In brief

On 15 September 2023, the IRS released private letter ruling 202337007 (PLR). The PLR provides that a conversion of an entity disregarded for federal income tax purposes into a domestic corporation does not, by itself, give rise to a deemed exchange of debt.

Background

For US federal income tax purposes, the significant modification of a debt instrument can give rise to taxable gain or loss. Section 1001 generally provides for recognition of gain or loss upon the “sale or other disposition” of property. Treas. Reg. § 1.1001-1(a) provides that an “exchange” of property for other property “differing materially either in kind or in extent” can give rise to income or loss. For this purpose, under Treas. Reg. § 1.1001-3(b), a “significant modification” of a debt instrument results in an exchange of the original debt instrument for a modified instrument.

It has been a matter of debate whether a conversion of an entity for tax purposes results in a “significant modification.” Under Treas. Reg. § 1.1001-3(e)(4)(i)(A), with certain exceptions, the substitution of a “new obligor” on a recourse debt instrument is considered a significant modification of that debt instrument. The section 1001 regulations do not clarify with precision whether the conversion of an entity for tax purposes, even without otherwise modifying debt held by such an entity, is a substitution of a new obligor and, thus, a significant modification of debt.

The New York State Bar Association (NYSBA) has noted the above ambiguity with respect to disregarded entities in its Report No. 1383. Disregarded entities may change tax classifications with no state law impact at all. Consequently, for state law purposes, the legal terms and rights of any debt owed by the disregarded entity would remain unchanged. However, for federal income tax purposes, the entity moves from being disregarded to regarded and intuitively would seem to be a “new” obligor. Additionally, a new taxpayer—the new regarded entity—would claim any interest deductions instead of the disregarded entity’s sole owner. The NYSBA described this dichotomy as a “fundamental contradiction” that exists between federal income tax law and state law. The NYSBA proposed two solutions to this dichotomy: the “Legal Rights” approach and the “Tax Status” approach.

Under the “Legal Rights” approach, no tax realization event results from a transaction in which there has been no substantive change under state law to creditors’ rights. This approach is supported by two notions. First, section 1001 is a rule which applies to holders of property, and whether an exchange of property is material in kind or extent should by determined with reference to the effects of the holders of that property, i.e., the holders of the debt. Pursuant to Cottage Savings, this is determined with reference to whether the rights and powers of the holders of the debt have changed. Second, the Legal Rights approach serves the policy goal of preventing sudden and unanticipated tax consequences arising from events with no legal or economic significance.

Conversely, under the “Tax Status” approach, a conversion from a disregarded entity into a regarded entity (or vice versa) would create a new obligor in recognition of the fact that a different taxpayer is entitled to take interest deductions. This approach is focused on treating disregarded entities consistently, i.e., disregarded entities remain disregarded for all purposes of the Code. Further, it is consistent with the notion that changing tax classification always lacks economic effect—it is entirely a matter of federal income tax law. Thus, triggering tax effects for a transaction which lacks economic effects is not a concern.

Proposed transaction

This issue was squarely faced by the taxpayer in the PLR. The taxpayer wanted to perform the type of conversion considered by the NYSBA: the conversion of a disregarded entity into a regarded entity without otherwise modifying the debt held by that entity for state law purposes.

The taxpayer in the PLR owned a chain of entities, at the bottom of which was LLC 1. LLC 1 was a disregarded entity wholly owned by LLC 2. LLC 2 itself was a disregarded entity wholly owned by LLC 3. For federal income tax purposes, LLC 3 was classified as a partnership. LLC 3 was partially owned by LLC 4 and a third party. LLC 4, in turn, was also classified as a partnership. LLC 4 was partially owned by Subsidiary 1, which was treated as a corporation for federal income tax purposes. LLC 4 was also partially owned by a third party. Subsidiary 1 was wholly owned by Parent, which was classified as a corporation for federal income tax purposes.

The debt at issue in the PLR was owed by LLC 1. LLC 1 owed debt to third parties, and this debt was recourse to LLC 1. The debt was guaranteed by LLC 2 and the domestic subsidiaries of LLC 1, and was secured by substantially all of the assets of LLC 1 and the guarantors.

The taxpayer proposed to reorganize the above structure with a three-step transaction. Under the first step, LLC 3 would redeem its third-party owner. Consequently, LLC 3 would become wholly owned by LLC 4 and convert from a partnership to a disregarded entity. Under the second step, LLC 4 would also redeem its third-party owner. LLC 4 would thus become wholly owned by Subsidiary 1 and convert from a partnership to a disregarded entity. Under the third step, LLC 1 would convert from a disregarded entity into a domestic corporation (“Subsidiary 2”). Immediately after LLC 1’s conversion into Subsidiary 2, the assets and liabilities of Subsidiary 2 would be identical to the assets and liabilities of LLC 1.

No step would change the yield on LLC 1’s debt (as computed under Treas. Reg. § 1.1001-3(e)(2)(iii)). Further, no step would change LLC 1’s debt payment timing, co-obligors or guarantors for state law purposes, priority, collateral, security, or legal rights or obligations.

The proposed transaction presented a potential problem for the taxpayer. LLC 1 was a disregarded entity which owed debt. As LLC 1 was disregarded for federal income tax purposes, LLC 1 could not claim interest deductions for that debt; instead, its first regarded owner, LLC 3, could claim those deductions. The proposed transaction would change this relationship. LLC 1 would convert from a disregarded entity into Subsidiary 2, a regarded entity. LLC 3, itself, would convert into a disregarded entity, and could not claim interest deductions for debt owed by a regarded subsidiary corporation. If this change in relationship resulted in a “new obligor,” then there could be a significant modification to the debt held by LLC 1 and, consequently, a taxable event for the taxpayer.

Law and analysis

The IRS began its analysis with a discussion of the rules regarding the significant modification of debt. As discussed above, a significant modification of a debt instrument can give rise to a deemed exchange of that debt instrument. In turn, that can trigger taxable gain or loss. However, for a significant modification to give rise to such gain or loss, it must first be a modification. Treas. Reg. § 1.1001-3(c)(1)(i) provides that a “modification” means any alteration, including any deletion or addition, in whole or in part, of a legal right or obligation of the issuer or a holder of a debt instrument, whether the alteration is evidenced by an express agreement (oral or written), conduct of the parties, or otherwise. The threshold question then was whether the conversion of LLC 1 into Subsidiary 2 was an alteration to LLC 1’s debt at all.

Relevant state law provided that the proposed transaction would not change any creditor rights or debtor obligations of LLC 1’s debt. Under the state law of the entities involved in the proposed reorganization, a conversion of an entity into a domestic corporation did not affect the obligations or liabilities of the converting entity. Further, the domestic corporation was deemed to be the same entity as the converting entity, and all rights of creditors or liens upon property regarding the converting entity would be preserved unimpaired. All debts, liabilities, and duties of the converting entity remained attached to the domestic corporation and may be enforced against it as if the domestic corporation incurred such liabilities.

The IRS determined, pursuant to Aquilino v. United States, 363 US 509, 513 (1930), and Morgan v. Commissioner, 309 US 78, 82 (1940), that federal tax law generally looks to state law to determine legal entitlements to property. The legal rights or obligations of a debt instrument that can be changed such as to create a “modification” are legal rights or obligations under state law.

Consequently, the IRS determined that the proposed transaction would not significantly modify LLC 1’s debt. Under relevant state law, the rights of Subsidiary 2’s creditors with respect to payment and remedies would be identical to their rights against LLC 1. Similarly, Subsidiary 2’s obligations to those creditors would be identical to the obligations of LLC 1. This led the IRS to determine that there was no substitution of an obligor or change in the recourse nature of LLC 1’s debt. Absent other facts, this meant LLC 1’s conversion did not create a significant modification because there was no modification at all.

Takeaway

The PLR provides tax practitioners greater clarity on the IRS’s view regarding the contested tax effects of an otherwise routine transaction. Previous IRS guidance on this issue has been contradictory, and though non-precedential, the PLR helps clear the air on the effect of a tax conversion on the deemed debt-for-debt exchange rules. Taxpayers can now stand on firmer ground when taking the position that moving from one form of tax entity to another will not necessarily cause a deemed exchange of debt with attendant tax consequences.

The IRS’s position in the PLR seems to lend support to the “Legal Rights” approach presented by the NYSBA. The IRS’s analysis and conclusion was underpinned by the proposed transaction’s lack of change to the state legal rights and obligations of LLC 1’s debt. This focus on state law rights and obligations is precisely what the Legal Rights approach advocates. By contrast, the Tax Status approach could have resulted in a significant modification, and thus a taxable event, because Subsidiary 2 would have been a new obligor of LLC 1’s debt.

Additionally, the PLR is notable for its reliance on state law generally speaking. Specifically, the PLR noted that the legal rights and obligations referred to in Treas. Reg. § 1.1001-3(c) are rights and obligations as determined under state law. This runs against the general theme of the Code that federal law, not state law, governs the tax treatment of transactions, but also might be limited in scope given the specific reference to “legal” rights in the regulation.