United States: Use of Limited Liability Companies in Corporate Transactions

Last Updated: June 21 2004

Originally published July 2003

By Mark J. Silverman and Lisa M. Zarlenga

TABLE OF CONTENTS

I. INTRODUCTION

A. Check-the-Box Regulations

1. In General
2. Election
3. Waiting Period

B. Amendments to the Check-the-Box Regulations – Effect of Change of Classification

1. In General
2. Timing
3. Tax Consequences
4. Waiting Period

C. Proposed Regulations Regarding Mergers Involving Single-Member LLCs

D. Final Regulations Regarding Section 332 Plan of Liquidation

E. Temporary Regulations Limiting Disregarded Entities in Certain Circumstances

F. Proposed Regulations Regarding Elections by Foreign Entities

II WHAT IS A DISREGARDED ENTITY?

A. In General

B. Determination of Single Owner

C. Assessment and Collection Issues

1. Liability for Tax
a. Classified as Corporation
b. Classified as Partnership
c. Classified as Disregarded Entity
2. Collection of Tax

D. Examples

1. Transactions Between Disregarded Entities and Their Owners
a. Example 1 – Contribution to Disregarded Entity
b. Example 2 – Distribution From Disregarded Entity
c. Example 3 – Transactions Between Commonly Owned Disregarded Entities
2. Corporate Structures Involving Disregarded Entities
a. Example 4 – Multiple Disregarded Entities
b. Example 5 – Preservation of S Corporation Status

III. TREATMENT OF CLASSIFICATION CHANGES

A. Treatment of Elective Classification Changes

1. In General
2. An Association Elects to be Classified as a Partnership
a. Deemed Transactions
b. Tax Consequences
3. A Partnership Elects to be Taxed as an Association
a. Deemed Transactions
b. Tax Consequences
4. An Association Elects to be a Disregarded Entity
a. Deemed Transactions
b. Tax Consequences
5. A Disregarded Entity Elects to be Classified as an Association
a. Deemed Transactions
b. Tax Consequences
6. Legal Effect of Deemed Transactions

B. Treatment of Automatic Classification Changes

1. Partnership to a Disregarded Entity – Rev. Rul. 99-6
2. Disregarded Entity to a Partnership – Rev. Rul. 99-5
3. Overlap between Automatic and Elective Classification Changes

C. Treatment of Actual Conversions of An Existing Entity Into An LLC

1. Converting Existing Corporations Into LLCs
a. Example 6 - Liquidation of Corporation Followed by Contribution of Assets to LLC Classified as Either a Partnership or a Disregarded Entity
b. Example 7 - Corporate Contribution of Assets to an LLC Classified as Either a Partnership or a Disregarded Entity Followed by Corporate Liquidation
c. Example 8 - Formation of LLC by the Corporation and its Shareholders Followed by Liquidation of Corporation
d. Example 9 - Merger of Corporation Into Multi-Member LLC
e. Summary of Tax Consequence Differences
f. Example 10 - Merger of Corporation Into Single-Member LLC
g. Example 11 – Merger of Wholly Owned Subsidiary Into Single-Member LLC
h. Solvency of Liquidating Corporation
2. Converting Existing Partnerships Into LLCs Classified as Partnerships
a. In General
b. Example 12 – Partnership-to-LLC Conversion

IV. TREATMENT OF OUTSTANDING INTERESTS AS EQUITY

A. Automatic Classification Change

B. Example 13 – Convertible Debt

C. Granting Nonvested Equity Interests to Employees

V. SALE OF A SINGLE-MEMBER LLC

A. Sale of All of the Membership Interests

1. Example 14 – Sale of All of the Membership Interests to a Single Buyer
2. Example 15 – Sale of All of the Membership Interests Through a Cash Merger

B. Sale of Less than All of the Membership Interests

1. Example 16 – Sale of Less than All of the Membership Interests
2. Example 17 – Initial Public Offering of LLC Interests

VI. REORGANIZATIONS INVOLVING SINGLE-MEMBER LLCS

A. Example 18 - B Reorganization

B. Example 19 - C Reorganization

C. A Reorganizations Involving Single-Member LLCs

1. Old Proposed Regulations
2. New Temporary Regulations
3. The Temporary Regulations Apply Only to Domestic Entities
4. Examples Illustrating Temporary Statutory Merger/Consolidation Regulations
a. Example 20 - Merger Into LLC (Base Case)
b. Example 21 – QSub Becomes C Corporation
c. Example 22 – Merger into LLC in Exchange for LLC Interests
d. Application of Proposed Regulations in the Context of Foreign Entities
(i) Example 23 – Merger into First-Tier Domestic LLC
(ii) Example 24 – Merger into Second-Tier Domestic LLC
e. Divisive Mergers Involving LLCs
(iii) Example 25 - LLC Merger Into Corporation
(iv) Example 26 – Merger of Corporation into Multiple LLCs
f. Example 27 – Forward Triangular Merger

D. Example 28 - F Reorganization

E. Use of LLCs in Spin-Off Transactions

1. Example 29 – Spin-Off
2. Example 30 – Distribution of LLC Interests as a Spin-Off
3. Example 31 – Avoiding the Requirements of Section 355
4. Example 32 – Section 355(e) Transaction

VII. USE OF LLCS IN CONSOLIDATED RETURN CONTEXT

A. Selective Consolidation

1. In General
2. Example 33 – Selective Consolidation

B. Avoiding SRLY Limitations

1. In General
2. Example 34 – SRLY Limitations

C. Avoiding Intercompany Transaction Rules

1. In General
2. Example 35 – Intercompany Sale
3. Example 36 – Intercompany Debt

D. Deconsolidation of Two-Member Consolidated Group

1. In General
2. Example 37 – Deconsolidation Using a Single-Member LLC

E. Avoid Triggering Restoration of ELAs

1. In General
2. Example 38 – Avoiding Trigger of ELAs

VIII. USE OF MULTI-MEMBER LLCS IN CORPORATE TRANSACTIONS

A. Mergers Involving Multi-Member LLCs

1. Example 39 – Merger of Target Corporation Into LLC
2. Example 40 – Merger of LLC Into Acquiring Corporation

B. Example 41 – Multi-Member LLCs in the Consolidated Return Context

C. Example 42 - Recognizing Losses Using Multi-Member LLCs

D. Change in Number of Members

1. Example 43 – Conversion of Multi-Member LLCs Into Single-Member LLCs
2. Example 44 – Conversion of Multi-Member LLCs Into Single-Member LLCs in the Consolidated Return Context

E. Treatment of Holder of Multi-Member LLC Interest as General or Limited Partner

1. Section 469 Passive Investment Rules
2. Self-Employment Tax

IX. DISADVANTAGES OF USING LLCS

A. Certain LLCs Cannot Be Parties to Reorganizations

1. In General
2. Example 45 – Achieving Results Similar to a Tax-Free Reorganization

B.Spinning Off a Lower Tier LLC

1. In General
2. Example 46 – Spin-off of an LLC

C. Loss of Basis in the Stock of a Corporate Subsidiary

1. In General
2. Example 47 – Disappearing Basis

X. OTHER ISSUES

A. Treatment of Indebtedness

1. Cancellation of Debt ("COD") Income
2. Modification of Debt

B. Start-Up v. Expansion Costs

C. Like-Kind Exchanges

1. General
2. Qualifying property
a. Section 1031(a)(2)(D
b. Example 48 – 1031 Exchange
3. Acquiring Replacement Property

D. Personal Holding Companies

E. Employment Issues

1. Employer Identification Number ("EIN")
2. Employment and Withholding Taxes
3. Employee Retirement Plans
4. Incentive Stock Option Plans

F. Filing Requirements

XI. STATE TAX CONSIDERATIONS

A. State Treatment of LLCs

B. Achieving Consolidated Results In States That Prohibit Consolidation

C. Achieving Section 338(h)(10) Results in States That Do Not Recognize the Election

1. General
2. Example 49 – Achieving Section 338(h)(10) Treatment for State Tax Purposes

I. INTRODUCTION

The check-the-box regulations provide a host of planning opportunities for taxpayers, particularly with respect to the use of disregarded entities, such as single-member limited liability companies ("LLCs"). However, the fact that an entity may be disregarded for federal tax purposes generally does not affect the rights and obligations of the owners under state law. Treas. Reg. § 301.7701-1(a). Thus, if a state does not sanction the use of single-member LLCs or follow the check-the-box regulations, an entity that is disregarded for federal tax purposes may be classified differently for state tax purposes.

The consequences of classification as a disregarded entity are not fully addressed either in the regulations or the amendments thereto. The regulations simply provide that "if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner," and that the entity classification rules apply for all federal tax purposes. See Treas. Reg. §§ 301.7701-1; -2(a). As a result, it is not entirely clear how a disregarded entity is treated when it is involved in corporate transactions. This outline will focus primarily on the federal tax consequences of converting, disposing, reorganizing, and otherwise using single-member LLCs in domestic corporate transactions. The outline will also address the use of multi-member LLCs and the state tax issues relating to the use of LLCs in corporate transactions.

A. Check-the-Box Regulations

1. In General

On December 17, 1996, the Internal Revenue Service (the "Service") issued final regulations under section 7701, which greatly simplified the classification of business entities for federal tax purposes. These so-called check-the-box regulations became effective on January 1, 1997.

The check-the-box regulations provide, in general, that an "eligible entity" (i.e., an entity that is neither a trust nor a "corporation" as defined in Treas. Reg. § 301.7701-2(b)) with two or more members can elect to be classified as either an association taxed as a corporation or as a partnership. Treas. Reg. § 301.7701-3(a). An eligible entity with only one owner can elect to be classified as a corporation or to be disregarded as an entity separate from its owner (a "disregarded entity"). Id. Certain default rules are provided in the regulations. Under these default rules, a multi-member entity will be classified as a partnership, unless it makes an affirmative election to be classified as a corporation; a single-member entity will be disregarded, unless it makes an affirmative election to be treated as a corporation. Id. § 301.7701-3(b)(1).

Under the check-the-box regulations, a corporation as defined in Treas. Reg. § 301.7701-2(b) is always classified as a corporation for federal tax purposes. A "corporation" includes a business entity organized under a state statute that describes the entity as incorporated, a corporation, body corporate, body politic, joint-stock company, or joint-stock association. Id. § 301.7701-2(b)(1), (3); see also P.L.R. 200139020 (June 29, 2001) (concluding that a company organized under a state cooperative LLC act was an eligible entity, because the act did not refer to the entity as incorporated, a corporation, body corporate, or body politic).

2. Election

An eligible entity makes an entity classification election by filing Form 8832, Entity Classification Election. Treas. Reg. § 301-7701-3(c)(1)(ii). The election will be effective on the date specified by the entity on Form 8832, or on the date filed if no date is specified. The effective date of an election cannot be more than 75 days prior to the date on which the election is filed and cannot be more than 12 months after the date on which the election is filed. Treas. Reg. § 301.7701-3(c)(1)(iii). If the entity is not eligible to make an election on the date specified on the Form 8832, the Service will treat the filing date as the effective date of the election, provided the election complies with the check-the-box regulations at that time. See I.L.M. 200238025 (June 14, 2002) (where entity was not properly characterized as a business entity under local law on the specified date, the effective date was the date the Form 8832 was filed).

The Service has authority under Treas. Reg. § 301.9100 to grant an extension of time to make an election. Typically the Service grants such extensions only in response to a private letter ruling request (for which a user fee must be paid) when the taxpayer establishes that it has acted in good faith and the grant of relief will not prejudice the interests of the government. In Rev. Proc. 2002-15, 2002-15 I.R.B. 490, the Service provided a simplified method for newly formed entities to request relief for the late filing of their initial classification election under Treas. Reg. § 301.7701-3. Relief is requested by filing Form 8832 within six months of the original due date for the initial classification election (i.e., within six months and 75 days of the entity’s formation). An entity is eligible for relief if (i) the entity failed to obtain its desired classification as of the date of its formation because Form 8832 was not timely filed, (ii) the due date for the entity’s initial tax return has not passed, and (iii) the entity had reasonable cause for its failure to make a timely election. Subsequently, Rev. Proc. 2002-59, 2002-39 I.R.B. 615, extended the time for requesting relief from six months to the unextended due date of the entity’s federal tax return for the year of the entity’s formation. An entity not eligible for relief under these revenue procedures or denied relief by the Service may apply for a private letter ruling requesting relief.

3. Waiting Period

Under the check-the-box regulations an eligible entity that has exercised its right to elect its tax classification may not elect a different tax classification for a period of 60 months (the "60-month waiting period"). An election by a newly formed eligible entity that is effective on the date of formation is not considered an elective change; thus, the 60-month waiting period is not triggered. See Treas. Reg. § 301.7701-3(c)(1)(iv).

B. Amendments to the Check-the-Box Regulations – Effect of Change of Classification

1. In General

a. There are essentially three ways in which to accomplish a classification change: (i) An elective classification change, wherein the entity simply checks the box to change its classification; (ii) an automatic classification change, wherein an entity’s default classification changes as a result of a change in the number of owners; and (iii) an actual conversion, wherein an entity merges into or liquidates and forms a new entity that has the desired classification.

b. On November 29, 1999, the Service issued final regulations amending the check-the-box regulations. These amendments address the tax consequences of an elective change in the classification of an eligible entity. In general, these consequences are intended to mirror the tax consequences of an actual conversion. See Preamble to Prop. Treas. Reg. § 301.7701, 62 Fed. Reg. 55,768, 55,769 (1997).

c. In addition, the amendments address the consequences of certain automatic classification changes. An automatic classification change occurs when there is a change in the number of owners of an entity that precludes its current classification. For example, an entity can no longer be treated as disregarded if the number of owners increases above one. Similarly, a partnership can no longer be classified as such if the number of partners decreases to one. The Service has provided further guidance on the tax consequences of such automatic classification changes. See Rev. Rul. 99-5, 1999-1 C.B. 434; Rev. Rul. 99-6, 1999-1 C.B. 432 (both discussed below).

d. These amendments are applicable on or after November 29, 1999.

2. Timing - A change of classification election is treated as occurring at the start of the day for which the election is effective.

Any transactions that are deemed to occur as the result of the change in classification are treated as occurring as of the close of the day before the election becomes effective. Treas. Reg. § 301.7701-3(g)(3). Because the tax impact of the deemed transactions may have different tax consequences depending upon the circumstances, care must be taken in choosing the effective date of the change in classification.

If an elective classification change is effective at the same time as an automatic classification change resulting from a change in the number of owners, the deemed transactions from the elective change preempt the transactions that would result from the automatic classification change. Treas. Reg. § 301.7701-3(f)(2). Similarly, the Service has ruled that an elective classification change that is effective at the same time as an actual conversion will govern the entity’s classification. See P.L.R. 200109019 (Nov. 29, 2000) (ruling that a corporation that converted into an LLC under state law and filed an election to be classified as an association effective on the date of conversion will not be classified as an entity other than a corporation).

The timing of the classification election conflicts with the timing of the deemed transactions where a section 338 election is made. See Preamble to Treas. Reg. § 301.7701, 64 Fed. Reg. 66,580, 66,581 (1999). As a result, the regulations provide that a corporation’s classification election cannot be effective before the day after the acquisition date of the target corporation. In addition, the transactions that are deemed to occur as a result of the classification election will be treated as occurring immediately after the section 338 transactions. Treas. Reg. § 301.7701- 3(g)(3)(ii).

When classification elections for a series of tiered entities are effective on the same date, the eligible entities may specify the order of the elections. If no order is specified, then the transactions are treated as occurring first for the highest tier entity’s classification change and then for each next highest tier entity’s classification change. Treas. Reg. § 301.7701- 3(g)(3)(iii).

3. Tax Consequences - The regulations treat an elective change in classification as triggering a series of deemed transactions, which differ depending upon the reclassification that takes place. The tax treatment of a change in classification is determined under all relevant provisions of the Code and general principles of tax law, including the step-transaction doctrine. Treas. Reg. § 301.7701-3(g)(2). This provision is intended to ensure that the tax consequences of an elective change will be identical to the consequences that would have occurred if the taxpayer had actually taken the steps described in the regulations. See Preamble to Prop.Treas. Reg. § 301.7701, 62 Fed. Reg. at 55,769.

4. Waiting Period - The regulations provide that an automatic classification change is not treated as an elective change, so the 60-month waiting period is unaffected by an automatic classification change. Treas. Reg. § 301.7701-3(f)(3). Thus, if an entity is formed on April 1, 1998, and an automatic classification change occurs on April 30, 1998, the entity may elect a different classification at any time, because the entity has not made a prior election for purposes of the 60-month waiting period.

C. Proposed Regulations Regarding Mergers Involving Single-Member LLCs

On May 11, 2000, the Service issued proposed regulations under section 368 in which it took the position that neither the merger of a disregarded entity into an acquiring corporation nor the merger of a target corporation into a disregarded entity could qualify as an A reorganization. Old Prop. Treas. Reg. § 1.368- 2(b)(1).

On November 14, 2001, the Service withdrew the 2000 proposed regulations and issued new proposed regulations. The new proposed regulations permit certain statutory mergers involving disregarded entities to qualify as A reorganizations, if all of the assets and liabilities of the target are transferred to the acquiror and the target goes out of existence. Prop. Treas. Reg. § 1.368-2(b)(1)(ii). On January 23, 2003, these proposed regulations were issued as temporary regulations with certain modifications. Temp. Treas. Reg. § 1.368-2T(b)(1)(ii); see Part VI.C., below, for a more detailed discussion of these regulations.

D. Final Regulations Regarding Section 332 Plan of Liquidation

On December 14, 2001, the Service issued final regulations that address the application of section 332 to a deemed liquidation of an association electing to be classified as a partnership or a disregarded entity. The regulations adopt, without modification, the proposed regulations that were issued on January 16, 2001.

As discussed further below in Part III.A.2. and 4., an elective conversion of an association to a partnership or to a disregarded entity is deemed to constitute distribution of the assets of the association to its shareholders in complete liquidation (in the context of a conversion to a partnership, such deemed liquidation is followed by a contribution of the distributed assets to a newly formed partnership). Treas. Reg. § 301.7701-3(g)(1)(ii), (iii). Section 332 may be relevant to the deemed liquidation if the association has a corporate owner. One of the requirements of section 332 is the adoption of a plan of liquidation. However, formally adopting such a plan is inconsistent with the elective regime of the check-the-box regulations, which allows a local law entity to remain in existence and liquidate only for federal tax purposes. Preamble to Prop. Treas. Reg. § 301.7701-3(g)(2)(ii), 66 Fed. Reg. 3,959, 3,959 (2001); Preamble to Treas. Reg. § 301.7701-3(g)(2)(ii), 66 Fed. Reg. 64,911, 64,912 (2001).

Thus, the regulations provide that, in the case of elective classification changes, a plan of liquidation is deemed adopted immediately before the deemed liquidation, unless a formal plan that contemplates the elective change in classification is adopted on an earlier date. Treas. Reg. § 301.7701-3(g)(2)(ii). The regulations are effective for elections filed on or after December 17, 2001. However, taxpayers may elect to apply the amendments retroactively. Id.

E. Temporary Regulations Limiting Disregarded Entities in Certain Circumstances

On August 1, 2002, the Service issued temporary regulations addressing the classification of entities owned by foreign governments and banks. The temporary regulations adopt, with certain modifications, the proposed regulations issued on January 12, 2001.

Treas. Reg. § 301.7701-2(b) provides that certain business entities are classified as per se corporations for Federal tax purposes and are therefore not permitted to elect a non-corporate Federal tax classification. Treas. Reg. § 301.7701-2(b)(6) classifies a business entity wholly owned by a State or any of its political subdivisions as a per se corporation. To achieve parallel tax treatment under the check-the-box regulations of a business entity wholly owned by a State or any of its political subdivisions and a business entity wholly owned by a foreign government, the temporary regulations provide that a business entity wholly owned by a foreign government cannot elect to be treated as a disregarded entity. Temp. Treas. Reg. § 301.7701-2(b)(6). This provision applies on or after January 14, 2002.

Treas. Reg. § 301.7701-2(c)(2)(ii) provides that a bank cannot treat a wholly owned nonbank entity as a disregarded entity for purposes of applying the special rules of the Code applicable to banks. The term bank for this purpose is defined in section 581 to include only domestic entities. The temporary regulations incorporate a reference to section 585(a)(2)(B) (which includes certain foreign banks that are engaged in a U.S. trade or business in the definition of the term bank) in Treas. Reg. § 301.7701-2(c)(2)(ii). As a result, neither domestic banks nor foreign banks engaged in a U.S. trade or business can treat wholly owned nonbank entities as disregarded entities for purposes of applying the special rules of the Code applicable to banks. This provision applies to taxable years beginning after January 12, 2001.

F. Proposed Regulations Regarding Elections by Foreign Entities

On November 29, 1999, the Service issued proposed regulations that would invalidate an election by an eligible foreign entity to be treated as a disregarded entity in certain circumstances. Prop. Treas. Reg. § 301.7701-3(h). The proposed regulations would treat a foreign entity as a corporation if it has been involved in an "extraordinary transaction" within the period beginning one day before and ending 12 months after the effective date of that foreign entity’s change in classification to a disregarded entity, and that foreign entity was classified as a corporation at any time within the 12-month period prior to the extraordinary transaction. Prop. Treas. Reg. § 301.7701-3(h)(1). For this purpose, an extraordinary transaction would include a sale, exchange, transfer, or other disposition of a 10-percent or greater interest in the foreign entity. Prop. Treas. Reg. § 301.7701-3(h)(1)(i)(A). The proposed regulations did not limit extraordinary transactions to those occurring with unrelated parties. Thus, conceivably a disposition of a sufficient interest in a foreign entity to another member of the affiliated group could trigger these rules.

The proposed regulations also applied to certain "shelf" entities that might be used in an attempt to circumvent the 12-month rule. Prop. Treas. Reg. § 301.7701-3(h)(2). The proposed regulations did not apply, however, if the taxpayer established to the Service’s satisfaction that the federal tax consequences of the transaction were not materially altered by the disregarded entity classification. Prop. Treas. Reg. § 301.7701-3(h)(3).

These proposed regulations were withdrawn on June 25, 2003 in Notice 2003-46. The Notice indicated that the approach in the proposed regulations was widely criticized as overly broad and potentially damaging to the increased certainty promoted by the entity classification regulations issued in 1996. The Notice also indicated the IRS and Treasury remain concerned about cases in which a tapayer, seeking to dispose of an entity, makes an election to disregard it merely to alter the tax consequences of the disposition. The Notice stated the IRS would continue to pursue the application of other principles of existing law (such as the substance over form doctrine) to determine the proper tax consequences in such cases.

Notice 2003-43 also indicated the IRS and Treasury are continuing to examine the potential use of the entity classification regulations to achieve results inconsistent with the policies and rules of particular Code provisions or of U.S. tax treaties. The Notice stated the examination would focus on ensuring that the substantive rule of particular Code provisions and U.S. tax treaties reach appropriate results notwithstanding changes in entity classification. This is consistent with the Service’s historic approach. The Service has previously attempted to police the use of disregarded entities in the foreign context through subpart F and other substantive Code provisions -- it has never proposed invalidating an entity classification election. See, e.g., Notice 98-11, 1998-1 C.B. 433; Notice 98-35, 1998-2 C.B. 34; Prop. Treas. Reg. § 1.954-9; I.T.A. 199937038 (June 28, 1999).

II. WHAT IS A DISREGARDED ENTITY?

A. In General - The assets and liabilities of a disregarded entity are treated as owned, and its activities are treated as actually performed, by its owner. If the owner is a corporation, the activities of the disregarded entity are treated as if they were conducted by a division or a branch of the corporation. Treas. Reg. § 301.7701- 2(a).

1. Even though the assets and liabilities of a single-member LLC are treated as owned by the LLC for state law purposes, they are treated as owned by the LLC’s owner for federal tax purposes.

a. For example, in P.L.R. 199947001 (Dec. 7, 1998), a partnership owned all of the interests in a single-member LLC. The Service ruled that if the partnership made a section 754 election, the adjustment under section 743(b) would be made to all of the partnership’s assets, including those of its single-member LLC.

b. In P.L.R. 200143012 (July 25, 2001), X, an S corporation, owned all of the stock of Sub, a qualified S corporation subsidiary. Sub owned directly and through single-member LLCs interests in several limited partnerships that operated commercial real estate - Sub held limited partnership interests directly and held general partnership interests through the LLCs. The Service ruled that for purposes of section 1362(d)(3), X would be treated as holding the general partnership interests directly, and the rents received by the partnerships would thus not be treated as passive investment income. Cf. P.L.R. 200218033 (Feb. 5, 2002) (ruling that rents from properties owned directly and through a multi-member LLC treated as a partnership were not passive investment income under section 1362(d)(3) where X provided various operational services to the properties, and solicited new tenants and negotiated leases for the properties).

c. However, the Service seems to look to state law to determine whether a modification of a debt instrument results in a taxable exchange under Treas. Reg. § 1.1001-3.

(i) In P.L.R. 200315001 (Sept. 19, 2002), the Parent group restructured into a holding company structure with Parent becoming a wholly owned subsidiary of New Parent. Parent then converted to a single-member LLC, LLC1. Parent achieved this conversion by filing a certificate, not by merging into a new legal entity.

(ii) Technically, because Parent is disregarded as an entity separate from New Parent for federal tax purposes, New Parent becomes the obligor on any debt of Parent, and any recourse debt becomes nonrecourse debt of New Parent. See Treas. Reg. § 1.465-27(b)(6), Ex. 6.

(iii) However, the Service determined that under the applicable State A law, the conversion of Parent into LLC1 would not affect the legal rights or obligations between debt holders and Parent because, as a matter of State A law, LLC1 remains the same legal entity as Parent. The Service therefore determined that the conversion of Parent into LLC1 did not result in a modification of the debt held by the debt holders.

2. Similarly, the owner is treated as conducting the activities of the LLC for federal tax purposes. Thus, for example, if the owner of a single-member LLC is a tax-exempt entity, the activities of the LLC will be considered conducted by the owner for purposes of determining the owner’s exempt status and for purposes of applying the unrelated trade or business provisions of sections 511-513. See P.L.R. 200124022 (Mar. 13, 2001).

3. Transactions between disregarded entities and their owners, and transactions between commonly owned disregarded entities should be treated as interdivisional transactions and, thus, ignored for tax purposes. See Examples 1-3, below.

4. Transactions between disregarded entities and third parties, however, should generally be treated as having occurred between the owner of the disregarded entity and the third party.

5. In analyzing issues regarding the use of disregarded entities in corporate transactions, it may be helpful to look to the treatment of similar situations in which corporations have been disregarded.

a. Qualified REIT Subsidiaries – Under section 856(i)(1), a wholly owned subsidiary of a real estate investment trust (i.e., a qualified REIT subsidiary) is disregarded as an entity separate from its owner, and all of its assets, liabilities, and items of income, deduction, and credit are treated as assets, liabilities, and items of its owner.

b. Qualified S Corporation Subsidiaries ("QSubs") – Similarly, under section 1361(b)(3)(A), a wholly owned subsidiary of an S corporation is not treated as a separate corporation, and all of its assets, liabilities, and items of income, deduction, and credit are treated as those of its owner.

c. Finally, the existence of corporate entities may be ignored through the application of the step-transaction doctrine, such as the case where a transitory subsidiary is ignored.

B. Determination of Single Owner

1. The preamble to the check-the-box regulations provides that the determination of whether an entity has a single owner is based on the underlying facts and circumstances. Preamble to Treas. Reg. § 301.7701, 61 Fed. Reg. 66,584, 66,585 (1996).

a. The Service’s ruling position under the prior entity classification rules was that members had to meet a one-percent ownership threshold in order to be considered as lacking certain corporate characteristics. Rev. Proc. 95-10, §§ 4.02-4.05, 1995-1 C.B. 501. No such threshold appears in the check-the-box regulations. Thus, these ruling guidelines are apparently no longer relevant.

b. The Service has provided some guidance on what constitutes an owner for purposes of the check-the-box regulations, applying a facts-and-circumstances analysis. See P.L.R. 200201024 (Oct. 5, 2001); P.L.R. 199911033 (Dec. 18, 1998); P.L.R. 199914006 (Dec. 23, 1998).

(i) In P.L.R. 199911033, a trust and a corporation wholly owned by the trust held interests in an LLC. The structure was used to achieve bankruptcy-remote status for the LLC, and provided no economic rights to the corporation. The LLC agreement provided that all LLC decisions would be made by the trust, except that the corporation had certain limited veto powers (e.g., the LLC could not file for bankruptcy without the corporation’s approval). In addition, all profits and losses were to be allocated to the trust, and all distributions were to be made only to the trust. The Service ruled that the trust and the corporation did not enter an agreement to operate a business and share profits and losses under general partnership principles. Accordingly, the LLC was treated as a disregarded entity wholly owned by the trust. See also P.L.R. 200201024.

(ii) In P.L.R. 19914006, the Service ruled that an LLC interest held by a corporation’s wholly owned subsidiary provided the subsidiary with no economic management rights and, therefore, the subsidiary would not be treated as a second member.

(iii) However, the Service declined to rule on the issue in a similar situation. See P.L.R. 200109018 (Nov. 29, 2000) (declining to rule whether a partnership’s stock ownership in an S coporation should be disregarded as a nominee interest, instead ruling that the S corporation’s termination was inadvertent); see also P.L.R. 9716007 (Jan. 8, 1997).

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