Taxpayers’ widespread adoption of the limited liability company (LLC) has caused Treasury and the IRS to take a closer look at transactions using it. For example, most states’ enactment of rules allowing for mergers involving LLCs was one reason Treasury issued Regs. Sec. 1.368-2(b), to address statutory mergers involving disregarded entities. Treasury and the Service should consider whether clarification is needed for transfers to a controlled corporation under Sec. 351, as discussed in Rev. Rul. 84-111.
Sec. 351(a) provides for tax-deferred treatment of property transfers to corporations in exchange for stock constituting control of the corporation. If Sec. 351’s requirements are met, the transferors recognize neither gain nor loss on the exchange. The transferee corporation takes a carryover basis in the property received, under Sec. 362. The transferor’s basis in the stock received is the same as its basis for the property transferred, according to Sec. 358; see Sec. 351(h)(2).
Sec. 351(b) requires gain, but not loss, recognition when the transferor receives property other than stock in the controlled corporation. The transferor recognizes gain of the lesser of the gain realized or the fair market value of nonqualifying property received. The character of the gain recognized depends on the character of the property transferred to the corporation; see Rev. Rul. 60-302.
The Code does not define “property” for Sec. 351 purposes, but the courts have broadly interpreted the term. In Hempt Bros., Inc., 354 FSupp 1172 (MD PA 1973), the court held that “the term encompasses whatever may be transferred.” An interest in a partnership or an LLC (taxed as a partnership) transferred to a corporation is also property for Sec. 351 purposes; see Rev. Ruls. 81-38 (transferring less than all interests) and 84-111 (transferring all interests).
Application of Rev. Rul. 84-111
Rev. Rul. 84-111 provides guidance for Sec. 351 transfers of 100% of the interests of a partnership under subchapter K. It offers the following three methods for determining the treatment of the transfers, and holds that the form of the transfer controls the treatment:
1. Assets over: a transfer by a partnership (or an LLC) of assets to the corporation in exchange for consideration, followed by the liquidation of the partnership (or LLC) via the distribution of the consideration.
2. Interests over: a transfer of the partnership (or LLC) interests by the partners (or members) to the corporation in exchange for consideration.
3. Assets up and over: a distribution of all partnership (or LLC) assets to the partners (or members) in liquidation, followed by a contribution of the assets received to the corporation, in exchange for consideration.
Assets over: The specific tax treatment of each transfer differs. With the assets-over form, the transferee corporation takes a basis in the assets received under Sec. 362; the transferor partnership takes a basis in the transferee stock received equal to the basis in the assets transferred, reduced by liabilities, under Sec. 358. On liquidation of the transferor partnership, the partners take a basis in the transferee stock received equal to their bases in their partnership interests, under Sec. 732(b).
Interests over: In the interests-over form, the transferee corporation’s basis in the assets received on the partnership’s termination is determined under Sec. 732(c) and equals the transferors’ bases in their partnership interests transferred, while the transferor partners take a basis in the transferee stock equal to their bases in the partnership interests transferred.
Asstes up and over: In the assets-up-and-over form, the partners take a basis in the assets distributed to them under Sec. 732(b) equal to their respective bases in the partnership; the transferee corporation takes a basis in the assets received under Sec. 362(a) equal to the transferors’ bases in the assets transferred.
An important distinction occurs in the assets-over transfer; the partnership, not each partner, is the transferor. Thus, to the extent gain is recognized under Sec. 351(b) on the receipt of cash or other property, the partnership recognizes the gain; a partner receiving only stock consideration on liquidation could recognize gain on the partnership’s receipt of cash or other property.
Other methods: In addition to the three methods prescribed in Rev. Rul. 84-111, two additional methods could apply to the incorporation of a partnership. The first is a “formless” incorporation, in which the partnership incorporates via a check-the-box election under Regs. Sec. 301.7701-3(g)(1)(i) or a state law formless conversion. This is an assets-over transfer; see Rev. Rul. 2004-59.
The second situation could exist when the transfer occurs via a merger involving the partnership and corporation (or a transitory disregarded entity of the corporation). The IRS and Treasury have yet to provide formal guidance on this issue; in fact, it is unclear whether such a merger even represents a situation separate from the three described in Rev. Rul. 84-111.
Additional Guidance Needed
However, by applying existing partnership rules and rules similar to those in the corporate context, transfers involving partnership mergers should fit within one of the three methods. In the corporate context, a merger’s effect depends on its direction. For example, a forward subsidiary merger, in which the target’s legal existence ceases, represents an asset transfer by the target, followed by its liquidation; see Rev. Rul. 69-6. However, in a reverse subsidiary merger involving a transitory subsidiary formed solely to perform the merger, the application of step-transaction principles casts the merger as the direct transfer of target stock, disregarding the subsidiary’s existence as transitory; see, e.g., Rev. Ruls. 90-95, 67-448, 73-427, 74-564 and 79-273.
Legal existence critical: Recently finalized corporate reorganization regulations support the fact that, despite being disregarded for Federal tax purposes, the legal entity’s existence is important in determining the reorganization’s substance; see Regs. Sec. 1.368-2. For example, according to Regs. Sec. 1.368-2(b)(1)(iii), Example (2), the merger of a target with and into a disregarded entity of a purchaser could qualify as an A reorganization. However, if the target remains in existence as a disregarded entity, a statutory merger has not occurred, because it “continues to exist as a juridical entity,” albeit as a disregarded one; see Regs. Sec. 1.368-2(b)(iii), Example (9).
Rev. Rul. 84-111 can be applied to mergers in the context of the incorporation of a partnership. In the case of both a forward and reverse partnership merger with a disregarded entity of a corporation, the partnership terminates and goes out of existence for Federal tax purposes; see Sec. 708(b)(1)(A). However, Rev. Rul. 84-111 holds that form controls treatment; thus, it is important to determine if the two mergers are distinguishable and how the substance-over-form doctrine applies in the context of that ruling.
A forward merger in which the target partnership’s legal existence ceases likely represents an assets-over transfer in which the partnership transfers assets to the corporation in exchange for consideration, followed by the liquidation of the partnership through distribution of the consideration. The IRS has so ruled in similar situations in which partnerships merged into a corporation or its disregarded entity; see IRS Letter Rulings 9915030 and 9409035.
However, in the case of a reverse merger involving a transitory disregarded entity, the facts are clearly distinguishable from the letter rulings cited; the transfer likely represents an interests-over transfer in which the partners transferred their partnership interests to the corporation in exchange for consideration, even though the partnership terminated under Sec. 708(b)(1)(A). In a similar situation, the Service, citing Rev. Ruls. 73-427 and 79-273, ruled that the transitory existence of a partnership is disregarded in determining that a merger involving a disregarded entity represented an acquisition of the target partnership interests; see Letter Ruling 9148041.
It seems clear that the transitory existence of a disregarded acquisition LLC should be disregarded, and the merger should represent the direct transfer of the LLC interests. This view is further supported by regulations, case law and formal IRS guidance. Regs. Sec. 1.741-1(b) states that the sale of all partnership interests to one or more parties outside the partnership, is a sale of partnership interests, not partnership assets. In addition, McCauslen, 45 TC 588 (1966), held that the acquisition by one partner of another partner’s interest represented a sale of the partner’s interest, despite the fact that the partnership terminated as a result of the acquisition.
McCauslen: The primary issue addressed in McCauslen was the treatment of the acquirer of the partnership interest, because the acquisition resulted in the partnership’s termination as a result of the acquirer becoming the sole owner. The court acknowledged that the tax ramifications of a transaction may differ, greatly depending on its form. Because the acquisition of the interest resulted in the partnership’s termination under Sec. 708(b)(1)(A), it was an acquisition of the underlying assets, not the partnership interests. The seller’s treatment was not an issue; however, the court’s analysis confirmed that Sec. 741 applied to the selling partner’s sale of the interest.
Partnership mergers: The partnership merger regulations under Sec. 708 provide a useful analysis of the importance of form within partnership mergers as well. Under Regs. Sec. 1.708-1(c)(4), if a partner sells an interest in a merging partnership via the assets-over form, the sale of the interest is respected if the partner and partnership consent to treat it as the sale of an interest. While the regulation applies to partnership mergers in which the partnership survives, it clearly shows the importance of and respect for the intended tax consequences to the parties, and adopts the availability of the interests-over method of Rev. Rul. 84-111.
LLCs: As to the acquisition of target LLC interests in which the target LLC remains in existence, the Service has held that the sale of LLC interests by the members to an outside party represents the sale of those interests under Sec. 741; see Rev. Rul. 99-6, which cites Rev. Rul. 84-111, situation 3 (interests over), in determining the appropriate treatment. Thus, if the reverse merger represents the acquisition of LLC interests, it should be an interests-over transfer under Rev. Rul. 84-111. Neither Rev. Rul. 99-6 nor 84-111 addresses the method of acquisition of the entity interest; thus, there seems to be no reason that a reverse merger, in which the transitory existence of the acquisition entity is disregarded under appropriate step-transaction principles, should not qualify as a direct acquisition of the interests in a target LLC.
Existing authority appears to support strongly the position that an (otherwise qualifying) transfer, accomplished by reverse merger of an LLC with a transitory disregarded entity of a corporation with the LLC surviving, represents an interests-over transfer. However, Treasury and the IRS should consider updating formal guidance to bring the analysis of Rev. Rul. 84-111 up-to-date with today’s business realities.