Entity’s Debt Is Not Modified Upon Conversion to Corporation, IRS Rules

In a recent private letter ruling (PLR 202337007), the IRS ruled that a taxpayer’s proposed transaction that would convert a limited liability company (LLC) that is treated as a disregarded entity into a subsidiary corporation of a consolidated group would not result in a modification of the debt issued by the LLC under Reg. §1.1001-3.

The IRS’s analysis in the ruling, while non-precedential, helps to resolve some confusion over the IRS’s position on the issue of whether similar entity changes would result in modifications of debt issued by the converting entity under the regulations. 

Entities, Existing Debt, and Proposed Transaction

Through a series of intermediary entities, Parent corporation partly owns LLC1. More directly, LLC1 is wholly owned by LLC2 – another disregarded entity, which, in turn, is wholly owned by LLC3. LLC 3 is owned partly by LLC4 and partly by third-party investors. LLC4, in turn, is owned in part by Sub1, a corporate subsidiary of Parent, and in part by other third-party investors. 

LLC1 has outstanding publicly traded debt, including senior secured notes, three term loans, and unsecured notes. The debt is held by third parties that are unrelated to LLC1, LL2, LLC3, LLC4, Sub1, Parent, or other members of Parent’s consolidated group. The debt is recourse to LLC1. The senior secured notes and term loans are (1) guaranteed by LLC2 and domestic subsidiaries of LLC1 and (2) secured by substantially all the assets of LLC1 and the guarantors.  

The parties propose to undertake a three-step transaction. In step one, LLC3 will redeem its third-party investors’ interests for cash and thereby become wholly owned by LLC4. Step two, LLC2 will likewise redeem its third-party investors’ interests for cash, and it will thereby become wholly owned by Sub1. Step three, LLC1 will convert to a corporation under state law. As a result of this transaction, LLC1 will become a subsidiary corporation (Sub2) of Parent corporation’s consolidated group. Immediately after the transaction, Sub2 will hold all of the same assets (and be subject to the same liabilities) as LLC1 immediately prior to the transaction. 

The proposed transaction would not change the yield to maturity of the debt instruments, timing of payments under the debt instrument, co-obligors or guarantors for state law purposes, priority of the debt instrument, collateral or security for the debt instrument, or otherwise change the legal rights and obligations with respect to the debt instrument. 

Debt Modification Regulations 

Tax consequences can result from a modification of existing debt that is deemed significant under the rules of Reg. §1.1001-3. If the modification constitutes a significant modification under the regulations, the pre-modification debt is deemed to be retired in exchange for newly issued debt. 

A modification includes  “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.”  

With some exceptions, the rules generally treat the substitution of a new obligor on a recourse debt instrument as a significant modification.  A modification that changes the recourse nature of an obligation (for example, from non-recourse to recourse) likewise may result in a significant modification. 

IRS Analysis and Ruling

The ruling focuses on whether the conversion of the issuer from an LLC to a corporation results in a change in the legal rights or obligations under the debt instrument such that the conversion would constitute a “modification” of the debt instrument.    

The IRS explained that federal tax law generally looks to state law to determine legal entitlements, including the legal rights and obligations referred to in Reg. §1.1001-3. Under the applicable state law, the IRS noted, Sub2 will be treated as the same legal entity as LLC1 prior to the conversion. Conversion of LLC1 into the corporation Sub2 will not affect the legal rights or obligations between the debt holders and LLC1/Sub2. The IRS noted that (1) the debt holders’ legal rights against Sub2 with respect to payments and remedies will remain the same as against LLC1 and (2) Sub2’s obligations and covenants will likewise remain the same as LLC1’s.

Having determined that under state law the proposed transaction will not alter the legal rights and obligations of the parties under state law, the IRS concluded the proposed transaction will not result in a modification of the debt under Reg. §1.1001-3. As a result, the proposed transaction will not constitute a modification that results in either a change of obligor or a change in the recourse nature of the debt instrument. 

BDO Insights

The fact pattern addressed in the ruling is analogous to another common fact pattern – a check-the-box election made by an entity that has outstanding indebtedness. The IRS’s analysis in prior (non-precedential) guidance concerning check-the-box elections involving indebtedness has been inconsistent, causing confusion as to whether a check-the-box election that changes the entity regarded for tax purposes as the issuer of the debt (but not the legal issuer of the debt under state law) constitutes a modification for federal income tax purposes. 

Guidance to address this issue is on the IRS’s current Priority Guidance Plan, so additional guidance on this issue may be forthcoming.  In the meantime, although the ruling is not precedential, the approach taken in the ruling is indicative of the IRS’s current view on this issue. Accordingly, the ruling’s conclusion that the determination of whether a modification of a debt instrument has occurred is determined by reference to the legal rights and obligations of the parties under relevant state law may assuage practitioner’s concerns regarding the tax implications of standard check-the-box transactions.  

Taxpayers should be also aware that the ruling does not address the tax implications to parties other than the debt holder. Such transactions may give rise to a number of additional (and very complex) tax implications to the other parties to the transaction that must still be analyzed.