Beware of "excess" liabilities in type A reorganizations.
Under the general rule of Sec. 361(a), a corporation exchanging property, pursuant to a reorganization plan, solely for stock or securities recognizes neither gain nor loss. However, Sec. 361(b) requires recognition of gain (but not loss) if boot also is received in such an exchange and is retained by the recipient corporation rather than distributed to its shareholders.
The general rule of Sec. 357(a) provides that, except when the principal purpose is tax avoidance or there is no bona fide business purpose (Sec. 357(b)), the transferee corporation in a tax-free reorganization can assume a liability or acquire the transferor's property subject to a liability without precipitating taxation under Sec. 361(b). Without Sec. 357(a) (enacted to overrule the Supreme Court's Hendler decision, 303 US 564 (1938)), all liabilities transferred pursuant to"a tax-free reorganization would be considered equivalent to cash distributions and, therefore, treated as boot.
Type D reorganizations, defined in Sec. 368(a)(1)(D), involve transfers to controlled corporations that may be either divisive (spin-offs, split-offs or split-ups) or nondivisive. For example, a nondivisive Type D reorganization involves the transfer of substantially all of the assets of one corporation to another corporation controlled by the transferor and/or one or more of its shareholders. For transactions pursuant to reorganization plans adopted after July 18, 1984, the control threshold for this purpose is 50%, determined under Sec. 304(c) (Sec. 368(a)(2)(H)). Like the other types of corporate reorganizations, Type Ds are also subject to subchapter C's operational rules.
For Type D reorganizations, Sec. 357(c)(1)(B) provides another exception to the general rule of Sec. 357(a) by requiring recognition of gain to the extent that the liabilities assumed (or which the acquired property is subject to) exceed the adjusted basis of the assets transferred. However, the applicability of Sec. 357(c)(1)(B) to Type A reorganizations cannot be eliminated just because Sec. 357(c)(1)(B) specifically refers only to Type D reorganizations. When a transaction qualifying as one type of tax-free reorganization also qualifies as another type, the IRS has ruled in some situations that the Code's provisions associated with the overlapping type of reorganization also must be applied.
Rev. Rul. 75-161 held that a Type A statutory merger of brother-sister corporations also meeting the requirements of a Type D nondivisive reorganization would be subject to the excess liabilities rule of Sec. 357(c)(1)(B). Thus, the transferor recognized gain equal to the excess liabilities. (See also Letter Ruling 7913101.)
If excess liabilities include shareholder loans, gain recognition may be avoided by canceling these loans before the merger. Rev. Rul. 78-330 allowed the gratuitous cancellation of a subsidiary's debt to its parent, before the merger of that subsidiary into an affiliated subsidiary, to avoid gain recognition under Sec. 357(c)(1)(B). The Service found that this conversion of debt to equity "had independent economic significance because it resulted in a genuine alteration of a previous bona fide business relationship."
The excess liabilities problem may be particularly acute in today's economy when loans relating to appreciating assets, such as real estate, have been refinanced. However, a very simple way to avoid this problem is found in Rev. Rul. 75-161, which indicates that gain recognition could have been avoided by reversing the merger's direction - with the transferor becoming the transferee, since the original transferee's assets had a basis exceeding their liabilities. From Edith E. Silvestri, CPA (sole practitioner), Vienna, Va.
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|Author:||Silvestri, Edith E.|
|Publication:||The Tax Adviser|
|Date:||May 1, 1995|
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