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Sec. 357(c) and single-member LLCs or QSSSs.

Sec. 357(c) provides an exception to gain nonrecognition in certain types of otherwise tax-free property transfers, such as Sec. 351 property transfers and D reorganizations (including acquisitive Ds in conjunction with Sec. 354). If Sec. 357(c) applies, it requires the transferor of property to recognize gain, to the extent the liabilities assumed plus the liabilities to which the property transferred is subject exceed the basis of the property transferred.

Sec. 357(c) also operates as a trap for the unwary. A merger of a corporation into a brother-sister corporation or a downstream merger of a parent corporation into a subsidiary may be a D reorganization (in addition to being an A reorganization); accordingly, Sec. 357(c) may apply.

The Sec. 357(c) "trap" may now have been expanded by the introduction into the tax law of the elective treatment of single-member limited liability companies (LLCs) under the "check-the-box" regulations and qualified subchapter S subsidiaries (QSSSs). If a single-member LLC chooses to be disregarded as an entity separate from its owner or an S corporation makes a QSSS election for an eligible subsidiary, the LLC or QSSS is treated as having distributed all of its assets and liabilities to its owner in liquidation; see Prop. Regs. Sec. 301.7701-3(g)(1)(iii) and the House Committee Report to the Small Business job Protection Act of 1996. If an existing C or S corporation acquires in a tax-free acquisition the entire membership interest of an LLC, which then elects to be disregarded as an entity separate from its owner, or if an existing S corporation acquires all of the outstanding stock of a C or S corporation in a tax-free acquisition and makes a QSSS election for the acquired corporation, under the step-transaction doctrine the acquisition of the entity followed by the deemed liquidation is treated as a direct acquisition of assets (see, e.g., Rev. Rul. 67-274). Accordingly, if the acquiring and acquired entities are under common ownership, an election by an acquired LLC to be disregarded or a QSSS election of an acquired corporation would constitute a tax-free property transfer under Sec. 351 or pursuant to a D reorganization, triggering Sec. 357(c).

In Prop. Regs. Sec. 301.7701-3(g)(2), the IRS has tentatively concluded that the step-transaction doctrine applies to elective entity classification changes:


The tax treatment of a change in the classification of an entity for federal tax purposes by election tinder paragraph (c)(1)(i) of this section is determined under all relevant provisions of the Internal Revenue Code and general principles of tax law, including the step transaction doctrine.

As of the date of this writing, proposed QSSS regulations have not been issued. However, the IRS National Office has recently indicated that the QSSS proposed regulations will be released within the next few weeks and are likely to follow the rules on the step-transaction doctrine included in the proposed amendments to the check-the-box regulations. (The AICPA has argued against this position in, comments submitted to the Service.)

Thus, Sec. 357(c) must be considered when planning the acquisition of an LLC or S corporation by a corporation with common ownership if, after the acquisition, the LLC will elect to be disregarded or a QSSS election will be made.
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Title Annotation:Internal Revenue Code s. 357(c), limited liability companies, qualified Subchapter S subsidiaries
Author:Luchs, Lorin D.
Publication:The Tax Adviser
Article Type:Brief Article
Date:May 1, 1998
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