LLC mergers

Sec. 708 governs the federal income tax treatment of the merger of two or more partnerships (including limited liability companies (LLCs) classified as partnerships). A merger of a partnership into a newly formed LLC is one method of converting an existing business from a partnership to an LLC. When discussing LLC mergers in this column, the resulting entity, for legal purposes, is assumed to be an LLC.

Note: The preamble to the proposed regulations addressing series LLCs indicates that a series of an LLC cannot merge with another entity (REG-119921-09).

Note: In Field Service Advisory 199952016, the IRS clarified that the substantive consolidation of a group of related partnerships in a bankruptcy proceeding did not result in a merger.

Mergers governed by state law

Although Sec. 708 governs the tax treatment of LLC mergers, from a legal standpoint, LLC mergers must be completed in accordance with state law. Generally, each state specifies within its statutes (1) which entities may be merged; (2) the approval procedures for such mergers; and (3) the state filing requirements necessary to consummate the transaction. Practitioners should note that although a state’s LLC statute may allow the merger of an LLC with a corporation, such a merger is not necessarily a tax-free merger under the provisions of Sec. 368(b). However, a merger of a target corporation into a disregarded entity may qualify as a tax-free statutory merger under Sec. 368(a)(1)(A) (see Regs. Sec. 1.368-2(b)(1)(iii), Example (2)).

If a merger involves LLCs (or other entities) organized in different jurisdictions, the transaction will be subject to the laws of each jurisdiction of organization. If an LLC is registered to do business in several states, a merger may require it to comply with filing requirements in each state in which it is registered to do business. To ensure compliance with state requirements, the practitioner should consult the statute under which the LLC is organized as well as the statutes in those states in which it is registered to transact business.

Determining the continuing entity for tax purposes

Sec. 708 provides that for federal income tax purposes, the LLC resulting from a merger is deemed to be a continuation of the premerger LLC or partnership whose members or partners own more than 50% of the interests in the capital and profits of the post-merger LLC (Sec. 708(b)(2)(A)). All other premerger LLCs or partnerships are considered terminated on the date of the merger. The tax years of the terminating LLCs close, and they file their returns for a tax year ending on the date of the merger or consolidation.

The post-merger LLC retains the federal tax identification number, accounting methods, and elections of the continuing LLC or partnership. The post-merger LLC continues the tax year of the continuing LLC and files a return for that year stating that the resulting LLC is a continuation of the premerger LLC (Regs. Sec. 1.708-1(c)(2)). The return should include the names and addresses of all the merged entities. The respective distributive shares of the members for the periods prior to and including the date of the merger or consolidation and subsequent to the date of merger or consolidation should also be shown as part of the return.

If no members or partners of a premerger LLC or partnership hold more than 50% of the interests in the post-merger LLC, all premerger LLCs and partnerships are considered terminated for federal income tax purposes, and the post-merger LLC or partnership is a new entity.

Example 1. Determining the continuing LLC in an LLC merger: AB LLC and CD LLC have decided to merge to form the ABCD LLC. AB and CD are classified as partnerships for federal taxes. The members’ ownership interests in the capital and profits of the two existing LLCs and the merged LLC are shown in the table “Ownership Interests in Example 1” (below).

The post-merger LLC will be considered a continuation of CD, since C and D own more than 50% of the interests in ABCD. AB is terminated as of the merger date.

Example 2. Analyzing a merger when all merging LLCs terminate: Three law firms operating as professional LLCs (PLLCs) decide to merge and form T PLLC. The members hold capital and profits interests in the merging PLLCs and T as shown in the table “Capital and Profits Interests in Example 2” (below).

Since the members in none of the three PLLCs collectively own an interest of more than 50% in T, all three of the merging PLLCs terminate on the merger date. T is a new LLC for tax purposes.

The regulations provide a tiebreaker where cross or multiple ownership of merging LLCs and/or partnerships results in the members or partners of more than one LLC and/or partnership owning greater than 50% of the post-merger LLC. In this situation, the LLC or partnership credited with contributing the greatest dollar value of assets to the resulting LLC will be the continuing entity, with all other entities considered terminated as of the merger date (Regs. Sec. 1.708-1(c)(1)). This dollar value amount is determined net of any transferred liabilities (Regs. Sec. 1.708-1(c)(1)).

Deemed sequence of events

The form of an LLC merger will be respected if it is either an assets-over transaction or an assets-up transaction (Regs. Sec. 1.708-1(c)(3)). An assets-over transaction is one in which the terminating LLCs transfer their assets to the continuing LLC and then distribute interests in the continuing LLC to their members. An assets-up transaction is one in which the terminating LLCs distribute their assets to the members, who then contribute the assets to the continuing LLC. If either of these forms is used, the form of the transaction will determine the tax consequences of the merger.

In determining whether an assets-up or assets-over transaction is preferable, practitioners should consider any potential tax gain recognizable under each option, any title issues that may arise if real property is transferred to members (particularly environmental issues), and the rights of spouses or other third parties in the interest or property if distributed.

Note: Under Sec. 743, the basis of LLC assets is potentially adjusted when an LLC interest is exchanged if the LLC has a Sec. 754 election in effect. An exchange also triggers a mandatory adjustment to the basis of LLC assets if the LLC has a substantial built-in loss. IRS attorneys have concluded that the deemed distribution of interests in the continuing LLC in a assets-over merger is treated as an exchange for these rules under Sec. 761(e) (Technical Advice Memorandum 201929019).

If an LLC merger does not follow the assets-over or assets-up form, the form of the transaction will be deemed to follow one of these two forms. A merger is deemed to be an assets-over transaction if the merger occurs under applicable state law and does not follow a form that is either an assets-up or assets-over transaction. For example, a merger is an assets-over transaction if (1) the members transfer interests in the terminating LLC to the continuing LLC and the terminating LLC liquidates (Regs. Sec. 1.708-1(c)(5), Example (4)); or (2) the merger occurs under a state law that does not require a form to be implemented (for example, a merger by certificate) (Regs. Sec. 1.708-1(c)(3)(i)).

If, as part of the merger, the LLC transfers its assets to its members in a manner that causes the members to be treated, under the laws of the applicable jurisdiction, as the owners of the assets, the merger is considered to be an assets-up transaction (Regs. Sec. 1.708-1(c)(3)(ii)). However, the regulations also provide that if the merger is part of a larger series of transactions that, in substance, is not consistent with the form used for the merger transaction, the IRS does not have to respect the form of the transaction and may recast it in accordance with the substance of the larger series of transactions (Regs. Sec. 1.708-1(c)(6)).

An LLC can use the assets-up form regardless of whether the members would otherwise hold certain assets, such as an undivided interest in goodwill, outside the LLC (Regs. Sec. 1.708-1(c)(5), Example (3)). The preamble to the regulations also provides that an LLC using the assets-up form must actually undertake the steps necessary under applicable state law to convey ownership of the assets distributed to the members. However, it should not be necessary for the members to actually assume the liabilities of the LLC to comply with the assets-up form.

An LLC merger or consolidation cannot be bifurcated to treat the transfer of some of the assets as an assets-up transaction and the transfer of others as an assets-over transaction. However, the preamble to the final regulations provides that where more than two LLCs are combined, each combination will be viewed as a separate merger so that the characterization of a merger of one LLC into the resulting LLC under the assets-over form will not prevent a simultaneous merger of another LLC into the same resulting LLC from being characterized under the assets-up form.

The regulations also address the problems created when a highly leveraged LLC (the terminating LLC) merges with another LLC in an assets-over transaction, causing the members in the terminating LLC to recognize gain because of a shift in the allocation of LLC liabilities under Sec. 752. To minimize these problems, when two or more LLCs merge using an assets-over form, increases and decreases in LLC liabilities associated with the merger are netted by the members in the terminating LLC to determine if gain or loss is recognized under the Sec. 752 rules (Regs. Sec. 1.752-1(f)).

Another problem is the situation where a member in a terminating LLC is bought out as part of an assets-over merger transaction. If the merger agreement (or another document) states the continuing LLC is purchasing the exiting member’s interest in the terminating LLC and the amount paid for the interest, and the selling member in the terminated LLC (either prior to or contemporaneous with the transaction) consents to sale treatment, the transaction is treated as a sale of the exiting member’s interest to the continuing LLC (Regs. Sec. 1.708-1(c)(4)). If the appropriate language is included in the merger agreement, this treatment applies even if the continuing LLC sends the payment for the member’s interest to the terminating LLC on behalf of the exiting member.

Cross-species mergers

Many state statutes provide for mergers between entities classified as partnerships and other types of business entities, such as C corporations and S corporations. To date, there is no definitive IRS position concerning how these types of mergers are taxed. Under the entity-classification regulations, elective conversions from partnership status to corporate status are treated as assets-over transactions. It is likely that this treatment will also be applied to mergers of partnership/LLC entities into corporations. When a corporation merges into a partnership/LLC entity, the outcome is even more murky. The IRS has treated such mergers as both assets-up (IRS Letter Rulings 9701032 and 7802043) and assets-over (IRS Letter Rulings 200310026, 200214016, 9701029, and 9543017) transactions. This seems to indicate that the IRS may respect the actual form that the merger takes in determining its tax consequences. See also IRS Letter Ruling 200633008, where an LLC merger was treated as part of a type F reorganization. Practitioners considering structuring a cross-species merger should consider obtaining a letter ruling if the dollars involved are significant.

This case study has been adapted from PPC’s Guide to Limited Liability Companies, 25th edition (October 2019), by Michael E. Mares, Sara S. McMurrian, Stephen E. Pascarella II, and Gregory A. Porcaro. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).