The "check-the-box" regulations1 permit certain eligible entities to elect their classification for U.S. tax purposes. An eligible entity generally can elect to be classified as a corporation, partnership, or disregarded entity simply by filing a form with the Internal Revenue Service (IRS) that states the desired classification. The income tax implications arising from the federal income tax treatment of a classification election however, may not be so simple. On August 18, 2011, the IRS addressed the U.S. federal income tax consequences that resulted when a foreign subsidiary owned in part by a domestic corporation elected to change its classification from a corporation to a partnership at a time when the subsidiary was insolvent.2
This guidance confirms that a parent corporation generally recognizes a loss with respect to its stock on the liquidation of an insolvent subsidiary, provides that no tax consequences should arise with respect to the debt instruments issued by the subsidiary, and provides that the partnership formation transaction should be tax-free. Although these holdings generally represent taxpayer-favorable conclusions in that no current tax is triggered, they are questionable in light of existing authority and fail to address the consequences of subsequent transactions, including repayment of the subsidiary’s indebtedness.
Consequences of Change in Classification
If an eligible entity classified as a corporation elects to change its classification to a partnership, the following is deemed to occur: (1) the corporation distributes all of its assets and liabilities to its shareholders in liquidation; and (2) immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.3 The tax treatment of these steps are determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.4 That is, the tax consequences of an elective change should be identical to the consequences that would have occurred if the taxpayer had actually taken the steps described above.5
This guidance posits the following facts: X, a U.S. corporation, owns 100 percent of Y, a foreign corporation, and 80 percent of Z, a foreign eligible entity currently classified as a corporation for U.S. tax purposes. The remaining 20 percent of Z is owned by Y. X’s basis in its Z stock was $100, and Y’s basis in its Z stock was $30. Z holds assets with a gross asset value of $100, a tax basis of $120, and has issued debt with a face amount of $110. Thus, Z’s liabilities exceed the value of its assets by $10. In Situation 1, Z’s $110 of debt is owed to X. In Situation 2, Z’s $110 of debt is owed to an unrelated third party. In both situations, Z elects to be classified as a partnership for U.S. tax purposes.
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X’s and Y’s Loss
The IRS reasoned that because Z was insolvent at the time of the entity classification election, it was not possible for X or Y to receive any amounts with respect to their Z stock in the deemed liquidation. As such, the IRS concluded that, provided the other requirements for worthless security deductions were satisfied, X and Y would recognize a $100 and $30 loss, respectively (i.e., amounts equal to their basis in the Z stock prior to the effective date of the election).6 This conclusion is consistent with Rev. Rul. 2003-125,7 in which a wholly owned, corporate subsidiary elected to be classified as a disregarded entity. In that ruling, the IRS held that the deemed liquidation of the subsidiary entitled the sole shareholder to a worthless security deduction under Section 165(g).
Z’s Debt Instruments
AM 2011-003 holds that (i) although "significant modifications" to debt instruments can result in a taxable exchange, cancellation of indebtedness income, or bad debt deductions,8 no significant modification occurred under the facts of the guidance, and (ii) because the liabilities survive the deemed liquidation, the entity’s creditors are not entitled to a bad debt deduction9 based solely on the entity classification election. This holding is questionable as applied to Situation 1, where Z is indebted to its 80-percent shareholder X.
The IRS indicated in Rev. Rul. 2003-125 that the deemed liquidation of a subsidiary into a creditor-shareholder results in a partial repayment of the outstanding debt. Following the deemed liquidation resulting from entity classification election (but prior to the partnership formation transaction), all of the creditor position and 80 percent of the debtor position of Z’s obligation to X is held by X. Since one cannot be indebted to itself, this would suggest that the deemed liquidation of Z extinguished at least 80 percent of the $110 debt. Moreover, the IRS’s basis for distinguishing the result in Rev. Rul. 2003-125 (i.e., that "the liabilities survive the deemed liquidation") appears questionable, as the liability deemed satisfied on the deemed liquidation of a owned subsidiary also survives the deemed liquidation under local law; the liability just happens to be issued by an entity that is disregarded for tax purposes. Consequently, the IRS appears to be reaching a result-oriented conclusion to deny a current loss to a U.S. taxpayer.
X’s and Y’s Basis in Distributed Assets
Once Z files its entity classification election, Z is deemed to distribute all of its assets and liabilities to its shareholders in liquidation. Because Z is insolvent, the IRS concluded that the rules for determining a shareholder’s basis upon a corporation’s liquidation do not apply.10 Rather, X and Y are deemed to acquire the assets in exchange for taking Z’s assets subject to Z’s liabilities. In this type of transaction, the basis of assets to the transferee equals the amount paid for the assets, which includes the amount of liabilities to which the transferred property is subject.11 As AM 2011-003 states, "a buyer that takes an asset subject to a seller’s liability is entitled to include the amount of the liability in computing the basis of the asset."
Consequently, the IRS concluded that X’s basis in the assets was $88 (80 percent times $110 of the liability) and Y’s basis in the assets was $22 (20 percent times $110 of the liability). The IRS reached this conclusion notwithstanding that the fair market value of X’s share of the assets was only $80 (80 percent times $100 of value) and Y’s share of the assets was only $20 (20 percent times $100 of value).
Consequences of Partnership Formation
Immediately after Z’s deemed distribution in liquidation, the shareholders are deemed to contribute all of the distributed assets and liabilities to a newly formed partnership.
No Gain or Loss
The IRS’s conclusion that no gain or loss is recognized to any of the parties is questionable. At first blush, one would expect X to be deemed to contribute assets worth $80, with a basis of $88, and subject to debt of $88 and Y to be deemed to contribute assets worth $20, with a basis of $22, and subject to a debt of $22. Thus, it would appear that the Z partnership is paying more by way of liability assumption (liabilities of $110) than it is receiving (assets worth $100). Viewed in this manner, it does not appear possible for either X, Y or the Z partnership to satisfy the provision permitting tax-free formations of partnerships, as this rule only permits nonrecognition treatment where there is a "contribution of property … in exchange for a partnership interest." That is, the "exchange" requirement appears to be lacking because X and Y are not transferring any value to the Z partnership.12 In addition, in Situation 1, X is contributing property in exchange for both a partnership interest (with no value) and a note receivable. Traditionally, a transfer of property to a partnership in exchange for both a partnership interest and other consideration is treated as a sale.13 In this case, sale treatment likely would not have resulted in further tax, as X was deemed to receive a basis equal to its share of the debt. Nevertheless, the IRS appears to be indicating that there is an exception to the "disguised sale" rules where transfers occur by reason of an entity classification election. Such an exception would run afoul of the IRS’s earlier statement that the tax consequences of an elective change should be identical to the consequences that would have occurred if the taxpayer had actually taken the steps set forth in the regulations.
X’s and Y’s Basis in Z Partnership Interests
The IRS noted that Section 752(c) provides that a partnership is only deemed to assume a liability from a contributing partner to the extent that such liability does not exceed the fair market value of the assets that are subject to the liability. As a result, in both Situation 1 and Situation 2, Z is deemed only to assume $100 of liability. This is important because the partnership tax rules provide basis to partners for their share of indebtedness incurred by the partnership.14 As a result, in Situation 1, X’s basis in its Z partnership interest is held to be $108. This represents $88 of basis in assets that carries over to the partnership, minus $80 (80 percent of the $100 liability assumed by Z from X), and the allocation of $100 of the indebtedness back to X. X is allocated 100 percent of the debt in Situation 1 because, as the lender, X is deemed to bear 100 percent of the economic risk of loss with respect to the debt. Y’s basis is $2, which represents $22 of basis in assets that carries over minus $20 of debt relief.
It is not clear why Section 752(c) should apply in this scenario. Although neither the statute nor the Regulations expressly provide, most commentators believe that the market-value limitation of Section 752(c) only affects liabilities that the transferee of the property does not expressly assume.15 It appears difficult to conclude that Z did not assume the $110 of indebtedness, as Z remains indebted after the elective change in classification and neither X nor Y have any liability for the debt. Moreover, in light of the IRS’s reliance on the fact that Z’s liability survives the elective change in classification, it is not clear why the IRS was comfortable with the application of Section 752(c) to X’s and Y’s contribution to Z.
The IRS’s reliance on Section 752(c) also puts X in an unclear position for subsequent transactions. First, the application of Section 752(c) to subsequent sales of a partnership interest acquired in a contribution to which Section 752(c) applied is not clear. The limitation of Section 752(c) does not apply when a partner sells its partnership interest,16 which means that the excess debt is included in the selling partner’s amount realized. Consequently, the selling partner could recognize gain on a subsequent sale if the excess debt is not included in the partner’s basis at the time of the sale. The proper treatment of subsequent repayments of the portion of the liability that exceeds the value of the contributed property is also not clear.17 Similarly, what effect a foreclosure on the partnership’s property would have with respect to the partnership’s determination of gain is not clear with respect to the excess portion of the liability. These issues are not particular to AM 2011-003, but the IRS declined the opportunity to provide meaningful guidance in these areas in the guidance.
Broadly speaking, AM 2011-003 concludes that the elective conversion of an insolvent corporate subsidiary into a partnership results in the recognition of a tax loss for worthless stock, with no income being triggered in the process. This guidance, however, denies bad debt deductions that previously may have been expected to be triggered, and its conclusion that no gain or income is triggered appears questionable. Moreover, the guidance leaves the taxpayer in an unsettled area of the law going forward. It departs from the rule that the fiction of a check-the-box election must mirror the tax consequences of the steps that are deemed to occur. Therefore, while AM 2011-003 provides a useful roadmap in framing the issues involved in determining whether to change an insolvent corporate subsidiary’s U.S. tax classification to a partnership, one must exercise caution before relying upon its conclusions.