Question

Research Problem 1. Turnaround LLC was formed several years ago. It incurred losses for several years, reducing many of its members' bases in their interests to zero. However, the business has recently obtained some new and promising contracts, anticipating profits in the coming years if it can obtain some financing. It admitted

Answer 1

In Rev. Rul. 70-239, the IRS ruled that the tax consequences of incorporating a partnership would be the same regardless of how the conversion was structured. In Rev. Rul. 84-111, the IRS reversed its position, ruling that the tax consequences of converting a partnership, including an LLC, to a corporation would depend on how the conversion was structured. Such a conversion could be structured either as (1) a contribution by the partnership of its assets to the corporation in return for stock, followed by the liquidation of the partnership; (2) a distribution by the partnership of its assets to its partners, followed by a contribution of those assets by the partners to the new corporation; or (3) a contribution by the partners of their partnership interests to the new corporation in return for stock. Treas. Reg. § 301.7701-3(g)(i) provides that a partnership electing to be taxed as a corporation under the check-the-box regulations will be treated as contributing all of its assets to the corporation in return for stock, followed by the liquidation of the partnership. These different structures could have different tax consequences for Turnaround.

If Turnaround contributes all of its assets to a new corporation in return for all of its stock, the transfer itself will be tax-free for the partnership under § 351. Per § 358(a), the LLC will take a basis in the corporate stock equal to its basis in the contributed assets. The liquidation of the LLC will be tax free to the LLC [§ 731(b)] as well as to its members [§ 731(a)]. However, per § 732(b), the basis of the stock in the hands of the original LLC members will equal their basis in their LLC interests, or $0. The corporation will take a basis in the assets equal to that of the LLC’s, or $1,000,000 [§ 362(a)]. The same result would be achieved if the partnership does not legally convert to a corporation but simply elects to be taxed as one under the check-the-box regulations [Treas. Reg. § 301.7701-3(g)(i)].

Very different tax consequences will result if Turnaround distributes its assets to its members, followed by a contribution of those assets by the members to the corporation. In that case, the partnership will still recognize no gain or loss on the distribution of its assets [§ 731(b)]. However, the members will recognize gain to the extent that the cash received exceeds their adjusted basis in their interests [§ 731(a)]. As the initial members have no basis in their interests, they will recognize $250,000 gain equal to the amount of cash deemed received by them. The basis of any remaining assets deemed distributed to them will be zero [§ 732(b)]. The contribution of the assets to the corporation will be tax-free under § 351, with the original members taking a basis in their stock equal to the basis of the contributed assets, or $250,000 [§ 358]. The corporation will take a basis in the assets equal to that of the contributors [$500,000 cash + ½($500,000) or $750,000 (§ 362)].

If the members contribute their LLC interests to the corporation in return for stock, the contribution will be tax-deferred under § 351. The old members’ basis in their stock will carry over from their bases in their interests (§ 358); in this case, $0. The corporation will take a basis in its LLC interest from the contributing members (§ 362). Liquidation of the LLC will result in no gain to the corporation unless the cash distributed exceeds the total bases of all the LLC interests contributed [§ 731(a)]. Finally, the corporation will take a basis in the assets equal to the total basis in all of the LLC interests [§ 732(b)].

Again, the tax consequences of the conversion will depend on how it is structured. Liquidation of the LLC while it has cash and the initial members still own their interests (option 2) will trigger the recognition of gain for them. Further, the corporation will have only $750,000 basis in their assets. Contribution of the LLC’s assets or the members’ LLC interests to the corporation will avoid gain recognition by the members as well as potentially provide the corporation greater basis in their assets (either $1,000,000 carryover from the partnership if the partnership contributed its assets to the corporation, or an amount equal to the outside basis of the new partners if the partners contribute their partnership interests). The simplest, and most tax-efficient, approach may be for the LLC to elect to be taxed as a corporation without changing its legal status. Treas. Reg. Sec. 301.7701-3(g)(i) provides that this will be treated as a contribution of assets by the LLC directly to the corporation.