Unexpected consequences of changes in entity classifications.

• Author: Friedel, David B.

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 Si, a currently disregarded entity. Si 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 Si elects to become regarded as a corporation, what issues arise in a state that does not follow the federal consolidated return rules? When Si elects to become regarded as a corporation, P is deemed to contribute all the assets and liabilities of Si to a deemed new corporation (Newco Si) in exchange for stock of Newco Si (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 Si. 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 Si should have a basis increase of $15 in one or more of its assets. The new bases in Newco Si stock and Newco Si 's assets are shown in Exhibit 1.

Exhibit 1: Basis adjustments in Example 1 P's basis in the Newco Newco S1's basis in S1 stock: assets: Adjusted basis $180 Adjusted basis $180 Liabilities (195) Gain 15 Gain 15 Basis $195 Basis 0 Note: If the facts instead were that Si 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 Si 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 Si '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...