Avoiding Adverse Tax Consequences in Partnership and LLC Reorganizations

Once parties decide to combine the assets and liabilities of two or more partnerships or limited liability companies (LLCs) taxed as partnerships or to divide such an entity into more than one entity, they are generally left to choose the form that provides the most advantageous tax results. State law grants partnerships and LLCs the power to merge with other entities. Such entities may join assets and liabilities through a state-law merger, or they may structure the combination through an asset transfer. An asset transfer often provides the greatest tax planning flexibility and may limit the exposure any resulting entity has to one of the transferring entity’s liabilities. Because states do not provide for statutory divisions, all divisions of partnerships and LLCs occur through asset transfers. Both partnerships and LLCs can be partnerships for tax purposes, so this article refers to them collectively as tax partnerships.

The tax rules provide that all mergers and divisions of tax partnerships will follow either an assets-over or assets-up form. An assets-over merger occurs when a terminating entity contributes all of its assets and liabilities to the continuing entity in exchange for interests in the continuing entity, and the terminating entity then distributes those interests to its members in complete liquidation. An assets-up merger occurs when a terminating entity distributes all of its assets and liabilities to its members in complete liquidation, and the members then contribute them to the continuing entity in exchange for interests in the continuing entity. An assets-over division occurs when one entity contributes some of its assets to a new entity in exchange for all of the interests in the new entity, and then distributes the interests in the new entity to some or all of its members. An assets-up division occurs when one entity distributes some of its assets to its members, and the members then contribute them to a new entity in exchange for interests in that entity. Diagrams of both types of mergers illustrate different flows of property.

If the parties to a merger or division of a partnership or LLC do not carry out the reorganization in one of those two forms, tax law will treat the transaction as an assets-over reorganization. Although the end result of such transactions may be the same from a non-tax standpoint, the form of a transaction may significantly affect the tax treatment of the parties. This article focuses on how the form of a merger of partnerships or LLCs can trigger gain and affect the basis the resulting entities have in assets. Divisions can raise similar issues.

The rules governing contributions to and distributions from tax partnerships apply to reorganizations of tax partnerships. Tax law recognizes that members of tax partnerships own interests in those entities, and the members take tax bases in those interests. The basis in a tax partnership interest is known as the “outside basis.” The law also recognizes that tax partnerships own property and have bases in such property. The basis a tax partnership has in property is known as the “inside basis.” If a person contributes property to a tax partnership in exchange for a tax partnership interest, neither the person nor the tax partnership will recognize gain or loss on the contribution. The basis the person had in the property will become the basis the tax partnership takes in the property and the basis the person will take in the tax partnership interest. The tax rules also provide that any built-in gain or loss that exists at the time of contribution of property, when triggered, must be allocated to the person who contributed the property to the tax partnership. A simple example illustrates these rules.

Sabeel contributes Worn Warehouse and Fabio contributes $650,000 of cash to form Saio LLC, a tax partnership. At the time of contribution, Worn Warehouse was worth $450,000 and Sabeel had a $150,000 basis in it. Sabeel takes a $150,000 outside basis in his 41 percent interest in Saio LLC, and Fabio takes a $650,000 outside basis in his 59 percent interest in Saio LLC. Saio LLC takes a $150,000 basis in Worn Warehouse. At the time of contribution, Worn Warehouse had a $300,000 built-in gain ($450,000 fair market value minus $150,000 basis). If Saio LLC were to sell Worn Warehouse immediately after contribution and recognize the $300,000 of built-in gain, it would allocate the entire amount of gain to Sabeel, the person who contributed it. The diagram represents Saio LLC’s tax situation after formation.

The distribution rules can affect the tax consequences of a reorganization. The distribution rules provide generally that neither the tax partnership nor any of its members recognize gain or loss on distributions. If the distribution is a liquidating distribution, the distributee member takes a basis in distributed property equal to the distributee member’s outside basis. If the distribution is not a liquidating distribution, the distributee member takes a basis in the distributed property equal to the property’s inside basis. An example illustrates this rule.

Margot, Sarah, and Kristalia are equal members of Marali LLC, a tax partnership. Margot’s outside basis in her Marali LLC interest is $350,000, Sarah’s is $250,000, and Kristalia’s is $150,000. Each of their interests are worth $350,000. Marali LLC owns four assets, all of which it purchased: Raw Land worth $350,000 with a $200,000 basis, Stonecrest Building worth $175,000 with a $100,000 basis, Stonehenge Building worth $175,000 with a $100,000 basis, and BigCorp stock, which are marketable securities, worth $350,000 with a $350,000 basis.

Marali LLC distributes Stonecrest Building to Sarah. Because the distribution does not liquidate Sarah’s interest in Marali LLC and the inside basis in the distributed asset was less than her outside basis, she would take Stonecrest Building with a basis equal to the $100,000 basis Marali LLC had in it immediately prior to the distribution. Assume alternatively that Marali LLC distributes both Stonecrest Building and Stonehenge Building to Sarah in complete liquidation of her interest in Marali LLC. Because the distribution is in complete liquidation of her interest, Sarah would take a basis in the distributed property that equals her $250,000 outside basis (a basis of $125,000 in each building). Thus, under these facts, the basis of the buildings increases when the distribution is in complete liquidation of Sarah’s interest. Because the buildings are depreciable, Sarah is able to take depreciation deductions using the larger basis, if the distribution is in complete liquidation of her interest. (Note, however, that if the tax partnership has made a Section 754 election, it would have to make a downward adjustment to the basis of its remaining assets to account for the basis step up on distribution.)

Two major exceptions apply to the general nonrecognition rule that applies to distributions. First, a member generally recognizes gain if the tax partnership distributes money or marketable securities to a member and the amount of the money or the fair market value of the securities exceeds the member’s outside basis. A member can recognize loss on a cash liquidating distribution if the cash distribution is less than the member’s outside basis. Second, a distribution of property with built-in gain or a distribution to a person who contributed property with built-in gain can trigger that built-in gain, if the distribution takes place within seven years after the contribution. An example illustrates the first exception.

Assume now that Marali LLC distributes the BigCorp stock to Kristalia in complete liquidation of her interest in Marali LLC. Because BigCorp stock is a marketable security, Kristalia would recognize gain on the distribution to the extent the value of the stock exceeds her outside basis. Her outside basis is $150,000, and the fair market value of the stock is $350,000, so Kristalia would recognize $200,000 of gain on the distribution. Kristalia would take a $350,000 basis in the stock. Notice that if Marali LLC had distributed the stock to Margot, who has an outside basis of $350,000, she would have recognized no gain on the distribution, and she would have taken a $350,000 basis in the stock. Thus, the distribution to Margot would not trigger gain recognition. The application of these basis rules illustrates that the type of distribution and the person to whom a tax partnership distributes property may affect the tax treatment of a distribution. The rules can therefore affect the tax treatment of a reorganization.

The second exception to the general nonrecognition rule is a bit more complicated because it requires tracking the movement of property with built-in gain. Returning to the first example, if instead of contributing Worn Warehouse and cash to Saio LLC, Sabeel had simply sold Worn Warehouse to Fabio, Sabeel would have recognized gain on the transaction. Tax law prevents Sabeel and Fabio from using Saio LLC to effect a tax-free property transfer by imposing anti-mixing bowl rules. Those rules provide that if a tax partnership distributes property with a built-in gain within seven years after the contribution, the person who contributed the property must recognize the remaining unamortized built-in gain. Thus, if within seven years after Sabeel contributed the property to Saio LLC, it had distributed the property to Fabio, Sabeel would have to recognize gain on that distribution in an amount equal to the remaining unamortized built-in gain at the time of the distribution.

The rules also provide that if a tax partnership distributes “other” property to a member who, within the last seven years, contributed built-in gain property to the tax partnership, the distributee member may recognize gain. Consequently, if Saio LLC were to acquire other property and distribute it to Fabio within seven years after he contributed Worn Warehouse, the distribution could trigger gain recognition for him. A distribution within two years after Sabeel contributes Worn Warehouse could also have a presumption of taxable gain under the disguised sale rules. Thus, distributions can trigger gain recognition, if they occur with respect to contributed property. Because mergers and divisions of tax partnerships include distributions, the parties to such transactions must be aware of these potential consequences. The rules also apply to property that is contributed as part of a reorganization.

The partnership tax merger and division rules coupled with the rules about contributions and distributions often allow parties to tax-partnership reorganizations to choose from the various restructuring alternatives to manage the tax bases of property and perhaps avoid triggering gain recognition. An example illustrates this point. Assume that the members of Saio LLC and Marali LLC agree to combine their two entities. Following the combination, Sabeel and Fabio will own 52 percent of the resulting entity, so Saio LLC will be the continuing entity. If the parties structure the transaction as a state-law merger, tax law will treat the transaction as an assets-over merger with Marali LLC transferring its assets to Saio LLC for a 48 percent interest in Saio LLC. Marali LLC would then distribute the Saio LLC interests to Margo, Sarah, and Kristalia in complete liquidation. The bases of Marali LLC’s assets would carry over to Saio LLC upon contribution, and Marali LLC would take a $750,000 basis in the Saio LLC interests, which equals to the aggregate basis it had in the assets it transferred. Because the distribution of Saio LLC interests is a liquidating distribution, Margo, Sarah, and Kristalia would each take basis in their interests in Saio LLC equal to their respective bases in Marali LLC.

With an assets-over merger, the transfer from the terminating entity to the continuing entity generally starts the seven-year clock on the anti-mixing bowl rules (unless the ownership of the terminating entity and the resulting entity are identical). Consequently, the anti-mixing bowl rules should apply to the assets that Marali LLC was deemed to contribute to Saio LLC. As a result, a distribution of Raw Land, Stonecrest Building, or Stonehenge Building to either Sabeel or Fabio would trigger gain recognition to Margo, Sarah, and Kristalia. Additionally, Saio LLC must allocate the built-in gain on Worn Warehouse to Sabeel. The contribution of the Marali LLC assets to Saio LLC also creates built-in gain in those assets that Saio LLC must allocate to Margo, Sarah, and Kristalia. It would allocate the built-in gain in the same manner that Marali LLC would have allocated the gain had it sold the property for cash.

If the parties instead structure the combination of entities as an assets-up merger, Marali LLC would distribute its property to Margo, Sarah, and Kristalia. They would then each contribute the assets that they hold in exchange for a 16 percent interest in Saio LLC. The tax rules do not require Marali LLC to distribute the property pro rata to the members. Consequently, they can decide which assets they would like to distribute to which member. The parties should manage the distribution in a manner that avoids gain recognition to the extent possible and places basis on property in a manner that provides the greatest future tax advantage. (Note that disproportionate distributions can create ordinary income, if a tax partnership has inventory or unrealized receivables, which is not the case with this set of facts.) Recall that the distribution of the BigCorp stock would trigger gain recognition to the distributee to the extent that the value of the stock exceeds the distributee’s outside basis. Consequently, if Marali LLC distributes the stock to Sarah, she would recognize $100,000 of gain on the distribution, and if it distributes the stock to Kristalia, she would recognize $200,000 of gain on the distribution. To avoid that gain recognition, the parties may agree that Marali LLC will distribute BigCorp stock to Margo, whose outside basis equals the value of the stock, so she would not recognize any gain on the distribution. Margo would take a $350,000 basis in the stock.

Next, the parties must determine how they will distribute the Raw Land and the two buildings. Because the buildings are depreciable, the parties would most likely prefer to have as much basis as possible go to the buildings to increase the depreciation deductions that Saio LLC will be able to take. Therefore, the parties may agree to distribute the buildings to Sarah, so she would take a $125,000 basis (one-half of her $250,000 outside basis) in each of the buildings. That leaves Kristalia to take the Raw Land with a $150,000 basis. The members would then contribute the property to the Saio LLC in exchange for their respective interests. Saio LLC would take the bases that the members have in the respective assets, and the members would each take a basis in their respective Saio LLC interests equal to the bases they had in the distributed assets.

This example illustrates that the form of the transaction can affect the tax consequences to the parties and the allocation of basis among the assets. The assets-up form moves basis from Raw Land to the buildings. This appears to be a good result from an overall perspective, but it changes the tax standing of some of the members. For example, the Raw Land would have a $200,000 built-in gain after the merger. Because Kristalia is the contributing member, all of that gain would be allocated to her, if Saio LLC were to sell or distribute the Raw Land. She thus bears that entire $200,000 gain, which otherwise would have been allocated equally among the members of Marali LLC. Sarah also benefits from a smaller built-in gain in the buildings, and Kristalia appears to avoid the built-in gain in those assets entirely.

This one example illustrates that the form a merger of two LLCs can raise interesting tax issues. The example focuses on how parties may avoid potential gain recognition on the transaction and how they can manage the bases of properties that are part of a merger. Tax-partnership divisions would raise similar issues. And other facts would also raise different issues. Mergers and divisions of tax partnerships therefore raise many issues, which may provide a planning opportunity for the careful planner or could be a pitfall for the unwary. Advisors can choose what variation to provide for their clients.