Rev. Rul. 99-58: Tax Treatment of a QSub to LLC Conversion
Explore the tax framework for converting a QSub into an LLC, focusing on how to maintain the entity's tax status and administrative continuity.
A business may be structured in many ways, and these structures can change over time to meet new objectives. An S corporation, for instance, may own a subsidiary entity known as a qualified subchapter S subsidiary, or QSub. For federal tax purposes, a QSub is not treated as a separate corporation; its assets, liabilities, and items of income and deduction are treated as belonging to the parent S corporation. Another common business structure is the limited liability company (LLC), which offers liability protection and operational flexibility.
Business owners may decide to convert a QSub into an LLC to achieve specific legal or operational goals, such as simplifying state-level compliance or preparing for a future transaction. This conversion involves changing the legal form of the entity under state law while it remains wholly owned by the parent S corporation.
The Tax Treatment of the Conversion
The Internal Revenue Service has clarified that the conversion of a QSub into a single-member LLC is a tax-free event. Because the change is one of form rather than substance, the transaction is considered a “Type F” reorganization, defined as a “mere change in identity, form, or place of organization.” This classification means the conversion does not trigger the recognition of gain or loss for the corporation or its owner.
The rationale for this treatment is that the core elements of the business enterprise remain unchanged. Before the conversion, the parent S corporation is treated as owning all the assets and liabilities of the QSub. After the conversion, the new LLC is considered a “disregarded entity,” assuming it is wholly owned by the parent and has not elected to be taxed as a corporation. For tax purposes, the parent S corporation is still treated as owning all the assets and liabilities directly.
Because the ultimate ownership and business operations are not altered, the transaction is a seamless transition from one type of disregarded entity to another. This perspective allows the business to modify its legal structure without creating an immediate tax liability.
Requirements for Tax-Free Treatment
For the conversion of a QSub to an LLC to be considered a tax-free F reorganization, several requirements must be satisfied. The primary requirement is that the newly formed LLC must be treated as a disregarded entity for federal tax purposes. This occurs when the LLC has a single owner—the parent S corporation—and does not file an election to be taxed as a corporation.
Another condition is that the conversion must be part of an overall plan of reorganization. This means the steps taken to change the entity’s legal status should be documented and intended to achieve the reorganization. The transaction cannot be isolated from a larger series of steps that might fundamentally alter the business structure.
The principle of continuity of business enterprise must also be met. This requires the new LLC to continue the historic business activities of the former QSub or use a significant portion of the QSub’s historic business assets in a business. Similarly, there must be continuity of interest, which requires that the parent S corporation that owned the QSub must be the sole owner of the new LLC immediately after the conversion.
Tax Consequences and Administrative Continuity
When a QSub to LLC conversion successfully qualifies as a Type F reorganization, several important administrative consequences follow that simplify tax compliance. A primary result is that the taxable year of the converting entity does not close on the date of the conversion, so there is no need to file a short-year tax return. The new LLC is treated as a continuation of the old QSub.
All the tax attributes of the QSub carry over to the new LLC. This means the tax basis of the assets held by the entity remains the same, and the holding periods for those assets are not reset. Any tax history, such as potential net operating losses, also carries over to the new entity.
The parent S corporation’s election to be an S corporation is not terminated by the transaction. Regarding the Employer Identification Number (EIN), the entity that was the QSub and is now the LLC retains its historic EIN. This administrative continuity is a benefit of a properly executed F reorganization.