Q: A business associate and I started investing in real estate about 15 years ago. We created state law limited liability companies to hold specific properties. We own commercial office space in Albuquerque, Colorado Springs and Scottsdale. Each is held in a separate LLC and our ownership is 50% in each entity. For business reasons we want to combine everything into a single reporting entity. We have been advised to set up a Delaware LLC that will be owned 50% by each of us, and to contribute the membership interests of the three existing entities to the new Delaware entity. We each have tax advisers and have received different advice about the treatment of this. One adviser says it will be tax free. The other says that only corporations can do tax-free reorganizations so he thinks this may be taxable, but he is not sure. If this is not too much for this column can you weigh in if you know the answer?
This will be nontaxable. It creates a few issues but it will still be nontaxable to the owners.
The adviser who says only corporations can have reorganizations is correct on that point. However, the law uses words in ways that others may not. A reorganization is a defined term, it can be done tax free, and it can only involve corporations.
So in a technical sense you do not have a reorganization. You instead have what is called a merger of partnerships. Corporate mergers can be reorganizations if done in a certain way. Partnership mergers cannot be reorganizations but can still be tax free.
The three existing LLCs are partnerships. They are being combined into one partnership. That’s the merger – three into one. In the end there will be four legal entities because the three existing entities will survive.
The tax law says that an LLC that has only one member is disregarded for tax purposes. It exists for state law, but the tax law pretends it does not exist.
At the end of this transaction the three existing LLCs will be owned by a single member, the new Delaware LLC. This means the three will be disregarded. The tax law pretends they were merged out of existence with their assets transferred to the new LLC.
You and your partner will receive 50% ownership interests in the new LLC. You will no longer own interests in the three existing entities because they are now owned by the new LLC. Because the tax law recognizes only the new LLC, only one tax return will be filed for all four entities.
The existing LLCs will each file a final tax return in the year of the transaction if they are considered to be terminated. Be careful to not file late because the merger event will end the tax year and the returns will be due by the 15th day of the third month after the merger.
For example, you may be used to filing by March 15 of each year (that is, March 15, 2020, for the 2019 year and so on). If this merger occurs in June 2020, the final returns are due September 15, 2020 rather than March 15, 2021. They can be extended.
Now back to an earlier comment – I said a final return is filed for any terminated partnership. Because this is a merger of existing partnerships, one may survive for tax reporting. But only one may survive.
So which one survived? This is determined by looking at which entity, if any, had more than 50% of the capital and profits interests continue. In this case, all three had 100% of the interests continue. So it’s a tie.
The tie-breaker is then which entity contributed the greatest net asset value to the resulting partnership. Let’s say it was the Scottsdale one (just for illustration).
The Scottsdale LLC is then deemed to continue and the other two terminate. Final returns are filed only for the two terminated ones. The new Delaware entity files using the surviving partnership’s year and uses the same employer ID number as the surviving entity.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.