Letter Ruling 201127004 reinforces the flexibility granted to taxpayers wishing to move assets around a qualified group without triggering gains or meeting the stringent qualifications of Sec. 355. The ruling addressed an intragroup restructuring using the conversion of a corporate subsidiary into a single-member limited liability company (SMLLC) that existed only momentarily as a disregarded entity prior to conversion back to corporate status. Similar in fact and result to Letter Ruling 200952032, the ruling also dealt with conversions into and out of disregarded entity status. In addition, while both of these rulings addressed domestic entities, international restructuring opportunities abound when using this transaction alternative.
The Rulings’ Facts
Letter Ruling 201127004: Parent (P) was the common parent of an affiliated group of corporations filing a consolidated U.S. federal income tax return that owned a first-tier subsidiary (Sub). Sub conducted business A and business B operations through its direct and indirect subsidiaries. Sub’s business A operations were conducted through a limited liability company (LLC1) classified as a partnership for U.S. federal income tax purposes. The ruling involved the following steps:
Sub converted into an SMLLC dis-regarded as a separate entity for U.S. federal income tax purposes;
The SMLLC assigned the LLC1 interests to P;
The SMLLC converted into a corporation (NewSub) under applicable state law.
The IRS ruled that the steps represented an upstream Sec. 368(a)(1)(C) reorganization followed by a Sec. 368(a)(2)(C) drop by P of Sub’s assets, other than the LLC1 interests, into the newly incorporated entity under Sec. 351. The ruling did not disclose what percentage LLC1 represented of Sub’s total assets prior to the transaction.
Letter Ruling 200952032: Under the fact pattern of this letter, somewhat simplified, Parent (P) wholly owns Subsidiary (Q) and Subsidiary 1 (Q1) and is the parent in the P-Q-Q1 group. Q operates business A, while Q and Q1 jointly operate business B. P apparently wanted Q1 to operate business B on its own. To accomplish the transfer by Q of business B’s assets to Q1, the following steps occurred:
Q merged with and into LLC, an entity wholly owned by P and disregarded from P for federal tax purposes;
LLC distributed business B’s assets to P;
P transferred business B’s assets to Q1; and
LLC elected to be treated as an entity taxable as a corporation. The ruling did not specify the percentage that business B’s assets represented of the total Q assets prior to the restructuring.
As with the more recent ruling, the IRS ruled the steps represented an upstream Sec. 368(a)(1)(C) reorganization followed by Sec. 368(a)(2)(C) asset drops under Sec. 351.
While the conversion of a subsidiary into a disregarded entity generally represents a liquidation for federal income tax purposes, the rulings implicitly indicated that these conversions did not represent Sec. 332 liquidations because of the subsequent downstream transfers (see Rev. Rul. 69-617). Integral to the rulings was the Regs. Sec. 1.368-2(k)(1) prohibition on recharacterization of a Sec. 368(a) transaction as a result of a subsequent downstream transfer within the qualified group as defined by Regs. Sec. 1.368-1(d)(4)(ii). Because of this prohibition, the IRS looked at whether the first step would qualify as a reorganization under Sec. 368(a). If so, subsequent transfers would not cause the first step to fail. Put another way, application of the step-transaction doctrine to certain qualifying asset or stock push-downs (or push-ups) is prohibited from recharacterizing an otherwise qualifying reorganization.
Notwithstanding Rev. Rul. 69-617, issues on potential upstream reorganizations have plagued taxpayers and their advisers for many years. In the revenue ruling, the subsidiary had minority shareholders (i.e., it was not wholly owned by a corporate parent). Thus, the question was whether that revenue ruling applied in the absence of a minority shareholder group. Formerly, the so-called Bausch & Lomb doctrine ( Bausch & Lomb Optical Co ., 267 F.2d 75 (2d Cir. 1959), cert . denied, 361 U.S. 835 (1959)) prevented upstream asset transfers from a subsidiary to its parent not done via a statutory merger from qualifying under Sec. 368. The IRS, however, rescinded the Bausch & Lomb doctrine with the publication of Regs. Sec. 1.368-2(d)(4). This regulation, together with the more recently published Regs. Sec. 1.368-2(k), paved the way for the results announced in these two letter rulings.
In addition, the letter rulings are significant because in them the IRS confirmed its ruling policy that Regs. Sec. 1.368-2(k) overrides the liquidation-reincorporation doctrine where less than all of the assets are immediately reincorporated into a single corporate entity. Also noteworthy is that the IRS respected the timing of the steps that resulted in the momentary disregarded entity status of the LLC and subsequent election to treat the LLC as a corporation for federal income tax purposes. These “first reorganization wins” rulings also help to distinguish these transactions from others that the step-transaction doctrine recasts because of subsequent steps that eliminate a recently acquired target corporation (see Rev. Ruls. 2001-46 and 2008-25).
Sec. 355 Alternative
If judicial and statutory requirements are met, Sec. 355 allows a single corporate enterprise to separate into two or more active businesses that remain under the same ownership. A Sec. 355 transaction is tax deferred to the distributing corporation and its shareholders. Nevertheless, due to complex statutory provisions and restrictions, taxpayers often find it difficult to structure a valid Sec. 355 transaction.
While it is unclear from the facts in the letter rulings, the taxpayers seeking these rulings might not have been able to satisfy the requirements of Sec. 355. However, the transaction steps clearly allowed the economic equivalent of a spinoff without having to meet those requirements. In Letter Ruling 200952032, the taxpayer accomplished the equivalent of a spinoff of the business B assets followed by a merger with and into Q1 . From a tax perspective, a Sec. 355 transaction differs in at least two ways from an upstream Sec. 368(a) reorganization followed by a Sec. 368(a)(2)(C) drop. First, the stock basis of the surviving entities differs. The subsidiary stock basis in Q (and any premium paid for the stock) disappears when Q converts or merges into an SMLLC. The second difference is the location of tax attributes. The tax attributes of Q (e.g., earnings and profits (E&P) and net operating losses (NOLs)) transfer to P rather than remaining at Q or moving with the spun-off entity. Whether these consequences are significant to a particular taxpayer requires a case-by-case determination.
Avoiding Intercompany Gains
As another alternative to a Sec. 355 transaction, a taxpayer could distribute the assets or sell the assets “across the chain” to another subsidiary. However, if the entities are not part of a consolidated group (e.g., a group of foreign corporations), cross-chain sales or distributions are likely not a viable alternative. In the consolidated return context, this could be a viable alternative if the taxpayer is assured that any deferred gains will not be triggered prior to disposition of the assets. However, such assurance is not easily attained, as internal restructurings like those discussed in the letter rulings may occur as part of a larger group restructuring. An initial public offering (IPO) represents one such example.
IPO example: Under the facts of Letter Ruling 200952032, assume the restructuring was a step toward an IPO of business B, now held solely by Q1. It is expected that the IPO will result in the issuance of shares representing approximately 30% of the post-IPO value, with P owning the remainder. The IPO would appear to compromise the reorganization. However, assume Q1 performed a recapitalization with the IPO, resulting in P’s receiving high-vote stock that allows P to retain Sec. 368(c) control (80% of the voting power and no nonvoting stock) along with 70% of the value. In this case, the IPO would not cause Q1 to leave the group qualified under the continuity-of-business-enterprise (COBE) requirements, and the transfer of assets to Q1 would continue to satisfy Sec. 368(a)(2)(C) and Regs. Sec. 1.368-2(k). However, Q1 would no longer meet the Sec. 1504(a)(2) ownership requirement for an affiliated group. As a result, if the business B assets had been sold or otherwise transferred to Q1 in a transaction creating deferred intercompany gains, the IPO would have accelerated the gains.
The combination of Regs. Sec. 1.368-2(k) with the entity classification rules provides a great deal of flexibility to taxpayers. The recent letter rulings exemplify this flexibility and signal the IRS’s apparent intention to strictly interpret the Regs. Sec. 1.368-2(k) prohibition against application of the step-transaction doctrine to post-reorganization asset transfers within the qualified group. If applied consistently by the IRS, the technical underpinnings of these rulings should provide taxpayers with some level of comfort that, with appropriate planning, they can move assets around the group in the form and direction of their choosing, with the expected tax results following the chosen form. Further, as with so many areas of tax law, the use of SMLLCs and other entities eligible to be disregarded or regarded as corporations greatly enhances the ability to plan the intended consequences. Prior to a restructuring, taxpayers and advisers considering a similar reorganization should carefully consider questions including:
- Does a subsidiary have an advantageous tax basis that should be retained (e.g., the subsidiary was acquired in a taxable stock acquisition at a premium)?
- Does the subsidiary have appreciated assets that will be transferred to other subsidiaries?
- Does the subsidiary have an excess loss account (negative basis) that needs to be eliminated?
- Where should tax attributes, such as NOLs and E&P, reside within the group following the restructuring?
- Does a subsidiary have NOLs or other attributes that may expire and result in unintended basis decreases?
Mindy Tyson Cozewith is a director, Washington National Tax in Atlanta, and Sean Fox is a director, Washington National Tax in Washington, DC, for McGladrey & Pullen LLP.
For additional information about these items, contact Ms. Cozewith at (404) 751-9089 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with McGladrey & Pullen LLP.