Two recent Internal Revenue Service rulings on the tax treatment of converting single-member limited liability companies into partnerships and vice versa likely will affect the commercial real estate industry because many transactions take place with partnerships and other entities with flow-through tax characteristics, including LLCs and single-member LLCs.
In late 1996, the IRS issued regulations that allow newly formed entities to choose how they will be taxed for federal income tax purposes. However, the IRS failed to address the tax treatment of entities that changed their tax classification. In 1997, the IRS issued proposed regulations regarding most such changes. In early 1999, the IRS issued Revenue Rulings 99-5 and 99-6, which provide technical guidance on two specific types of entity classification changes - known as disregarded entity conversions - that intentionally were left out of the 1997 proposed regulations.
Revenue Ruling 99-5
Rev. Rul. 99-5 addresses the federal tax consequences of converting a single-member domestic LLC to a partnership. The IRS addresses this issue using two separate situations. In both, an LLC is formed and operates in a state that permits an LLC to have a single owner. Each LLC has a single owner, X, and is disregarded as an entity separate from its owner for federal tax purposes. In addition, the LLC would not be treated as an investment company if it were incorporated. All of the LLC's assets are capital assets or property used in trade or business. Moreover, for simplicity it is assumed that neither LLC is liable for any indebtedness, nor are the LLCs' assets subject to indebtedness.
Situation 1. Y, who is not related to X, purchases 50 percent of X's ownership interest in the LLC for $5,000. X does not contribute any portion of the $5,000 to the LLC. X and Y continue to operate the business of the LLC as co-owners.
The IRS determined that the LLC converts to a partnership when the new member, Y, purchases an interest in the disregarded entity from the owner, X. Y's purchase of 50 percent of X's ownership interest is treated as the purchase of a 50 percent interest in each of the LLC's assets, which are held directly by X for federal tax purposes. Immediately, X and Y are treated as contributing their interests in those assets to a partnership in exchange for partnership ownership interests. The IRS concludes that X recognizes gain or loss from the sale to Y of the 50 percent interest in each asset of the LLC, but X and Y recognize no gain or loss from the conversion. Y's basis in the partnership interest is equal to $5,000. X's basis in the partnership interest is equal to X's basis in X's 50 percent share of the LLC's assets. The basis of the property treated as contributed to the partnership by X and Y is the adjusted basis of that property in X and Y's hands immediately after the deemed sale.
X's holding period for the partnership interest received includes X's holding period in the capital assets and property used by the LLC when it converted. Y's holding period begins on the day after the date of Y's purchase of the LLC interest.
Situation 2. C, who is not related to D, contributes $10,000 to the LLC in exchange for a 50 percent ownership interest. The LLC uses all of this cash in its business. C and D continue to operate the LLC's business as co-owners.
When new member C contributes cash to the LLC, it converts to a partnership. This is treated as a contribution to a partnership in exchange for an ownership interest. D is treated as contributing all of the assets of the LLC to the partnership in exchange for a partnership interest.
Under these facts, the IRS ruled that C and D recognize no gain or loss as a result of the conversion. C's basis in the partnership interest is equal to $10,000, the amount of cash contributed. D's basis in the partnership interest is equal to D's basis in the assets of the LLC that D was treated as contributing. The basis of the property contributed to the partnership by D is the adjusted basis of that property in D's hands. The basis of the property that C contributed to the partnership is $10,000. D's holding period for the partnership interest received includes D's holding period in the capital and property contributed when the disregarded entity converted to a partnership. C's holding period begins the day after C's contribution to the LLC.
Revenue Ruling 99-6
Rev. Rul. 99-6 addresses converting an LLC from a partnership to a single-member LLC. Again, the IRS addresses this issue using two situations in which an LLC is formed and operates in a state permitting an LLC to have a single owner. Each LLC is classified as a partnership. Neither holds any unrealized receivables or substantially appreciated inventory. Again, it is assumed that neither LLC is liable for any indebtedness, nor are the LLCs' assets subject to any indebtedness.
Situation 1. X and Y are equal partners in XY, an LLC. X sells X's entire interest in XY to Y for $10,000. After the sale, the business is continued by the LLC, which Y solely owns.
The IRS ruled that the XY partnership ends when Y purchases X's entire interest. Accordingly, X must treat the transaction as the sale of a partnership interest and report any gain or loss.
To determine Y's tax treatment, the XY partnership is deemed to make a liquidating distribution of all of its assets to X and Y, and after this distribution, Y is treated as acquiring the assets distributed to X in liquidation of X's partnership interest.
Y's basis in the assets attributable to X's one-half interest in the partnership is $10,000. Y's holding period for these assets begins the day immediately after the sale.
Upon the termination of XY, Y is considered to receive a distribution of those assets attributable to Y's former interest in XY. Y must recognize any gain or loss on the deemed distribution to the extent required by the IRS. Y's holding period for the assets attributable to Y's one-half interest in XY includes the partnership's holding period for such assets.
Situation 2. C and D are equal partners in CD, an LLC. C and D sell their entire interests in CD to E, an unrelated person, in exchange for $10,000 each. After the sale, the business is continued by the LLC, which is owned solely by E.
The IRS determined that the CD partnership terminates when E purchases the entire interests of C and D. C and D must report any gain or loss resulting from the sale. To classify E's acquisition, the CD partnership is deemed to make a liquidating distribution of its assets to C and D. Immediately afterward, E is deemed to acquire, by purchase, all of the former partnership's assets. E's basis in the assets is $20,000. E's holding period begins the day immediately after the sale.
Engaging in a disregarded entity conversion may be an effective tool to help meet business objectives. However, consult with a tax adviser to understand the potential tax consequences.