In a ruling that could afford significant benefits where a New York City unincorporated business is sold, the New York  City Department of Finance has ruled that gain from the sales of membership interests in a limited liability company (“LLC”) that is subject to the New York City unincorporated business tax (“UBT”), but which are carried out as a merger transaction, will not result in gain to the LLC for UBT purposes.  Finance Letter Ruling, FLR 12-4946 (N.Y.C. Dep’t of Fin., Apr. 15, 2014).

Facts.   The LLC provides IT management and technology solutions in New York City for the hospitality business.  It is taxable as a partnership and subject to the UBT.  Its members, mostly individuals, will sell 100% of their membership interests at a gain to a corporate purchaser (“Purchaser”).  However, the sales will be structured as a single merger of the Purchaser’s wholly owned subsidiary (“Merger Sub”) into the LLC, and will be carried out pursuant to the Delaware Limited Liability Company Act and the Delaware General Corporation Law.  The reason given  for structuring the transaction as a merger, rather than as direct purchases of the members’ respective interests, is to avoid having to obtain signatures from every LLC member. For federal income tax purposes, the transaction is treated as the sale of LLC interests by each member, but the Purchaser will treat it as the acquisition of assets from the LLC.  The business of the LLC — which will now be solely owned by the Purchaser — will continue after the transaction.

The question presented was whether the gain on the transaction would be considered income of the LLC for UBT purposes.  The Department ruled that it would not be, concluding that although structured as a merger of Merger Sub into the LLC, the Department would apply substance over form and treat it as a sale of partnership interests by the individual members.

The Department first determined that the substance of the transaction is the sale of partnership interests, since after the transaction the Purchaser will be the sole owner of the LLC.  Under IRC § 741, gain or loss on the sale or exchange of a partnership interest is recognized by the transferor partner.  The ruling notes that the facts presented are “more complicated,” however, because the merger will result in the complete termination of the LLC, which had been taxable as a partnership.  The Department relied on Revenue Ruling 99-6, where the IRS ruled that partners who sold their interests to a single buyer should be treated as having sold their partnership interests, even though from the buyer’s perspective there has been a sale of partnership assets. According to the Department, the critical fact is that the federal tax precedent does not suggest that the sale should be treated as a sale by the LLC itself.

The ruling then addresses the question of whether the gain is includable in the LLC’s unincorporated business taxable income.  The computation of unincorporated business taxable income starts with “unincorporated business gross income,” which is defined, in part, as “the sum of the items of income and gain of the business . . . includible in gross income for the taxable year for federal purposes, including income and gain . . . from the liquidation of the business.” Admin. Code §11-506(a) (emphasis added).  According to  the Department, since unincorporated business gross income is limited to the amount includable as gross income for federal tax purposes — and for federal purposes, the sale of member interests does not give rise to partnership income to the LLC — the resulting gain will not be subject to UBT.

Additional Insights

Although letter rulings are only binding on the Department with respect to the named requester, this letter ruling is noteworthy in several respects.  First, the Department applies substance over form in analyzing the transaction to the taxpayer’s benefit, rather than taking the position that the taxpayer is bound by the form of the transaction (in this case, as a merger transaction).  Second, the ruling confirms that for UBT purposes, the Department will only require  the inclusion of income that is includable in the taxpayer’s income for federal income tax purposes. Although the ruling does not recite it as a fact, it is assumed that the gain was not reported on the LLC’s Federal Form 1065, Schedule K.

It is also significant that the Department adopted an interpretation that results in the gain not being taxed at all under the UBT (the individual members of the LLC are not subject to the UBT), and in the LLC’s assets getting a stepped-up basis in the hands of the Purchaser.

Finally, the ruling appears to confirm that the statutory  language limiting unincorporated business gross income to income “includible in gross income . . . for federal purposes” will trump the language in the same code section (§11-506(a)) that requires the inclusion of income and gain “from the liquidation of the business,” which might have been triggered, since the partnership did terminate as a result of the transaction.