The nature of the debt and the constancy of the debt holders are what matters in a corporate restructuring. What doesn’t matter is that the debt has been shifted among subsidiaries.

That was the bottom line in a letter ruling (LTR 201010015) released March 12 by the Internal Revenue Service. The IRS concluded that a shift in debtors doesn’t give rise to a significant modification of a debt instrument. If there had been such a modification, the debtor might have experienced cancellation of indebtedness: income on which taxes would have to be paid.

In the case at hand, a parent corporation, which we’ll call Papa Corp., owns all of the stock of a subsidiary, which we’ll call Sibling Corp. Sibling owns, through its ownership of a series of limited liability corporations, the stock of, let’s say, Grandchild Corp. Grandchild, in turn, owns all of the stock of Great Grandchild Corp. Sibling had several series of indebtedness outstanding, including senior notes, term loans, and a revolving credit facility.

Papa wanted to convert Sibling into a single-member LLC, Sibling Ltd. For tax purposes, Sibling Ltd. would be treated as part of Papa. Further, Papa would distribute, in a tax-free spin-off, all of the stock of Grandchild to its shareholders. The proposed transaction would not change the yield on any of Sibling Corp.’s indebtedness nor the specific timing of payments on the debt. Neither would it result in the addition or subtraction of co-debtors or guarantors of the debt, nor change the priority of any of the debt relative to other debt, nor alter the legal rights or obligations with respect to the debt.

At issue was whether the substitution of debtors with respect to the debt would give rise to a “significant modification.” The IRS ruled that such a substitution doesn’t result in such a modification.

The substitution of a new debtor is not a significant modification if three conditions apply, according to the ruling. One is that the acquiring corporation becomes the new debtor, and the second is that the transaction doesn’t result in a change in “payment expectations”; that is, the debtor must have at least “adequate capacity” to meet its payment obligations both before and after the modification. The third condition is that the transaction does not result in a “significant alteration.” In this case, that means the conversion of an entity into an LLC shouldn’t affect any obligations or liabilities of the entity incurred before its conversion to an LLC, according to the IRS.

Checking off on the transaction for all three provisions, the IRS held that while the company went through a significant reorganization, the debt and debt holders remained the same. Hence Papa and its corporate children did not have to pay additional tax.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.