Incorporating a partnership or LLC: does Rev. Rul. 84-111 need updating?

• Author: Gruidl, Nick

Taxpayers' widespread adoption of the limited liability company (LLC) has caused Treasury and the IRS to take a closer look at transactions using it. For example, most states' enactment of rules allowing for mergers involving LLCs was one reason Treasury issued Regs. Sec. 1.368-2(b), to address statutory mergers involving disregarded entities. Treasury and the Service should consider whether clarification is needed for transfers to a controlled corporation under Sec. 351, as discussed in Rev. Rul. 84-111.

Background

Sec. 351(a) provides for tax-deferred treatment of property transfers to corporations in exchange for stock constituting control of the corporation. If Sec. 351's requirements are met, the transferors recognize neither gain nor loss on the exchange. The transferee corporation takes a carryover basis in the property received, under Sec. 362. The transferor's basis in the stock received is the same as its basis for the property transferred, according to Sec. 358; see Sec. 351(h)(2).

Sec. 351(b) requires gain, but not loss, recognition when the transferor receives property other than stock in the controlled corporation. The transferor recognizes gain of the lesser of the gain realized or the fair market value of nonqualifying property received. The character of the gain recognized depends on the character of the property transferred to the corporation; see Rev. Rul. 60-302.

The Code does not define "property" for Sec. 351 purposes, but the courts have broadly interpreted the term. In Hempt Bros., Inc., 354 FSupp 1172 (MD PA 1973), the court held that "the term encompasses whatever may be transferred." An interest in a partnership or an LLC (taxed as a partnership) transferred to a corporation is also property for Sec. 351 purposes; see Rev. Ruls. 81-38 (transferring less than all interests) and 84-111 (transferring all interests).

Application of Rev. Rul. 84-111

Rev. Rul. 84-111 provides guidance for Sec. 351 transfers of 100% of the interests of a partnership under subchapter K. It offers the following three methods for determining the treatment of the transfers, and holds that the form of the transfer controls the treatment:

1. Assets over: a transfer by a partnership (or an LLC) of assets to the corporation in exchange for consideration, followed by the liquidation of the partnership (or LLC) via the distribution of the consideration.

2. Interests over: a transfer of the partnership (or LLC) interests by the partners (or members)...