Page 514 - TaxAdviser_2022

LLCs & LLPs

able to demonstrate that the circum- though under state law an LLC’s equity
The failure to review stances surrounding its invalid elec- ownership is normally represented by a
tion were inadvertent and unintended.
membership interest.20
the operating Hence, the IRS granted relief. Whether a transferor recognizes gain
agreement Reason 2: Potential gain or loss upon a transfer or contribution
for provisions recognition at time of of assets to a corporation is governed
by Sec. 351 and Sec. 357.21 Sec. 351
incompatible with election provides that no gain or loss is recog-
Subchapter S The second reason why LLCs should nized (to a transferor(s)) if property is
think carefully before electing to be S
transferred to a corporation solely in
can result in the corporations is that an S election can exchange for stock in the corporation
termination of the result in gain recognition at the time if immediately after the exchange, the
transferor(s) are in “control” of the cor-
of the election. The tax treatment of
S election. a change in classification of an entity poration.22 Unlike a transfer of property
for federal tax purposes by making an to an existing corporation where the
entity classification election is “deter- transferor may not be in control of the
An LLC that determines that its S mined under all relevant provisions of corporation immediately after the trans-
election was terminated due to a defec- the Internal Revenue Code and general fer (and, hence, Sec. 351 would not apply
tive operating agreement may avail principles of tax law, including the step and gain or loss could be recognized), an
itself of the inadvertent termination transaction doctrine.”16 S election by an LLC should not theo-
relief of Sec. 1362(f). The request for If an LLC classified as a partnership retically present the same 80% control
relief is in the form of a private ruling elects to be classified as an “association” issue. In case of an LLC treated as a
request to the IRS national office and (the term the relevant regulations use partnership, the partnership should be in
requires a significant user fee be paid.15 for an S corporation),17 the LLC is control of the S corporation immediately
For example, in IRS Letter Ruling treated as though it has contributed its after the deemed transfer of property.
202111011, an LLC that elected S sta- assets to an association in exchange for In the case of an LLC entity treated as
tus applied for inadvertent termination stock in the association. Immediately a disregarded entity, the member of the
relief under Sec. 1362(f). The LLC’s after the deemed contribution, the LLC should be in control of the S cor-
operating agreement included partner- LLC is deemed to liquidate (for tax poration immediately after the deemed
ship provisions that failed to provide purposes only) and distribute the stock transfer of property.
identical distribution and liquidation of the association to its members.18 Gain, but not loss, is recognized to
rights to its members. The operating If an LLC classified as a disregarded the transferor(s) if money or other prop-
agreement required the LLC to make entity elects to be classified as an as- erty (“boot”) is received in the exchange
liquidating distributions to its members sociation, the member of the LLC is in addition to stock of the transferee
in accordance with the members’ posi- deemed to contribute all of the assets corporation.23 Because this is an elec-
tive balances in their capital accounts and liabilities to the association in tion with a deemed exchange and not
rather than in proportion to their exchange for stock in the association.19 an actual exchange, it may be difficult
membership interests. The LLC was The regulations refer to “stock” even to conceive of a situation involving an

15. Regs. Sec. 1.1362-4(c). See the first issued revenue procedure of the year 19. Regs. Sec. 301.7701-3(g)(1)(iv).
for the list of user fees, e.g., Rev. Proc. 2022-1. 20. “The term ‘stock’ includes shares in an association, joint-stock company, or
16. Regs. Sec. 301.7701-3(g)(2)(i). insurance company” (Sec. 7701(a)(7)).
17. See Regs. Sec. 301.7701-2(b)(2). See also Sec. 7701(a)(3), which provides 21. For purposes of this article, it is assumed that the entity is not an investment
that “[t]he term ‘corporation’ includes associations, joint-stock companies, company as defined in Sec. 351(e).
and insurance companies.” 22. Sec. 351(a). “Control” is defined as “ownership of stock possessing at least
18. Regs. Sec. 301.7701-3(g)(1)(i). The tax effects of the deemed liquidation 80 percent of the total combined voting power of all classes of stock entitled
would need to be considered. For example, in the partnership context, to vote and at least 80 percent of the total number of shares of all other
if there is LLC debt that is deemed relieved and is treated as a deemed classes of stock of the corporation” (Sec. 368(c)).
distribution of money to the members under Sec. 752, gain at the member 23. Sec. 351(b).
level could be recognized under Sec. 731(a)(1) if the deemed cash exceeds
a member’s tax basis of its membership interest.

28 October 2022 The Tax Adviser