Cooperative’s Consolidation and Liquidation of Subsidiaries
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Like for-profit corporations owned by investors and shareholders, cooperatives provide services through subsidiaries. Whereas for-profit corporations own and operate subsidiaries to generate greater income for shareholders, cooperatives typically own and operate subsidiaries to provide diverse services to patrons and non-patrons. Like corporations, however, cooperatives occasionally find advantages in liquidating and consolidating subsidiaries when their need for such subsidiaries expires.
A relatively recent private ruling provides some insight into how one cooperative liquidated and consolidated its multiple tiers of subsidiaries without recognizing a substantial gain. It also managed to avoid the troublesome deemed-liquidation rules that would otherwise apply to similar transactions.
Background
Cooperative owned multiple tiers of subsidiaries, all but one of which were disregarded for tax purposes or were pass-through entities. After the liquidation process, Cooperative would own one subsidiary that would be disregarded for tax purposes.
Before the liquidation process, Cooperative was a tax-exempt cooperative. But after the liquidation process, Cooperative would operate as a taxable cooperative. Cooperative envisioned eventually reverting back to a tax-exempt status.
Cooperative wanted to consolidate and liquidate the subsidiaries for various reasons. It wanted to consolidate at the parent-cooperative level all of the diverse services previously provided by the separate subsidiaries. Consolidating services at the parent-cooperative level offered a strategic marketing advantage. It also allowed Cooperative to streamline management and accounting functions and minimize state franchise and sales taxes.
No Gain on Conversion Back to Tax-Exempt Status
In most cases, the conversion from a taxable organization to a tax-exempt organization results in a deemed-liquidation, in which the organization recognizes a gain on its assets as if they were sold for their fair market value. But Section 501(c)(12) cooperatives may qualify for an exception from the deemed-liquidation rule when (i) the sole reason they failed to qualify under Section 501(c)(12) is due to the Member Income Test and (ii) they become tax exempt again because they pass the Member Income Test.
Cooperative questioned whether the exception would apply in the present transaction. As noted above, after the transaction, Cooperative would operate as a taxable cooperative, but it expected to eventually qualify as a tax-exempt cooperative.
While the ruling is devoid of important facts surrounding this issue, Cooperative obtained a favorable ruling from the IRS. Fortunately for Cooperative, it identified legitimate non-tax reasons for the transactions. As a result, the IRS ruled that if Cooperative eventually became a tax-exempt cooperative, it would qualify under the exception noted above, stating the transaction did not have “a principal purpose of avoiding the application of the change in status rules under the anti-abuse rule.”
No Gain on Conversion of Subsidiary 1 to Disregarded Entity
As part of the transaction, Subsidiary 1 (which was previously taxable apart from Cooperative) would elect to become a disregarded entity. It converted from a limited partnership to a single-member LLC, which is one of the few organizations that may qualify to be disregarded for federal income tax purposes. After the conversion, all of Subsidiary 1’s taxable income and expense would be recognized by Cooperative.
Cooperative also questioned whether the conversion of Subsidiary 1 into a disregarded entity would result in a deemed liquidation. In certain circumstances, the conversion of an entity from a regarded entity to a disregarded entity will result in a deemed-liquidation similar to a conversion from taxable to tax exempt. So Cooperative was right to question the tax effect of the conversion.
Based on the particular facts at issue, the IRS ruled that Subsidiary 1’s conversion to a disregarded entity would not result in a deemed-liquidation. In support of its position, Cooperative cited two important Code sections. From the viewpoint of Cooperative, Section 332 provides: “No gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation.” This section has multiple requirements that Cooperative apparently satisfied (e.g., parent corporation owned 80% of voting power and stock value, and subsidiary’s stock was redeemed pursuant to plan of liquidation).
From the viewpoint of Subsidiary 1, Section 337 provides: “No gain or loss shall be recognized to the liquidating corporation on the distribution to the 80-percent distributee of any property in a complete liquidation to which section 332 applies.” Like Section 337, this section contains several requirements and exceptions. But the IRS apparently ruled that Subsidiary 1 satisfied all requirements for non-recognition of the gain on conversion.
Importantly, the IRS further ruled that Cooperative would take a carry-over basis and holding period in the assets previously held by Subsidiary 1. In addition, Cooperative would receive Subsidiary 1’s “net operating loss carryovers,” “capital loss carryovers,” and other tax attributes of Subsidiary 1.
Conclusion
Cooperative received a favorable private ruling from the IRS on its liquidation and conversion transaction. It avoided the potentially large gains resulting from deemed-liquidation of itself and Subsidiary 1. But it should be noted, as with all private rulings, the applicable facts govern the outcome, so each transaction should be analyzed on a case-by-case basis.