In this episode of How Tax Works, host Matt Foreman discusses the tax consequences of going from a disregarded entity to a partnership (Rev. Rul. 99-5) and from a partnership to a disregarded entity (Rev. Rul. 99-6).  From explaining when there is taxable income (and how to structure to avoid it), as well as capital accounts, inside basis, and outside basis, this episode is for anyone who is starting, selling, or investing in a business, whether alone or with a partner.

Please also see Matt Foreman’s upcoming webinars! Links are below:

• Positives and Negatives of S Corporations
  October 29th, 2024 @ 1:00pm – 2:00pm EDT 
• Tax Strategies for Limited Partner Investors in Private Investment Funds
  November 14th, 2024 @ 1:00pm – 2:30pm EST

Listen to the episode here:

  

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

Whether you’re a seasoned entrepreneur, accountant, lawyer, or financial advisor, “How Tax Works” offers a wealth of knowledge to empower you in making sound business decisions. Tune in and embark on a journey to unravel the complexities of tax law, one episode at a time.

This podcast may be considered attorney advertising. This podcast is not presented for purposes of legal advice or for providing a legal opinion. Before any of the presenting attorneys can provide legal advice to any person or entity, and before an attorney-client relationship is formed, that attorney must have a signed fee agreement with a client setting forth the firm’s scope of representation and the fees that will be charged.

Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:09]:
Welcome to the 10th episode of How Tax Works. I’m Matt Forbin. In this episode, I’m going to talk About Revenue Rulings 99.5and 99.6 focusing on how they operate, specifically ordinary income, capital gains, inside basis, outside basis, and capital accounts. How Tax Works and is meant for informational and entertainment purposes only. This may be attorney advertising. It is not legal advice. Please, please, please hire your own attorney.

Matthew Foreman [00:00:34]:
How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices we all make. Before we get started, a few administrative things. New episodes every two weeks. Next episode is going to be an interesting one. I’m going to talk about basically payroll taxes, which I promise will be more interesting than it sounds, specifically relating to Soroban Capital Partners. If you haven’t been following what’s going on, which if you’re a normal human being, even if you do listen to this podcast, probably aren’t. Sorbonne Capital Partners deals with whether basically partners in hedge fund need to pay payroll taxes on their ordinary income and whether you can structure around it, how to structure around it, things like that. And it’s really an interesting case and it’s dealt with just years and years of sort of pent up, I would say uncertainty and aggressive structuring that’s dealt with it.

Matthew Foreman [00:01:30]:
So I’m going to talk about that in two weeks. I think it’s a really interesting one. I think it’s one that’s really, really worth the time. And the tax board has a really interesting decision that they didn’t actually answer the question but they said hey, you know, maybe this structuring doesn’t work. The code is not so literal. So I think it’s an interesting one. If you have any questions, comments or constructive criticism, important word there, you can email me at my FRB email address which you can find in your favorite search engine. Have two upcoming, you know, webinars I want to mention.

Matthew Foreman [00:01:58]:
One is free. October 29th there’s a free webinar. There is CLE for New York, CPE for CPAs and CE for EAs. It’s on October 29th. It’s on S Corporations, which I just, I love them. They’re the best. Another one is tax. It’s November 14th.

Matthew Foreman [00:02:14]:
Tax strategies for limited partner investors in private investment funds. It’s it’s Stratford. They’re both at 1pm Eastern. The link will be, there will be links for both on the How Tax Works episode page. So, so you can just go there. I don’t know if they’ll be there. If you get it through Spotify or Apple or Amazon or anything like that. But if you go to the regular FRB page that has it, it’ll have the link so you can sign up for that.

Matthew Foreman [00:02:36]:
The Stratford one is not free. I think it’s $200 and it’s, it’s 80 minutes. So it’ll give you a one and a half credits doing with a corporate part, a corporate colleague of mine and the October 29th one about IT S corporations is 100% free. The only thing you lose is your time because there is no such thing as a free webinar, as we all know. All right, so let’s get, let’s get going. So revenue ruling 99. 5996 have been out for obviously 25 years. Right.

Matthew Foreman [00:03:03]:
If you can, if you can do the math, they are what’s called sub regulatory guidance. I know there’s been a lot of discussion about regulations and things like that with the end of Chevron deference, with Lope or Bright. But basically what they are is a statement of the IRS’s position. 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. They work in very mechanical ways, they make things easier and you can rely on them. I have yet to come up with a situation in which 99.5 or 99.6 a, I felt like it was incorrect and B, perhaps more importantly, was not taxpayer friendly. 99% of 99. 5.

Matthew Foreman [00:03:46]:
99. 6. So it’s revenue ruling 99. 5, revenue ruling 99. 6. I’m not going to include links. If you Google them, you can find them. Tax notes gives them to you for free.

Matthew Foreman [00:03:54]:
If you go on taxnotes.com, just a great, great site. You know, we subscribe, but you can get them for free. But 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. You don’t say, we’re doing this. Just say, look, we’re following 99. 5.

Matthew Foreman [00:04:13]:
This is how we’re doing it. That’s it. You’re good. So I think that’s really, really helpful. So revenue ruling 99. 5. Well, look, let’s, let’s back up for a Second, let’s talk about the format of the revenue rulings. So they were released at the same time in the same basic way.

Matthew Foreman [00:04:28]:
And the idea is that they’re really intended to be listened to and thought about together, right? So each of them has two situations which are variations on really specific and detailed facts. There’s a lot of definitions, right? First off, they’re always LLCs. These types of problems really can’t happen with anything other than an LLC because they deal with partnerships and disregarded entities going back and forth and it happening without changing entity types. So unless you’re a general partnership, which don’t really exist. They do exist, but there’s very, very few. This is a common issue with LLCs. So, right. You think about LLC is really not a big thing until the early 90s, early mid-90s.

Matthew Foreman [00:05:07]:
By 1995, the IRS is like, all right, let’s, let’s deal with this, hit it head on, give an answer, move on. So it really first deals with, you know, the question of what is a partnership and what is a disregarded entity, right? Partnership, at least two partners, at least two owners. It’s an llc, so you’re members of an llc. I’m always going to talk about partners and partnerships, disregarded entity, you know, for income tax purposes, right? Sales tax, payroll tax, they exist. But a disregarded entity is literally disregarded or ignored for income tax purposes. They talk about the format is they give you the general law specific analysis and then the conclusion, what, what is the answer? What does he actually mean? And then I’m going to explain a bit more and focus on inside basis, outside basis and capital accounts. Because I think those are really, really important points, okay. And I think it’s really important to think about what they mean, what they’re doing, how to deal with that.

Matthew Foreman [00:06:03]:
So inside basis is a partnership’s basis in its underlying assets. All right? Each partner has its own share of the inside basis. So each partner has its own share of the partnerships based basis in its underlying assets. Outside basis is a partner’s basis in the LLC interest. You can have outside basis in a partnership, llp, general partnership, whatever. That’s the idea. It’s a corollary of like stock basis, escorp stock basis, etc. Etc.

Matthew Foreman [00:06:32]:
Capital account. It’s not real capital accounts don’t exist. They really are. They’re just a cap. They’re just a, a accounting mechanism that exists. And I could do a whole mech in the whole episode on them, but I’ll mention them mostly in passing here, even Though if you ever hear me talk about operating agreements in a lot of detail, what you’ll hear me say is that capital accounts are actually the heart and soul of partnership taxation. They are the first thing that happens. And then basically whenever I ask people, okay, what happens to capital accounts, how does that affect inside basis, how does that affect outside basis? Who gets allocations, distribution? So I’m going to talk about them very in passing in this episode.

Matthew Foreman [00:07:11]:
But at the same time, I’m really, really, really gonna just point out that they’re really important, just not right here. So, you know, before I get into the first revenue ruling 995, let’s take a quick music break. Okay, I’m back. So Revenue Ruling 9.5 is a disregarded entity to a partnership. So what happens is A owns 100% of an LLC. A can be an individual, it can be a corporation, it can be another partnership. In fact, it can be a little different. Same a partnership at top.

Matthew Foreman [00:07:48]:
And certain things happen differently. But basically, you know, in this situation, they generally say, okay, A is an individual. A owns 100% of an LLC. Two situations, right? Situation one, B purchases 50% of the LLC. 50% of the LLC units from A for $5,000. Can be for $1 billion, can be for a dollar. Doesn’t really matter. It’s about the ratio, it’s about how things work out.

Matthew Foreman [00:08:12]:
What’s really interesting, people laugh when I say use the word interesting probably correctly, is that Revenue Ruling 995, Situation 1 uses $5,000. All of the other examples are like, oh, $10,000, $10,000,$10,000. Not totally sure how that, how that worked out, but just a quirk of it. Again, doesn’t really matter. So here are the steps of how it works. So reimagined for tax purposes, right? We’re talking about tax here. It’s just tax podcast and it’s reimagined as If B purchases 50% of every asset for $5,000 and then A and B contribute, right, tax free the assets into newly formed partnership. A recognizes gain or loss as if it sold the underlying assets.

Matthew Foreman [00:08:52]:
So in this one there’s no discussion of hot assets because they actually don’t exist. You bought the actual assets themselves. So you could determine on an asset by asset basis, you know, ordinary income, recapture capital assets, et cetera, et cetera. B has a gets it receives a fair market value basis in the LLC interest, which is your outside basis. And the partnership has half fair market value basis in the property. That’s its inside basis, which is all B’s share of the inside basis. Remember, P bought, B bought. Therefore B has outside basis.

Matthew Foreman [00:09:25]:
Therefore B has inside basis. The alliteration, I’ve never noticed that till now. But here we are, right? B then gets all the depreciation and amortization, which again must be allocated to B because B is the only one who has basis. And so that’s really important. The holding period for B starts at the purchase, at the moment of the purchase. Whereas A gets a carryover or transfer holding period. Going back to a point I made earlier, right here, I said A recognizes gain and loss is they sold the assets. So each asset has its own holding period.

Matthew Foreman [00:09:56]:
Where this gets really complex is you’ll have situations, you, we all will, where a partnership becomes a disregarded entity, then becomes a partnership again, right? And so you have to track holding periods, track basis, and it can get really complex and it goes across different years and things like that. 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. That’s, that’s always a partnership. The technical termination rules were repealed. It’s been seven years ago now. Can’t, can’t believe it’s been that long. And, and thankfully we don’t have to worry about technical terminations. It’s just a continuation of the partnership.

Matthew Foreman [00:10:33]:
Even though it was out on one day and started again the next, you basically just pretend that it never really went out. Even if it was redemption or a buyout and then a new part coming in. You basically just smooth it over, this little accounting, you know, how things get allocated partners. But for that purpose it’s always still a partnership. Then situation two, right? Pretty similar. Instead of, you know, B purchasing the LLC units from A, what happens is B contributes $10,000 for 50% interest and the money remains in the LLC. Pretty common fact pattern. You think about it, you have a one person running a business, they need capital, they take on an investor and they use the money for the business.

Matthew Foreman [00:11:09]:
Pretty standard, right? So, so no, you know, if B contributes, then distributes, so I’m going to back up. So if the B contributes the money and then distributed within two years to A, this is what’s called a disguise sale. The presumption is that it’s a disguise sale and you have to look through how the money was out, was distributed, what was it for, did the partnership make profits, things like that. If it is a disguised sale, it’s tax like situation one. But you, you sort of can Assume it’s not. A lot of times it’s not. And the business, you know, if it’s kicking off profits or things like that. But watch out, sometimes you see contributions and then a cash refi with a cash out refi that can trigger disguise sale.

Matthew Foreman [00:11:48]:
A whole, whole host of issues that can run along with that. So I’m just going to say watch out for contributions and then distributions within two years. The presumption is a disguise sale. So, so to watch out for that. So the tax consequences again of the contribution A, which was the LLC member that owned it before as A disregarded no gain, no loss, nothing. B has a fair market value outside basis as if you bought the assets and then fair market value inside basis. Right. Capital accounts are full fair market value.

Matthew Foreman [00:12:17]:
So 10,000, 10,000, 10,000. Pretty easy. B again gets a depreciation, amortization, new holding period. A gets carryover or transfer or holding period. So it’s a little simpler. There’s no tax consequences for it in the context of there’s. There’ll be no tax benefits paid. But watch out, you know, people are.

Matthew Foreman [00:12:34]:
So it’s as if you bought the assets, why don’t you actually buy the assets? So a lot of states, you know, I live in New York, one of the states that does this, if you actually physically buy the assets and not do a contribution, but you buy the assets, put it into a new entity, what’s things like that, what happens is that’s actually going to be subject to sales tax. So watch out for that. Or if you do it and there’s real estate, right. That may trigger transfer taxes. So watch out different. This is again, this is an income tax fiction only. This is how it’s worked for income tax. Different rules.

Matthew Foreman [00:13:06]:
Because if you think about it for sales tax or for real property transfer tax purposes, what you’re actually doing is buying an LLC interest or you’re contributing into an LLC interest, which is completely different. So remember that while this is only for income tax, you have to think about am I creating issues with sales tax or transfer tax or other other ad flor impacts as other taxes. So let’s take a quick break before we get to revenue ruling 99.6. Okay, now we’re going to round back into revenue ruling 99. 6. So 996 is the inverse to 99.5 and it deals with a partnership to a disregarded entity. Right.995 is disregarded entity to partnership.99.6 Partnership to disregarded and in all situations. And this is basically nine to partners are equal partners, right? So they do that.

Matthew Foreman [00:14:01]:
It’s a little easier obviously. You know, things can be a little different. But jokingly says but it’s just math, right? So situation one, you have an AB partnership, right? Equal partners in an LLC. It’s a partnership a sells its LLC interest to be for $10,000. So what happens basically is one partner sells to the other. It becomes a disregarded entity. The assumption is no hot assets or debt. You know one Neil, one day I’ll do an episode on on debt issues relating with partnerships.

Matthew Foreman [00:14:30]:
752 is, is a, is a beast. There’s a lot of quirks that go along with it and that day is not going to be today. Definitely could not get through it in the five minutes of extra time I might have here. So we want to think about that. But, but we’re going to assume again, no hot assets, no debt, hot assets, right? Ordinary income items, deep depreciation, recapture, accounts receivable, stuff like that. So after the sale we have a disregarded entity, A which is. I’m going to call it the seller, which is probably correct, right? It’s a sale of a partnership interest. So capital gains, generally speaking, other than hot assets under McCallson and Revenue ruling 6765 for B only.

Matthew Foreman [00:15:06]:
This is a liquidating distribution from a partnership under 731. B gets a step up in one half of the assets. So the assets that it bought and the those assets were attributed that assets had bought from A. Right? And you can depreciate or amortize those once you’re disregarded any. Right. So it’s going to go to schedule C. I’m assuming it’s an individual. You get a step up in basis for half the amount the $10,000 that it used to purchase.

Matthew Foreman [00:15:30]:
And that’s it. That’s the crux of how things work with revenue ruling 99.6 situation 1. So you know, it’s a very interesting split one, right? Because a gets a sale of partnership interest which is generally capital gains except for hot assets and B gets a step up in the basis. Now people always ask me look, if it’s sale, purchase, a partnership interest, how do you get a step up in basis? That’s not how that works. And I say look, you idiot. Right? No, but, but if you make an election under 754, you get the step up in basis when you buy it. So what they’re saying is you don’t even actually have to make the 754election. Not that it’s necessarily that hard to make the election.

Matthew Foreman [00:16:10]:
The math is actually the calculation of the work under 734, 743 as the case may be is probably the more complex part. But what it’s really allowing you to do is just look, just take the step up in half, move on, you know, that’s it. So you think about you have a partnership right to disregard entity, then back to partnership, get the step up in basis, move along. And that’s how it works. I think that’s really important. Then there’s situation two, right? Cd equal partner partnership, equal partners in an LLC which is taxed as a partnership. Interesting. Again, this is finding things interesting.

Matthew Foreman [00:16:45]:
You know, they use A B, A B, A B and all them. Then all of a sudden they go cd right? I again don’t know why, but what happens is C and D both or each, I guess, you know, each sell their interest to E, who is an unrelated third party. Important. That’s an unrelated third party. If they were to sell to a child or something else, there are a number of code sections that could convert this to ordinary income or just generally create other tax consequences and other concerns. So you know, the key here is unrelated third party, that’s really, really important. So you know, for cd, right, C and D are going to get the exact same thing, exact same tax treatment. And what happens is it’s the sale of partnership interest rate similar to a.

Matthew Foreman [00:17:28]:
The seller in situation one, capital gains, less hot assets. Again assuming no hot assets in this. But I think it’s important, you know, you should think about what is your holding period, right? Was there a carryover when it was contributed or transfer or when it’s contributed to the partnership, the partnership actually buy it is capital gain, is it short term capital gain? I always run into issues where people bought something, you know, three months ago and they’re like, oh, I’m selling it, it’s capital gains, great. I’m like bought it three months ago, don’t have a holding period long enough. So definitely watch out for things like that because capital gains doesn’t always get capital gains rates, so to speak. And then for E, the buyer, right, after a deemed liquidating distribution, E acquires all the assets. So he gets a full step up in basis in all the assets, which it can then depreciate, amortize, you know, however. However you want to do it.

Matthew Foreman [00:18:16]:
So I think that that’s really important. This is a, this is a shorter one, but I thought it was really important to do even though it’s. It’s short because I get a lot of questions on this. If you do a transaction, right, you start off with an S Corp, you do the F. Re or you end up with the S Corp that owns a disregarded partnership below, right? Then you do a part contribution, part sale, whatever the order is. What actually happens is you trigger one of the two situations in Revenue Ruling 99. 5 and then the entity, the acquiring entity ends up with 100% of the disregarded entity. Then partnership might be able to hear a fire truck.

Matthew Foreman [00:18:51]:
I don’t know if you can actually hear that, but there’s a fire truck over by me in New York City right now. Had had helicopters earlier today. I wonder who was coming or going. It’s. It’s un week here. So yeah, welcome to New York as a noted philosopher once said. But what’s really interesting about it, right Is then you have the situation where you have a partnership and then a lot of times it redis regards it goes underneath the purchaser again and the. The S Corp becomes a member in the upper tier partnership, right? And so you really run into 99.

Matthew Foreman [00:19:17]:
5 and 99. 6. And you need to really think through what is the order to do it. Do we contribute first or do we sell first? How do we want the basis to exist? Because if you contribute before you sell, right, you could run into anti stuffing rules. There could be interesting issues with 163J interest limitation rules can. Can bump into the structure. And you could also run to, you know, who owns the step up basis and assets. Which is why a lot of times in these transactions you sell and then you contribute because that gets the basis to the buyer.

Matthew Foreman [00:19:49]:
Buyer wants that basis. Buyer wants to redepreciate a lot of times re amortize, right. With goodwill, right? Capital, capital, assets, intangibles. There we go. I’ll leave that one and let you know that I’m going kind of off the cuff here. So I think it’s really important to think through these. They come up in unexpected ways, right? But I think it’s really important to think through it. Make sure you do it.

Matthew Foreman [00:20:09]:
Do it. Do a diagram. You know, 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 because I like to visually see it. That way everyone can look at it, agree, draft documents, make sure they agree and you know, push the button. So why, why you know, why do they exist? Right. Again, I think the clarity that the IRS provided by putting two you know, they’re three pages each, right? They’re.

Matthew Foreman [00:20:34]:
They’re really short. Brevity is the solo wit, but I think the clarity is really helpful. It’s basically saying, you don’t need a 754election in this context. I can hear the fire truck. Again, I don’t know if you all can. I have noise reduction and echo cancellation on, so I don’t know if you’ll get them, but definitely interesting to hear anyway. So, you know, you don’t have to do a lot of structuring, right. Because of these revenue rules.

Matthew Foreman [00:20:56]:
What I think the IRS achieved here is really some of the better drafting they’ve come out with. Perhaps a simple problem. Perhaps it’s because they’re being taxpayer friendly already and there’s a relatively. Relatively minimal opportunity to structure around these beyond what you could have done under the code anyway. So a lot of times it’s just, look, here. Here are the answers. Here’s what’s going on. Let’s just.

Matthew Foreman [00:21:17]:
I don’t say structure into it, but let it work out. And I think that’s the key for. For both these revenue rulings, that they’re really helpful. Okay, that was the 10th episode of How Tax Works. Hopefully. Hopefully you get to hear the fire trucks in New York going by. Hopefully you learned something. You know, like I said, read them, sit there and go through.

Matthew Foreman [00:21:34]:
It’s pretty good. I’ll be back in two weeks with the 11th episode. Episode. It’ll put us at the end of October. So really, really exciting for that. I’m going to be talking about, like I said, you know, payroll taxes. Right. Social Security taxes, which are a relatively minor amount of revenue, but really create a lot of structuring.

Matthew Foreman [00:21:51]:
I mean, there are recent S Corps exist, and it’s a question of how can you, you know, avoid them, not evade. Vade is legal. Voiding is structuring. It’s allowed. How can you avoid them? And what does SORB on Capital Partners? What does that case say? Hope you enjoyed it. And now you know a little more. The best song of all time. Thank you for listening.