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ALTHOUGH THE CHECK-THE-BOX (“CTB”) regulations and the qualified subchapter S sub- sidiary elections provide many planning oppor- tunities for taxpayers, recent regulatory changes can cause certain transactions with respect to a disregarded entity or a qualified subchapter S corporation (“QSub”) to have surprising tax re- sults. This article examines some of the surpris- es that can occur if a taxpayer sells an interest in a disregarded entity or a QSub without fully un- derstanding the tax consequences of that sale. CTB REGULATIONS • The CTB regulations became effective on January 1, 1997, and greatly simplified the classification of business entities for U.S. federal tax purposes. These regulations allow certain entities—most notably in the do- 5 Gregory Walkauskas has an LL.M. from New York University and is of counsel to Rose, Schmidt, Hasley & DiSalle, P.C. He is a past Chairman of the Allegheny County Bar Association Tax Section. Some Potential Tax Problems Resulting from Sales of Disregarded Entities and QSubs Gregory Walkauskas Disregarded entities can cause some nasty surprises for unwary taxpayers and their counsel. mestic arena, a limited liability company (“LLC”)—to be disregarded entities or associa- tions taxed as corporations for U.S. federal tax purposes. If the disregarded entity has one member, it will be treated as a division or branch if it is owned by a corporation, and it will be treated as a sole proprietorship if it is owned by an individual. If the disregarded entity has more than one member, it will be treated as a partnership for U.S. federal tax purposes. Similarly, corporations that own 100 percent of the stock of another corporation that would be an S corporation if its stock were owned di- rectly by the shareholders of the S corporation parent may elect to treat the subsidiary as a QSub. §1361(b)(3)(B). A valid QSub election will result in the separate existence of the QSub being ignored for U.S. federal tax purposes. The subsidiary is treated as liquidated into the S cor- poration parent tax-free under sections 332 and 337. Therefore, it becomes a division of the S corporation parent. §1361(b)(3)(A). (All section references are to the Internal Revenue Code un- less otherwise indicated.) On November 29, 1999, CTB regulations be- came effective that addressed the U.S. federal tax consequences of changes in the number of members of an entity and changes to the classi- fication of an entity. On April 22, 1998, the Internal Revenue Service issued proposed regu- lations with respect to QSubs under sections 1361 and 1362. These regulations were adopted on January 21, 2000. As a result of these regula- tions, the sale of a disregarded entity or a QSub can result in some surprises. DISREGARDED ENTITIES • If a taxpayer owns 100 percent of a disregarded entity (other than a QSub) and sells part of its interest in the disregarded entity, for example 21 percent, that sale is treated in the following manner. The tax- payer is treated as if it sold an undivided 21 per- cent interest in the assets owned by the disre- garded entity to the buyer. The taxpayer and the buyer are then treated as if they transferred the assets owned by the disregarded entity to a partnership in exchange for interests in the part- nership. The taxpayer would be taxed on any gain (and could deduct any loss, subject to cer- tain antideduction provisions such as section 267) as a result of the sale of the undivided in- terest in 21 percent of the assets. There would be no taxable event with respect to the other 79 percent of the assets owned by the disregarded entity. The deemed transfer of those assets to a partnership for an interest in the partnership should be tax-free under section 721. Rev. Rul. 99-5, 1999-1 C.B. 434. Example: The Disregarded LLC For example, A, an individual, owns 100 per- cent of an LLC worth $5,000 that owns only cap- ital assets and that is being treated as a disre- garded entity for U.S. federal tax purposes. On January 1, 2001, Asold 21 percent of this interest to B, an unrelated individual, for $1,050. This sale will be treated as a sale by A of an undivid- ed interest in each of the assets of the LLC. If the total tax basis of all of the assets is $1,000, the tax basis of 21 percent would be $210. A will have a gain of $840 ($1,050 selling price, less $210 tax basis). A and B would then be treated as con- tributing their respective interests to the LLC, which is now a partnership. This deemed trans- fer should be tax-free under section 721. The LLC will have a tax basis equal to the tax basis of the property in the hands of the transferors of $1,840 (B’s cost basis of $1,050, plus A’s basis of $790 ($1,000 .79)). §723. The contributing part- ners will have a basis in their respective inter- 6 The Practical Tax Lawyer Winter 2001 Sales of Disregarded Entities and QSubs 7 ests in the partnership equal to the deemed basis of the property the partners contributed. §722. Therefore, A’s basis in the partnership would be $790 and B’s basis in the partnership would be $1,050. This tax result is logical and should afford no surprises to the parties, especially A. A should expect to pay tax on any gain on the sale of 21 percent of the property owned by the LLC. Deemed Exchange and Sale of Corporate Stock However, what if A sold a 21 percent interest in the LLC to B on January 1, 2001, and A and B made a CTB election, effective January 1, 2001, to treat the LLC as a corporation for U.S. feder- al tax purposes? The tax treatment of combining the sale of the interest with a CTB election to treat the LLC as a corporation for U.S. federal tax purposes may surprise A and B: A is treated as if A transferred all of the assets owned by the LLC to a corporation in exchange for stock, and as part of the same transaction Asold 21 percent of the stock to B. The CTB regulations incorpo- rate the effect of the step-transaction doctrine into a transaction whenever an entity is reclassi- fied. Treas. Reg. §301.7701-3(g). Consequently, A’s deemed transfer of the assets to the LLC that is treated as a corporation for federal tax pur- poses for all of the interest in the LLC results in a busted section 351 transfer since, as a result of selling 21 percent of the interest in the LLC, A does not meet the “80 percent control immedi- ately after” requirement of section 351. The tax result to A is gain on the deemed transfer of all of the assets owned by the LLC, not just 21 percent of the assets. The amount of this gain would be $4,000 ($5,000 value of the 100 percent interest of the LLC, less $1,000 tax basis of all of the assets owned by the LLC). The tax basis to the LLC of the assets would be $5,000 under section 1012. A would not have any further gain on the sale of the 21 percent in- terest and A’s basis in this 79 percent interest in the LLC would be $3,950 ($5,000 .79). B’s basis in its interest in the LLC would be $1,050. Treas. Reg. §301.7701-3(f)(4), Example 1. Avoiding the CTB Election If A is properly informed, A would not allow the CTB election where he owns less than 80 percent of the entity. (If A and B wanted an im- mediate change in the classification of the LLC to a corporation, the transaction could be struc- tured by B contributing assets to the LLC for an interest in the LLC and, therefore, B would be part of the transferor group. For example, B would contribute cash to the LLC for a 21 per- cent interest in the LLC.) However, if A sells more than 50 percent of A’s interest in the LLC and B has control of the LLC, perhaps B could unilaterally cause the LLC to make the election on the date of the sale with the resulting detri- ment to A. Obviously, A, if informed, would want a clause in the sales contract prohibiting such an election. Conversely, if the LLC owns assets with built-in losses, A may want the deemed transfer to the association to be a tax- able event if he can avoid section 267 and he wants the built-in loss recognized now. QSUBs • If an S corporation owns 100 percent of the stock of a qualifying corporation, the S corporation can elect to treat the subsidiary as a QSub. The QSub’s separate existence is disre- garded and the QSub is treated as a division of the S corporation. §1361(b)(3)(A). However, once the QSub is no longer a qualifying corpo- ration, for example if the S corporation does not own 100 percent of the stock of the subsidiary, then the QSub is treated as a new corporation acquiring all of its assets, and assuming all of its
