IRS rules that conversion of LLC not a debt modification

Editor: Greg A. Fairbanks, J.D., LL.M.

On Sept. 15, 2023, the IRS released Letter Ruling 202337007 (the 2023 letter ruling), which addressed whether the conversion of a limited liability company (LLC) to a corporation under state law is a modification of debt issued by the LLC pursuant to Regs. Sec. 1.1001-3. This item discusses the relevant authorities in this area and the sometimes inconsistent approach the IRS has taken in past rulings on similar transactions. Although the 2023 letter ruling is not precedential and can be formally relied on only by the taxpayer it was issued to, its conclusion provides a valuable look into the Service’s current thinking.

Modifications of debt instruments

If a debt instrument is found to have a significant modification, Regs. Sec. 1.1001-3(b) provides that there is a deemed exchange of a new debt for an old debt, which can result in taxable gain or loss to the holder of the debt instrument and cancellation-of-debt income or repurchase premium to the issuer of the debt instrument.

Generally, Regs. Sec. 1.1001-3 provides a two-step approach to analyzing changes to the terms of a debt instrument. First, taxpayers must determine whether a change constitutes a “modification” of the debt within the meaning of Regs. Sec. 1.1001-3(c). If the change constitutes a modification, taxpayers must then determine whether such a modification rises to the level of a “significant modification” within the meaning of Regs. Sec. 1.1001-3(e).

Under Regs. Sec. 1.1001-3(c), a modification is defined as any alteration, including any addition or deletion, in whole or in part, of a legal right or obligation of the issuer or holder of a debt instrument. The alteration can be evidenced by an express agreement (oral or written), simply by the conduct of the parties, or otherwise. The regulations further provide that alterations of a legal right or obligation that occurs by operation of the terms of the debt instrument are generally not considered a modification (Regs. Sec. 1.1001-3(c)(1)(ii)).

Under Regs. Sec. 1.1001-3(c)(2), certain changes nonetheless constitute modifications of debt even if they occur by operation of the terms of a debt instrument. These are (1) changes to the obligor of a debt instrument, (2) changes to the recourse or nonrecourse nature of a debt instrument, (3) a change that converts the instrument into property that is not debt, and (4) changes resulting from the exercise of certain options.

A modification is significant if, based on all the facts and circumstances, the legal rights or obligations that are altered and the degree to which they are altered are economically significant (Regs. Sec. 1.1001-3(e)(1)). In addition to this general facts-and-circumstances test, specific rules apply to certain types of alterations. While a full discussion of these rules is outside the scope of this item, two of them are relevant to the discussion.

First, Regs. Sec. 1.1001-3(e)(4) provides that a substitution of a new obligor on recourse debt instruments is generally a significant modification. For certain types of transactions (such as Sec. 381(a) transactions and asset acquisitions in which the new obligor acquires substantially all of the assets of the old obligor), the substitution of a new obligor is a significant modification only if the transaction results in a change in payment expectations or the alteration is a “significant alteration” (i.e., an alteration that would be a significant modification but for the fact that the alteration occurs by operation of the terms of the instrument).

Second, Regs. Sec. 1.1001-3(e)(5) provides that changes in the recourse nature of a debt instrument (i.e., a change from recourse to nonrecourse or vice versa) is a significant modification.

Past IRS guidance

The IRS ruled in Letter Ruling 200315001 (the 2003 letter ruling) that the conversion of a corporation to an LLC was not a modification of the corporation’s outstanding debt. In the 2003 letter ruling, a corporation, Parent, was the issuer of recourse debt. A subsidiary of another corporation, New Parent, merged with and into Parent, with Parent surviving as a wholly owned subsidiary of New Parent. Parent then converted into an LLC and became a disregarded entity of New Parent in a transaction intended to be a reorganization pursuant to Sec. 368(a). The reorganization transaction proceeded without the consent of the debt holders and did not change their rights or obligations with respect to the debt.

The IRS concluded that the change of the obligor from a corporation to an LLC was not a modification under Regs. Sec. 1.1001-3(c) because the rights and obligations of both the issuer and holders had not changed under the relevant state law. This ruling also held that the relevant state law was a controlling factor because “generally, the federal tax law looks to State law to determine legal entitlements in property.”

The IRS ruled in Letter Ruling 200630002 (the 2006 letter ruling) for a taxpayer with nearly identical facts to those of the 2003 letter ruling but came to a different conclusion regarding whether the debt was modified. Similar to the 2003 letter ruling, the 2006 letter ruling involved a corporation that was the issuer of recourse debt and converted to an LLC that was a disregarded entity. The transaction was intended to be a reorganization, specifically, one defined in Sec. 368(a)(1)(F).

While the 2003 letter ruling concluded that the transaction did not result in a modification of the debt, the 2006 letter ruling did not conclude that the debt was not modified. Instead, the IRS concluded only that the transaction did not result in a “significant modification” within the meaning of Regs. Sec. 1.1001-3(e). In other words, the IRS did not rule on the first step of the Regs. Sec. 1.1001-3 regime (whether there was a modification), but ruled on Step 2 of the regime (whether there was a significant modification) to conclude that there was no deemed exchange under Sec. 1001. (The IRS subsequently concluded that similar transactions did not constitute significant modifications of debt, in Letter Rulings 200709013 and 201010015.)

Finally, the IRS concluded in Advice Memorandum 2011-003 (the 2011 AM) that a check-the-box election of a corporation resulted in a modification that was not a significant modification. In the 2011 AM, an insolvent foreign corporation, Z, was owned by a U.S. corporation, X, and Y, a foreign corporation wholly owned by X. Z made a check-the-box election to be classified as a partnership. Under the check-the-box rules, Z was deemed to distribute all its assets to its shareholders, and the shareholders were then deemed to contribute the assets and liabilities of Z to a new partnership.

Although the election did not affect the rights and obligations of the entity’s creditors under local law, the IRS affirmatively concluded that Z’s change in tax classification from corporation to partnership was a modification. However, the IRS ruled that, under Regs. Sec. 1.1001-3(e)(4)(i)(C), the substitution of a new obligor was not a significant modification because the new partnership acquired substantially all the assets of the old obligor (the corporation).

The 2023 letter ruling

With this background in mind, let us turn to the 2023 letter ruling. The parent of a consolidated group owned a corporation, Subsidiary 1, which was a member of the parent’s consolidated group. Subsidiary 1 owned an interest in a partnership, LLC 4 (the remaining interests in LLC 4 were owned by an unrelated third party, LLC 4 Investor). LLC 4 owned an interest in another partnership, LLC 3 (the remaining interests in LLC 3 were owned by an unrelated third party, LLC 3 Investor). LLC 3 directly wholly owned LLC 2, which was disregarded as a separate entity for federal income tax purposes (a disregarded entity). LLC 2 directly wholly owned LLC 1, which was also a disregarded entity.

LLC 1 had outstanding publicly traded senior secured notes, three tranches of term loans (Term Loan A, Term Loan B, and Term Loan C), and unsecured notes owed to third-party lenders (collectively, the LLC 1 Debt). The LLC 1 Debt was recourse to LLC 1. The senior secured notes, Term Loan A, Term Loan B, and Term Loan C, were guaranteed by LLC 2 and by the domestic subsidiaries of LLC 1 and secured by all the assets owned by LLC 1 and the guarantors. Parent, Subsidiary 1, LLC 3, and LLC 4 were not obligors or guarantors and had not pledged any assets as collateral for the LLC 1 Debt.

The parent group proposed the following three-step transaction:

1. LLC 3 will redeem all its interests owned by LLC 3 Investor for cash, and LLC 3 would become a disregarded entity owned by LLC 4 as a result.
2. LLC 4 will redeem all its interests owned by LLC 4 Investor for cash, and LLC 4 would become a disregarded entity owned by Subsidiary 1.
3. LLC 1 will convert to a corporation (Subsidiary 2) under applicable state law, and Subsidiary 2 will become a member of the parent consolidated group as a result.

Immediately after the proposed transaction, the assets and liabilities of Subsidiary 2 will be the same as the assets and liabilities of LLC 1 immediately prior to the proposed transaction.

Under the applicable state law, Subsidiary 2 was the same legal entity as LLC 1, notwithstanding that it was a new corporation for federal income tax purposes. None of the debt holders’ rights against LLC 1 would be altered by the proposed transaction, and the debt holders would continue to have exactly the same legal relationship with Subsidiary 2 as they had with LLC 1.

The IRS noted that (1) the creditors’ legal rights against Subsidiary 2 with respect to payments and remedies on the LLC 1 Debt would be the same legal rights that the creditors had against LLC 1 prior to the transaction, and (2) the obligations and covenants from Subsidiary 2 to creditors of the LLC 1 Debt would be the same as the obligations and covenants from LLC 1 to the creditors. Because these state-law rights and obligations remained unchanged, the IRS ruled that the transaction did not result in a change of obligor or a change in the recourse nature of the LLC 1 Debt for purposes of Regs. Sec. 1.1001-3(c)(2)(i). Thus, the Service concluded that the proposed transaction would not cause a modification of the debt.

Commentary

Because of the inconsistent conclusions between the 2003 letter ruling and later guidance (including the 2006 letter ruling and 2011 AM) regarding the existence of a debt modification, there has been uncertainty about the IRS’s approach to applying the debt modification regulations to certain transactions. Specifically, there is ambiguity about whether a debt modification exists when the legal relationship between an issuer and a lender remains unchanged but the transaction causes changes in the tax classification of an issuer (such as a transaction in which a disregarded entity becomes a regarded entity or a corporation becomes a partnership).

Although the 2023 letter ruling is not precedential and can be formally relied on only by the taxpayer it was issued to, it suggests that the current IRS view may be more in line with the 2003 letter ruling and that it has moved away from the views taken in the 2006 letter ruling and 2011 AM. In other words, when the rights and obligations of the issuer and lender remain unchanged under state law, the IRS appears willing to conclude that there has not been a modification, truncating the Regs. Sec. 1.1001-3 analysis at the first step (whether there was a modification) and eliminating the need to analyze the second step (whether there was a significant modification). Although the IRS ended up concluding that there was no significant modification and therefore no deemed taxable transaction with respect to the debt in the 2006 letter ruling and 2011 AM, in doing so, it relied on exceptions to the general rule that might not be available to all issuers that have a change of their tax classification.

The 2023—2024 Priority Guidance Plan, which outlines the projects that Treasury and the IRS view as priorities through June 30, 2024, includes regulations under Sec. 1001 on the modification of debt instruments, including issues relating to disregarded entities. Taxpayers hoping for certainty may want to seek a private letter ruling before these regulations are issued. However, the 2023 letter ruling suggests that the IRS may be considering an analytical approach that treats a change to the tax classification of an issuer that does not affect state law rights as not being modifications. The Service may do so without requiring further analysis of whether there is a significant modification, which may be welcome news to taxpayers undertaking similar transactions.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C. For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com. Contributors are members of or associated with Grant Thornton LLP.