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Entity Conversion Under State Law Is Not a Modification of Debt

After almost 20 years, the IRS has again ruled that the conversion under state law of a limited liability company (LLC) disregarded for tax purposes to a corporation did not result in a “significant modification” of the various classes of debt previously issued by the LLC (PLR 202337007, released September 15, 2023). The IRS based its conclusion on the provision of applicable state law stating that any such conversion “shall not be deemed to affect any obligations or liabilities” of the converting entity.

As part of a larger restructuring, a parent company converted a lower-tier LLC to a corporation pursuant to state law. The LLC’s outstanding debt was not modified in any way in the restructuring. State law made clear that any conversion from a limited liability company to a domestic corporation does not change any rights or obligations of the debtholders of such entity.

Prior to the conversion, the LLC was disregarded, for federal income tax purposes, from its partnership shareholder. Accordingly, the partnership was the obligor of the debt for tax purposes. Moreover, because the debt was limited to the assets of the LLC, and debtholders had no recourse to any other assets of the partnership, the debt was treated as nonrecourse obligations of the partnership for tax purposes. Upon the conversion of the LLC to a corporation, the LLC’s debt became recourse obligations of the corporation, thus raising the question of whether the conversion of the LLC to a corporation resulted in a significant modification of the debt.

If the modification of debt constitutes a significant modification, the existing debt is deemed to be exchanged for newly issued debt.  Under Section 1001, 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.”  Further, with certain exceptions, a change in obligor on a recourse obligation or a change from recourse to nonrecourse (or vice versa) is a significant modification resulting in a taxable exchange of the debt. As a technical tax matter, the conversion of the LLC to a corporation resulted in a change in obligor and a change in the recourse nature of the debt. Nevertheless, the PLR concludes that because the conversion does not change the debtholders’ state law legal rights or obligations, the conversion does not result in a significant modification of the debt.

It is noteworthy that this ruling related to a conversion of an entity pursuant to state law, as tax law also has its own set of entity classification regulations.  Tax practitioners have long debated whether a change in tax status under the entity classification regulations—which allow taxpayers to “check-the-box” to convert a disregarded entity to a regarded entity (e.g., a partnership or a corporation) or vice versa—and the resulting change in obligor and/or tax recourse nature could result in a taxable exchange despite no change in the legal rights and entitlements of the debt. The IRS has provided conflicting guidance over the years, and this PLR (which may not be used as precedent) may demonstrate the IRS’s prevailing view, although more definitive guidance would certainly be helpful. 

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