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September 22, 2023

US IRS rules converting disregarded entity to domestic corporation does not modify debt

  • The IRS ruled that a corporate conversion does not result in a modification of the original entity’s debt as long as the rights and obligations between the debtor and creditor are unchanged.
  • The ruling clarifies the IRS’s position, which has shifted a number of times over the past 20 years.

In PLR 202337007 (the Ruling), the IRS ruled that a transaction in which a disregarded entity is converted into a domestic corporation will not cause a modification of debt previously issued by the entity under Treas. Reg. Section 1.1001-3. Accordingly, the transaction does not give rise to a taxable debt-for-debt exchange.  The Ruling clarifies the IRS’s current position on an issue that has been the subject of various private letter rulings, but which has not been addressed in a revenue ruling or other precedential guidance.


LLC 1 is an entity wholly owned by LLC 2, which in turn is wholly owned by LLC 3. For federal income tax purposes, LLC 3 is a treated as a partnership and LLC 1 and LLC 2 are disregarded entities. LLC 3 is partially owned by LLC 4, an entity that is also treated as a partnership and is partially owned by Subsidiary 1.

LLC 1 has outstanding, publicly traded debt held by unrelated third parties. The debt is legally fully recourse to LLC 1. In addition, most of the outstanding debt instruments are guaranteed by LLC 1 and LLC 2’s domestic subsidiaries and secured by substantially all the assets of LLC 1 and the guarantors.

The companies have proposed to undertake a three-step transaction pursuant to which:

  • LLC 3 will become a wholly owned subsidiary of LLC 4, causing LLC 4 to become the regarded owner of LLC 1, LLC 2 and LLC 3
  • LLC 4 will become a wholly owned subsidiary of Subsidiary 1, causing Subsidiary 1 to become the regarded owner of LLC 1, LLC 2, LLC 3 and LLC 4
  • LLC 1 will convert to a corporation under state law, resulting in it becoming a regarded corporation (renamed Subsidiary 2 in the ruling) for federal income tax purposes

No step of the proposed transaction will change the yield on the debt (as computed under Treas. Reg. Section 1.1001-3(e)(2)(iii)), timing of the debt payments, co-obligors or guarantors for state law purposes, priority of the debts, collateral or security, or the legal rights or obligations with respect to the debt.

Law and analysis

The IRS focused its analysis on step (3), in which a limited liability company converted to a corporation under state law with no change to the legal rights or obligations of the parties to the debt. Under Treas. Reg. Section 1.1001-1(a), gain or loss is realized from exchanging property for other property that differs materially either in kind or in extent.

Under Treas. Reg. Section 1.1001-3(b), a debt instrument differs materially in kind or in extent if it has undergone a “significant modification.” A significant modification of a debt instrument results in a new debt instrument that is deemed to be exchanged for the unmodified debt instrument.

Treas. Reg. Section 1.1001-3(c) provides rules for determining whether a change in the legal rights or obligations of a debt instrument is a modification that is then tested to determine if it is significant under Treas. Reg. Section 1.1001-3(e). Pursuant to Treas. Reg. Section 1.1001-3(c)(1)(i), a modification means 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.

The Ruling provides that the legal rights or obligations referenced in Treas. Reg. Section 1.1001-3(c) are determined under state law. Under the facts in the Ruling, state law provides that converting an entity into a domestic corporation is not deemed to affect the obligations or liabilities of the entity. Further, the domestic corporation is deemed to be the same entity as the converted entity and all debts, liabilities and duties of the converted entity remain attached to the domestic corporation and may be enforced against it to the same extent as if they had been incurred or contracted by the domestic corporation.

Applying the state law, the IRS concluded that following the conversion transaction, any debt holder of LLC 1 will have the same legal rights against Subsidiary 2, and the obligations and covenants from Subsidiary 2 to debt holders will be the same as those from LLC 1. Thus, the Ruling held that the proposed transaction will not result in a modification for purposes of Treas. Reg. Section 1.1001-3(c)(2)(i).


The IRS has addressed this fact pattern and an analogous fact pattern (a check-the-box election on an entity that had debt outstanding) on three occasions over the past 20 years (the most recent being Advice Memorandum 2011-003). The analysis on each occasion was different, thus creating confusion as to the tax implications for such transactions. In particular, the IRS’s position has varied as to whether a “modification” existed for purposes of Treas. Reg. Section 1.1001-3 where, as here, the identity of the issuer changes for federal income tax purposes but the state law rights and obligations of the parties do not change. In a 2017 letter, the Tax Section of the American Bar Association suggested that the IRS clarify its position in a manner adopted by the Ruling. Thus, while the Ruling likely represents the prevailing view on the issue, it would be helpful if Treasury and the IRS were to issue regulations or a revenue ruling to definitively resolve the inconsistencies in prior advice and to permit taxpayers to rely on the analysis described in the Ruling.

In addition to the main issue addressed in the Ruling, the Ruling is noteworthy for another reason. The IRS specifically noted in the Ruling that the determination of whether a debt instrument is recourse or nonrecourse for purposes of Treas. Reg. Section 1.1001-3 is determined under state law based on the legal entity that is the obligor. In other contexts, most notably Treas. Reg. Section 1.1001-2, the IRS has ruled that in determining whether debt of a disregarded entity is recourse or nonrecourse, the state law determination is not important; rather, debt of a disregarded entity has been treated as nonrecourse if the creditor has claims only against the assets of the disregarded entity and not other assets of the taxpayer. Thus, it appears that the IRS is signaling that a determination of the recourse status of debt is dependent on the purpose of the underlying tax rule.

There is one further consideration.  Although a determination that no significant modification of the debt has occurred results in no tax consequences for the holder, there likely are tax consequences for the issuer where the tax location of the debt changes. For example, in the Ruling, Subsidiary 2 (a corporation) becomes the obligor on debt that for tax purposes was debt of LLC 3 (previously taxed as a partnership). The Ruling does not address the tax consequences of the movement of the debt or otherwise address the tax consequences related to the three steps of the transaction, which may give rise to complex tax issues.


Contact Information
For additional information concerning this Alert, please contact:
International Tax and Transactions Services – Capital Markets
   • Lena Y. Hines (
   • Matthew A. Stevens (
   • Lee Holt (
   • Michael Yaghmour (
   • Tyler Arbogast (
   • Huvie Weinreich (

Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor


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