its shareholders. This is true whether the conversion is accomplished under a seamless conversion provision or a cross species merger provision of state law. Therefore, before any such transaction is implemented, consideration of all of the tax consequences is necessary to determine if those consequences warrant the conversion transaction. 256 See I.R.C. 731(a), (b). 257 Rev. Rul , C.B See I.R.C. 735(b) (referring to Code section 1223(4) for determination of holding period).