Editor: Annette B. Smith, CPA
When entities change their classification, several income tax issues that are not immediately apparent may come into play. When these issues are discovered, they may require amending tax returns and could result in tax penalties as well. The following examples illustrate potential issues.
Example 1. Separate filing state returns: P wholly owns limited liability company S1, a currently disregarded entity. S1 owns two assets: A, which has a fair market value (FMV) of $220 and adjusted basis of $70 and is subject to liabilities of $105, and B, which has an FMV of $300 and adjusted basis of $110 and is subject to liabilities of $90. If S1 elects to become regarded as a corporation, what issues arise in a state that does not follow the federal consolidated return rules?
When S1 elects to become regarded as a corporation, P is deemed to contribute all the assets and liabilities of S1 to a deemed new corporation (Newco S1) in exchange for stock of Newco S1 (see Regs. Sec. 301.7701-3(g)(1)(iv)). The transaction ordinarily would qualify for tax-free treatment under Sec. 351 but for the liabilities assumed by Newco S1. P recognizes gain in the amount of the excess of the assumed liabilities over the total of the adjusted bases of the transferred property under Sec. 357(c). Therefore, P recognizes gain of $15 (combined liabilities of $195 over combined bases of assets of $180). Newco S1 should have a basis increase of $15 in one or more of its assets. The new bases in Newco S1 stock and Newco S1's assets are shown below in Exhibit 1.
Note: If the facts instead were that S1 owns only asset A before the check-the-box election, then under Sec. 357(c), P would recognize gain of $35 (amount that the liability assumed on asset A exceeds its basis). Likewise, if S1 owns only asset B before making the election, P would have no gain because the liability associated with asset B does not exceed the basis and Sec. 357(c) would not apply.
What happens to the $15 additional basis in Newco S1's hands? Does it increase the basis of asset A, asset B, or both in some allocable manner?
It is not clear how the $15 increase in basis should be allocated. However, only one particular asset (asset A) has assumed liabilities in excess of basis. Therefore, it would seem reasonable to take an approach of allocating the $15 basis increase only to asset A. For more information on this uncertain area of law, see McMahon, "Now You See It, Now You Don't: The Comings and Goings of Disregarded Entities," 65 The Tax Lawyer 267 (Winter 2012).
The additional $15 of basis is treated as a separate asset placed in service in Newco S1's hands at the time of the contribution transaction. For the convenience of making calculations, it is assumed that the check-the-box election was made effective on Jan. 2 of year 3, with the deemed transfer occurring on the previous day (Jan. 1 of year 3).
Assume that P bought asset A for $100 and it is depreciable over five years with a straight-line election and half-year recovery period. With the transfer, Newco S1 steps into P's shoes for the carryover basis. For the $15 separate asset, it presumably likewise is depreciated over five years and also with a straight-line election and half-year recovery period. Newco S1 will claim depreciation deductions as shown below in Exhibit 2.
Example 2. Federal consolidated return: The facts are the same as in Example 1 except that P is a member of a consolidated group. What are the U.S. federal income tax consequences if S1 elects to become regarded as a corporation?
Just as in Example 1, when S1 elects to become regarded as a corporation, P is deemed to contribute all S1's assets and liabilities to Newco S1 in exchange for Newco S1 stock. It may appear sensible to assume that the election to be regarded as a corporation results in Newco S1 filing a separate federal return, but that would be wrong. Newco S1 becomes a member of the consolidated group. As noted, the assumption of liability does not prevent the exchange from qualifying for Sec. 351 treatment. However, the Sec. 357(c) requirement does not apply in a consolidated return year under Regs. Sec. 1.1502-80(d). Therefore, P does not recognize the $15 gain, which results in an excess loss account for Newco S1's stock that P holds. Under Sec. 168(i)(7), Newco S1 steps into the shoes of P (for the carryover basis) on the date of the transfer and takes any remaining depreciation deductions going forward. The basis adjustments are shown below in Exhibit 3.
When the consolidated group files a consolidated federal return, it reports no gain on the consolidated return, a direct result of Sec. 357(c)'s being inapplicable. How does the preparer of a state return know that there was a gain of $15 to P and that Newco S1 should be taking additional depreciation deductions resulting from the additional $15 of basis?
Unless the state return preparer is aware of how these issues might affect a state return, the preparer may not identify these issues, resulting in the taxpayer's understating its state gross income or its deductions.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.