Unanticipated Tax Consequences Under the Conversion Regs.

Unanticipated tax consequences may result when an automatic change in entity classification is coupled with an affirmative election to change entity classification.

The Rules

Automatic change. Regs. Sec. 301.7701-3(f)(2) provides that a disregarded entity will be classified as a partnership if it has more than one member. Rev. Rul. 99-5 describes the income tax consequences that occur on converting from disregarded entity status to partnership status. When a new member acquires that interest by purchase of a portion of an existing interest, Rev. Rul. 99-5 provides that the transaction is treated as an asset sale followed by a contribution to a partnership.

Elective change. Regs. Sec. 301.7701-3(g)(1)(i) provides that a partnership making an election to be treated as an association is deemed to contribute all its assets and liabilities to a new corporation in exchange for stock in the corporation. Immediately thereafter, the partnership is deemed to liquidate by distributing the stock to its partners. These deemed transactions are treated as occurring immediately before the close of the day before the election is effective (Regs. Sec. 301.7701-3(g)(3)(i)).

Regs. Sec. 301.7701-3(f)(2) provides that the second of these two transactions will govern if both occur simultaneously; see Regs. Sec. 301.7701-3(f)(4), Example 1:

J is the sole owner of a disregarded entity. On Jan. 1, 1998, J sells 50% of its interest to S. Assuming the entity is an eligible entity, it converts to partnership classification on the acquisition by S of an interest. If J and S elect to treat the partnership as a corporation effective Jan. 1, 1998, S would be treated as buying shares of stock (rather than assets) from J.

Pursuant to the ordering rules in the regulations, the deemed transactions resulting from the election to change the entity's classification are treated as occurring on Dec. 31, 1997. Thus, the contribution of assets and liabilities to a new corporation is made on Dec. 31, 1997, when J is the sole owner, and is followed by the purchase by S of 50% of the stock. Because J is not in control of the corporation following that purchase (as required by Sec. 351), J's contribution is a taxable event. The assets contributed receive a stepped-up basis in the corporation, and J takes a fair market value (FMV) basis in the stock received. J recognizes no gain on the subsequent sale of 50% of the stock to S.

Trap for the Unwary

This example reveals a potential trap for unwary taxpayers resulting solely from the regulation's ordering rules. If the regulations did not treat the deemed transactions as occurring on the day before the election is effective, the sale of a 50% interest in a disregarded entity would be treated as a sale of assets under Rev. Rul. 99-5, and J would recognize gain only on those assets deemed sold. On a subsequent election to treat the partnership as a corporation, J and S would be deemed to make a joint contribution to a corporation in exchange for stock in a nontaxable Sec. 351 transaction. The basis of the assets in the corporation would be 50% carryover (J's contribution) and 50% FMV (S's contribution).

In drafting the regulations, the IRS clearly anticipated the difference in these results (attributable solely to the "day before" fiction created in Regs. Sec. 301.7701-3(f)(2)). J and S could avoid the result in the example (albeit with the existence of a partnership for one day), by delaying the election to treat the partnership as a corporation for one day. In either case (simultaneous or delayed election), the parties would be entitled to a basis step-up equal to the amount of gain recognized, either 50% or 100%, depending on the date of the election.

The Consequences

Nevertheless, some unintended consequences may result from these transaction-ordering rules.

Example: X is a C corporation with certain appreciated assets it wishes to distribute to numerous shareholders. The shareholders wish to hold the distributed assets in corporate form. For administrative or legal reasons, X cannot distribute the assets in-kind. X forms a single-member entity, Y, to which it contributes the appreciated assets and immediately distributes the Y interests to its shareholders.

The following results occur:

• X recognizes gain on the distribution of the Y interest under Sec. 311(b), as if the property were sold for its FMV.
• The shareholders recognize ordinary income from the dividend distribution (to the extent of earnings and profits (E&P)), followed by a return of capital and capital gain.
• On receipt of the Y interests by X shareholders, Y defaults into partnership status, because it has more than one member. The partners immediately make an election to treat Y as a corporation.

Absent Regs. Sec. 301.7701-3(f)(2), the following would be deemed to occur:

• Under Rev. Rul. 99-5, the shareholders would be treated as purchasing assets rather than ownership interests in Y, so their basis in the assets would equal the FMV of those assets.
• X would recognize gain on the distribution of the Y interest under Sec. 311(b), as if the property had been sold for its FMV.
• The shareholders would recognize ordinary income from a dividend distribution (to the extent of E&P), followed by a return of capital and capital gain.
• The distributed assets would be contributed to a new partnership, which would take a carryover basis in the assets (now stepped up to their FMV).
• On a subsequent election to treat the partnership as a corporation, the partners would be deemed to contribute the assets to a new corporation in exchange for stock (Regs. Sec. 301.7701-3(g)(1)(iv)). Under Sec. 351, this transaction would be nontaxable; the corporation would take a carryover (i.e., FMV) basis in the assets. The shareholders would have an FMV basis in their stock.

Observation: This result seems reasonable. X and its shareholders would recognize gain on the distribution of assets, and Y would include the gain recognized in the assets' bases. The gain also would be reflected in the basis of the shareholders' stock in the new corporation.

However, Regs. Sec. 301.7701-3(f)(2) provides a very different result. Because of the simultaneous occurrence of an elective entity classification and a membership change, the election is deemed to override the membership change. The following consequences are deemed to result under Regs. Sec. 301.7701-3(f)(2):

• Corporation X forms a disregarded entity (Y) with a contribution of appreciated assets.
• Y contributes the assets to a new corporation (N) for N's stock.
• N takes a carryover basis in the assets under Sec. 351.
• X distributes the N stock to its shareholders, recognizing the gain inherent in the stock under Sec. 311(b). (Under Sec. 351(c), this distribution of N stock to the X shareholders does not cause X to fail the control requirements of Sec. 351.)
• The shareholders recognize ordinary income from a dividend distribution (to the extent of E&P), followed by a return of capital and capital gain.
• The shareholders receive the N stock with a basis equal to its FMV. However, N's basis in its assets remains equal to the original carryover basis, notwithstanding subsequent gain recognition on the distribution of its stock, because the original contribution to N was a "successful" Sec. 351 transaction. Consequently, the gain equal to the appreciation in value would be taxed twice at the corporate level if N disposes of any of its assets (in addition to being taxed, in both cases, as a dividend distribution to the shareholders).

Possible Solutions

The simplest solution to this potentially disastrous result would be to delay "checking the box" for a day. As a result, the new entity would be a partnership for one day and deemed to contribute its assets to a corporation at the end of that day. The election to be treated as a corporation would be deemed a change in classification and not an initial classification. (Regs. Sec. 301.7701-3(f)(3) provides that a change in classification resulting from a change in the number of members does not result in a new entity for purposes of the 60-month rule.) When the existence of a partnership for a day is not a viable alternative, complex maneuvering may be required to avoid a result that presumably was not intended by the regulation's drafters.

From Susana E. Noles, B.A., Washington, DC