How Tax Works – Episode 10

Tax Consequences of Forming, Selling, and Dissolving Partnerships and Disregarded Entities (Rev. Ruls. 99-5 and 99-6)

Host: Matthew Foreman, Co-Chair, Falcon Rappaport & Berkman’s Taxation Practice Group
Release Date: October 15, 2024

Episode Overview

Matthew Foreman leads listeners through the nuances of two fundamental IRS Revenue Rulings—99-5 and 99-6—that clarify the tax consequences of entity conversions between disregarded entities and partnerships. This episode breaks down how income, gain, and basis are allocated when:

• A disregarded entity becomes a partnership
• A partnership collapses into a disregarded entity
  He focuses on practical applications, critical definitions (inside/outside basis, capital accounts), and provides tips for effective structuring. The tone is accessible, conversational, and layered with practical advice.

Key Discussion Points & Insights

1. Context and Relevance of Rev. Ruls. 99-5 and 99-6

• Purpose: These IRS sub-regulatory guidances define mechanical rules for LLCs converting between partnership and disregarded entity status, simplifying what could otherwise require complex structuring and elections.
• Quote:

  "You can disagree with them, you can file differently, but I'm not really sure I'd recommend doing that, especially because they're really, really, really taxpayer friendly." (06:40)

• Applicability: The rules mainly apply to LLCs (not corporations or standard partnerships), topics of increasing importance since LLCs rose to prominence in the 1990s.

2. Fundamental Concepts: Basis and Capital Accounts

• Inside Basis: Partnership’s basis in its underlying assets.
• Outside Basis: Partner’s basis in the partnership interest itself.
• Capital Account: An accounting tool; while not "real," they are described as "the heart and soul of partnership taxation" (14:14).
• Quote:

  "They [capital accounts] really are... an accounting mechanism that exists. If you ever hear me talk about operating agreements... they are actually the heart and soul of partnership taxation." (14:22)

• Takeaway: Accurately tracking these is crucial for proper tax compliance.

3. Detailed Walkthrough: Revenue Ruling 99-5 (Disregarded Entity ➔ Partnership)

• Situation 1 (B Purchases from A):
  • Scenario: Single-member LLC (A) admits another by selling 50% to B.
  • Tax Treatment:
    • Treated as B buying 50% of each asset; A recognizes gain/loss as if selling assets.
    • B gets FMV (fair market value) basis (outside and inside); new holding period starts at purchase.
    • Depreciation/amortization goes fully to B.
  • Quote:

    "You could determine on an asset by asset basis... ordinary income, recapture, capital assets, etc. etc. B gets a fair market value basis in the LLC interest, which is your outside basis." (18:15)

• Situation 2 (B Contributes Cash):
  • Scenario: B contributes $10,000 cash for 50% interest; cash stays in LLC.
  • Tax Treatment:
    • No gain/loss to A (previously sole owner).
    • Outside/inside/capital accounts set at FMV; no hidden sale unless distributed within two years (potential disguised sale).
  • Alert: "Watch out for contributions and then distributions within two years." (25:38)
  • Practical Twist: Structure matters for state sales tax and transfer tax—even though differences are only for income tax purposes at the federal level.

4. Detailed Walkthrough: Revenue Ruling 99-6 (Partnership ➔ Disregarded Entity)

• Situation 1 (A Sells to B):
  • Scenario: Two equal LLC partners, A sells their interest to B.
  • Tax Treatment:
    • A: Recognizes capital gain (except hot assets).
    • B: Treated as liquidating distribution from partnership—gets a step-up in half the asset basis (no 754 election needed).
    • Post-sale: Simple depreciation/amortization, straightforward step-up.
  • Quote:

    "People always ask me... how do you get a step up in basis? That's not how that works. And I say look, you idiot, right? No, but if you make an election under 754..." (39:21)

• Situation 2 (Both Sell to Third Party):
  • Scenario: C and D each sell their interests to unrelated E.
  • Tax Treatment:
    • Sellers: Both recognize capital gains (watch holding period).
    • Buyer: Gets full basis step-up in all assets.
  • Practical Note: Structuring for unrelated parties keeps things simple; related-party deals can have ordinary income or loss recharacterization under other code sections.

5. Structuring Advice and Practical Considerations

• Order of Transactions Matters:
  • "Do we contribute first or do we sell first? How do we want the basis to exist?" (49:08)
• Diagram Everything:
  • "I'm big on transaction diagrams. You haven't done any deals with me, you'll know that I put together a deck every single time..." (53:01)
• State Taxes:
  • Be alert to state-level (sales, transfer, franchise) tax impacts that don't align with federal income tax rules.
• Quote:

  "A lot of times in these transactions you sell and then you contribute because that gets the basis to the buyer. Buyer wants that basis. Buyer wants to re-depreciate a lot of times." (51:16)

Notable Quotes & Memorable Moments

• "99% of them are just a combination of various Parts of subchapter K. 721, 731, 754. And what they do is they basically say, look, you don't have to make extra elections." (09:37)
• "Capital accounts... are actually the heart and soul of partnership taxation." (14:22)
• "I'm just going to say watch out for contributions and then distributions within two years. The presumption is a disguise sale." (25:38)
• On practical challenges:

  "I've seen situations where you have a partnership that one person gets bought out on day one and a new partner comes in on day two... The technical termination rules were repealed...and thankfully we don't have to worry about technical terminations." (21:44)

• "This is an income tax fiction only... Different rules. Because if you think about it for sales tax or for real property transfer tax purposes..." (28:12)
• Light Moment:

  "I wonder who was coming or going. It's... UN week here. So yeah, welcome to New York as a noted philosopher once said." (50:37)

Important Timestamps

| Segment/Topic | Timestamp | |--------------------------------------------------------------------------|--------------| | Introduction & Episode Purpose | 00:00–02:55 | | Explanation of Revenue Rulings as Guidance | 06:40–09:37 | | Basis and Capital Accounts Explained | 13:41–15:39 | | Rev. Rul. 99-5 Situation 1 (Purchase Interest) | 16:42–21:44 | | Rev. Rul. 99-5 Situation 2 (Cash Contribution/Disguised Sale) | 22:24–28:12 | | Rev. Rul. 99-6 Situation 1 (A Sells to B) | 33:07–39:21 | | Rev. Rul. 99-6 Situation 2 (Both Sell to E) | 41:14–45:00 | | Structuring Considerations (Sequence, Basis, Diagrams) | 49:08–53:00 | | Summary & Advice to Read the Rulings | 54:10–56:30 |

Final Takeaways

• IRS Rev. Ruls. 99-5 and 99-6 offer predictable, taxpayer-friendly mechanics for LLC conversions, avoiding unnecessary complexity.
• Understanding inside/outside basis and capital accounts is crucial for correct reporting and maximizing tax benefits.
• State tax issues can differ; always consider broader tax implications.
• Transaction sequence and visualization (via diagrams) are vital tools for practitioners.
• As always:

  "Read them, sit there and go through. It's pretty good." (54:16)

For further clarification and legal advice, listeners are encouraged to consult a qualified attorney.

Next Episode Teaser:
Payroll taxes and their implications for hedge fund partners—promises to be “more interesting than it sounds!” (02:34)