Partnership interest recapitalization avoids S corporation built-in gains tax

Plain-English summary

An S corporation owned all preferred interests in a limited liability company taxed as a partnership and proposed converting them into common interests. It represented that the exchanged interests would have equal fair market value, the conversion would not shift ownership of the partnership's capital, and no liability shift would cause a deemed distribution above basis. The IRS ruled that the S corporation would recognize no gain or loss from the conversion. Because there was no recognized gain, the transaction would not trigger entity-level built-in gains tax under IRC § 1374 during the corporation's recognition period.

Ruling snapshot

• Question: Will converting preferred partnership interests into common interests create recognized gain and built-in gains tax for the S corporation?
• Outcome: Approved. The conversion produced no recognized gain or loss and no IRC § 1374 tax.
• Key authorities: IRC § 1374(a), (d)(2), (d)(3), (d)(7); Treas. Reg. § 1.1374-4(a)(1)

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201722008 Third Party Communication: None
Release Date: 6/2/2017 Date of Communication: Not Applicable
Index Number: 1374.00-00 Person To Contact:

---------------------- --------------------, ID No. ------------------
Telephone Number:

-------------------------------------------- -------- --------------
Refer Reply To:

------------------------------------- CC:PSI:03
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                                                           Date:
                                                           February 22, 2017

X = ----------------------------------------

Y = -------------------------------------------

Date = ----------------------

State = --------------

Dear ------------------

  This letter responds to a letter dated August 23, 2016, submitted on behalf of X,

requesting a ruling under section 1374 of the Internal Revenue Code (Code).

                                                 FACTS

   The information submitted states that X is a State corporation that elected to be a

subchapter S corporation effective Date. X owns a controlling interest in Y, a State
limited liability company that is classified as a partnership for Federal income tax
purposes. Y has both preferred and common membership interests outstanding. X
currently owns all of the preferred interests while other members own the common
interests.

   Y proposes to undertake a recapitalization under which X would convert its

preferred interests in Y to common interests. X represents that (1) the fair market value
of the preferred interests will equal the fair market value of the common interests to be
received in the conversion, (2) there will not be a shift in the ownership of the capital of
Y associated with the conversion, and (3) the recapitalization will not result in a deemed
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distribution in excess of basis as a result of any change in any member’s share of Y’s
liabilities.
X requests a ruling that no gain or loss will be recognized by X as a result of the
conversion of its interest in Y during the recognition period under section 1374(d)(7) and
X will therefore not be subject to tax under section 1374(a).

                              LAW AND ANALYSIS

   Section 1374(a) provides that if for any taxable year beginning in the recognition

period an S corporation has a net recognized built-in gain, there is imposed a tax
(computed under section 1374(b)) on the income of such corporation for such taxable
year.

    Section 1374(d)(2) provides that the term “net recognized built-in gain” means,

with respect to any taxable year in the recognition period, the lesser of (i) the amount
which would be the taxable income of the S corporation for such taxable year if only
recognized built-in gains and recognized built-in losses were taken into account, or
(ii) such corporation's taxable income for such taxable year (determined as provided in
section 1375(b)(1)(B)).

   Section 1374(d)(3) provides that the term “recognized built-in gain” means any

gain recognized during the recognition period on the disposition of any asset except to
the extent that the S corporation establishes that (A) such asset was not held by the S
corporation as of the beginning of the 1st taxable year for which it was an S corporation,
or (B) such gain exceeds the excess (if any) of (i) the fair market value of such asset as
of the beginning of such 1st taxable year, over (ii) the adjusted basis of the asset as of
such time.

  Section 1.1374-4(a)(1) of the Income Tax Regulations provides that section

1374(d)(3) applies to any gain or loss recognized during the recognition period in a
transaction treated as a sale or exchange for Federal income tax purposes.

   Section 1374(d)(7) provides that the term “recognition period” means the 5-year

period beginning with the first day of the first taxable year for which the corporation was
an S corporation.

                                  CONCLUSION

   Based solely on the information submitted and representations made, we

conclude that no gain or loss will be recognized by X as a result of the conversion of its
interest in Y. Accordingly, no entity level tax under section 1374 will be imposed on X
as a result of the conversion.
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   Except as specifically ruled above, we express or imply no opinion concerning

the Federal tax consequences of the transaction described above under any other
provision of the Code.

  This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of

the Code provides that it may not be used or cited as precedent.

   The ruling contained in this letter is based upon information and representations

submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the ruling request, it is subject to verification on examination.

   In accordance with a power of attorney on file with this office, a copy of this letter

is being sent to X’s authorized representative.

                                              Sincerely,



                                              Holly Porter
                                              Chief, Branch 3
                                              Office of Associate Chief Counsel
                                              (Passthroughs & Special Industries)

Enclosures (2):
Copy of this letter
Copy for § 6110 purposes