Category: Partnerships & LLCs; Corporations
Subject: Conversion of S Corporation to LLC
Title: Basis of Assets Contributed to Newly-Formed LLC
IRC Sections: 336(b), 723, 334, 7701(g)
Filename: 1137.html
Date Produced: 2/96

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Background
Taxpayer,TP, is an S corporation. For various reasons, management wants to convert to the limited liability company form of doing business. In essence, the conversion requires liquidation of the S corporation in conjunction with a transfer of the former S corporation assets to a newly-formed LLC.

TP has assets with tax basis of $64,000 and outstanding debt of $379,000. On liquidation, Section 336(b) will require recognition of income at the corporation level as if TP's assets were worth at least the amount of its liabilities, $379,000.

I assume that the debt in question is to non-shareholders, and I assume further that the debt must be (or will be ) assumed be the liquidating shareholders.

Issue
What is the basis of the assets contributed to the newly-formed LLC?

Answer
The basis of the assets contributed to the LLC will be fair market value of those assets without regard to Section 336(b); in essence, there is no step-up for debt assumed in excess of the real fair market value of the assets.

Discussion
A properly formed LLC is treated as a partnership. Since the basis of assets contributed to a partnership carries over under Section 723, the issue here is merely determination of the basis of the liquidated assets in the hands of TP's former shareholders.

The basis of assets distributed in corporate liquidation is determined under Section 334 which provides simply that the basis of such assets in the hands of the distributee is fair market value. The issue becomes whether or not fair market value for purposes of Section 334 is affected by the minimum fair market value rule of Section 336(b). It is clear that the scope of Section 336(b) is limited and by its terms does not affect other Code Sections such as Section 334. Section 336(b) provides in part ..."for purposes of subsection (a) and section 337, the fair market value of such property shall be treated as not less than the amount of such liability." [Emphasis added.] This narrowly-defined scope as set forth in the statute precludes the application of the rule to basis determinations under Section 334. Accordingly, the minimum fair market value rule as set forth in Section 336(b) affects only that section and cannot have the same effect on the operation of Section 334.

Apparently, there seems to be no other provision of law that produces a step up in basis. In the case of Ford v. U.S., 311 F2d 951, 63-1 USTC ¶9193, (CtCls, 1963), which predates Section 336(b), the taxpayer was denied an increase in basis of liquidated assets for liabilities assumed in connection with the corporate liquidation. In addition, Section 7701(g) provides a generally applicable counterpart to Section 336(b). Section 7701(g) provides as follows.

For purposes of Subtitle A, in determining the amount of gain or loss (or deemed gain or loss) with respect to any property, the fair market value of such property shall be treated as being not less than the amount of any nonrecourse indebtedness to which the property is subject.

Note that the scope of Section 7701(g) is limited to determinations of gain or loss which is not at issue when deciding the basis of property distributed in liquidation. In addition, per the Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1984 [the source of Section 7701(g)], Section 7701(g) is not intended to affect the other party's basis (i.e., the buyer) in a sale or exchange subject to Section 1001.

Important Collateral Matter
It seems to me that since the basis of the assets distributed to TP's shareholders is not stepped up to include assumed debt, a further transfer of those assets subject to the debt to a newly formed LLC would potentially give rise to gain to the contributors by virtue of Section 752.Alternative Point of View
I assume that the amount of assets set forth above, some $64,000, represents only tangible assets. Is there something else such, something intangible such as goodwill, patents, formulas, secret processes, research in progress, etc., that has value? It seems logical to me that there must be something, otherwise why don't the parties just walk away?

If there is something else that has value, that could mitigate both the basis issue as well as the gain on contribution to the LLC. Clearly, the taxpayer in the case would bear the burden of proving the value of any intangibles that may or may not exist; however, this may be an avenue to explore with the client.