Unanticipated tax consequences under the conversion regs.

• Author: Noles, Susana E.
• Position: IRS check-the-box regulations

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...