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Using A and C reorganizations in restructurings.

EXECUTIVE SUMMARY

* The merger of a subsidiary into a parent-owned disregarded LLC qualifies as an A reorganization, as long as all parties to the transaction are domestic entities.

* C reorganizations have become an invaluable resource in restructuring controlled groups to move operations within the group, especially if foreign entities are involved.

* The liquidation-reincorporation doctrine uses the step-transaction doctrine to recast the form of a transaction.

Restructuring controlled groups can be perilous, risking loss of tax-free treatment if conducted improperly.

This article discusses various types of reorganizations within controlled groups; its numerous examples demonstrate ways to approach restructuring.

Corporate officers often seek to realign and transfer businesses within a controlled group. One way to do this is via a merger of a subsidiary into its parent, followed by the parent's transfer of all or part of the subsidiary's assets and liabilities to another subsidiary(ies). However, the merger transfers not only the subsidiary's assets, but also its liabilities. It is often desirable to keep such liabilities out of the parent, an objective sometimes accomplished by use of a limited liability company (LLC) that is a disregarded entity for Federal tax purposes (disregarded LLC) (i.e., treated as a division of its owner).

Normally, when a subsidiary merges into a parent-owned disregarded LLC, the transaction is treated as a liquidation of the subsidiary directly into the parent, a tax-free merger under Secs. 332 and 337. However, as discussed in this article, if the parent transfers all or part of the assets to another subsidiary, Secs. 332 and 337 may not apply under either the complete liquidation requirement or the liquidation-reincorporation doctrine. However, if the transaction is a merger of a subsidiary directly into the parent (i.e., not into a disregarded entity), followed by a dropdown of all or part of the liquidated subsidiary's assets to another subsidiary, it might qualify as an A reorganization. (1)

Under Prop. Regs. Sec. 1.368-2(b)(1), a merger of a subsidiary into a parent-owned disregarded LLC qualifies as an A reorganization, as long as all parties to the transaction are domestic entities. (2) C reorganizations have been used when an unrelated foreign corporation is to be acquired. They have now become an invaluable resource in restructuring controlled groups to move operations within the group when foreign entities are involved.

This article examines eligibility for tax-free treatment of a restructuring and the obstacles to overcome in achieving it.

Liquidation Requirements

Complete Liquidation

Perhaps a parent seeks to restructure a subsidiary's operations by transferring all or part of the subsidiary's assets to another subsidiary. Sec. 332 tax-free liquidation treatment is not available if the subsidiary transferred its assets and liabilities to the parent, who then transferred all or part of them to another subsidiary as part of a liquidation plan. (3)

A subsidiary must completely liquidate to qualify for Sec. 332 tax-free treatment. (4) Regs. Sec. 1.332-2(c) states that a mere retention of a nominal amount of assets for the sole purpose of preserving the corporation's legal existence will not disqualify the transaction. Rev. Proc. 2002-3, (5) Section 4.01(24), states that the Service will not ordinarily issue a ruling or determination letter on the:

... tax effect of the liquidation of a corporation preceded or followed by the transfer of all or a part of the business assets to another corporation (1) that is the alter ego of the liquidating corporation, and (2) which, directly or indirectly, is owned more than 20 percent in value by persons holding directly or indirectly more than 20 percent in value of the liquidating corporation's stock. For purposes of this section, ownership will be determined by application of the constructive ownership rules of [section] 318(a) as modified by [section] 304(b)(3).

According to the procedure, if a subsidiary liquidates into its parent, which then transfers some of the assets to another subsidiary as part of a liquidation plan, the transaction is a tax-free liquidation, as long as the transferee subsidiary is not the liquidating corporation's alter ego. However, to obtain a ruling that such a liquidation is tax free under Sec. 332, Rev. Proc. 90-52 (6) requires the following representation about the subsidiary (S):

The liquidation of S will not be preceded or followed by the reincorporation in, or transfer or sale to, a recipient corporation (Recipient) of any of the businesses or assets of S, if persons, holding directly or indirectly, more than 20 percent in value of the S stock also hold, directly or indirectly, more than 20 percent in value of the stock in Recipient. For purposes of this representation, ownership will be determined by application of the constructive ownership rules of section 318(a) of the Code as modified by section 304(c)(3).

A parent that receives subsidiary assets under a liquidation plan and transfers part of those assets to another subsidiary it continues to own as part of the plan cannot make this representation. If the parent intended to spin off the transferee subsidiary to its shareholders, it might be able to make this representation if persons holding (directly or indirectly) more than 20% in value of the liquidating subsidiary's stock do not also hold more than 20% in value of the transferee subsidiary's stock. Ownership would be tested under Sec. 318(a), as modified by Sec. 304(c)(3)(B)(i)(i.e., substituting 5% for 50%).

The overlap-of-ownership requirement allows Sec. 332 to apply when a liquidation of a subsidiary into a parent is followed by the parent's transfer of the subsidiary's assets to a recipient subsidiary as part of a spinoff of the latter to the parent's shareholders. (7) Nevertheless, except in the case of a spinoff of the recipient subsidiary when not more than 20% of the liquidating subsidiary's value is held (directly or indirectly) by persons who also hold more than 20% of the recipient subsidiary's stock, a taxpayer may not be able to obtain a ruling that the liquidation is tax free under Sec. 332 if, as part of the liquidation plan, (8) all or part of the liquidating subsidiary's assets are transferred to another subsidiary. An exception might exist if a nominal amount of assets is transferred to another subsidiary to protect the corporate names. (9)

Liquidation-Reincorporation Doctrine

The liquidation-reincorporation doctrine uses the step-transaction doctrine to recast the form of a transaction. Prior to the repeal of the General Utilities (10) doctrine by the Tax Reform Act of 1986, shareholders employed a liquidation-reincorporation technique to obtain capital-gain treatment on a corporate liquidation and a fair market value (FMV) basis in the corporate assets. The new corporation did not inherit the liquidating corporation's tax attributes. The Service used step-transaction principles to attack such transactions, arguing they were D reorganizations with a boot distribution taxable as a dividend.

As is discussed below, in a D reorganization, one corporation transfers to another all or part of its assets; immediately after the transfer, the transferor corporation (or one or more of its shareholders) is in control of the transferee corporation. As part of the plan, transferee corporation stock must be distributed in a transaction that qualifies under Sec. 354, 355 or 356. Sec. 356 deals with distributions of boot (e.g., cash). Sec. 354 addresses acquisitive D reorganizations; Sec. 355 deals with divisive D reorganizations. For a distribution to meet Sec. 354(b)'s requirements, the transferee corporation must acquire substantially all of the transferor's assets; the stock, securities and other property received by the transferor (as well as the transferor's other properties) must be distributed as part of the reorganization plan. If the Service tries to recast a transaction as an acquisitive D reorganization, the courts have interpreted the "transfer of substantially all the assets" requirement very loosely when the liquidating corporation's operations were essentially carried on by the transferee corporation. (11)

If the same shareholders own stock in both corporations, the requirement that the transferor corporation distribute transferee-corporation stock is ignored. (12) The requirement that the shareholder be in control of the corporation to which the assets are transferred was a problem for the Service when the liquidating corporation was wholly owned by an individual and the transferee corporation was equally owned by the individual and his spouse. Originally, control was defined as ownership of 80% of the voting power and 80% of all other classes of stock, without ownership attribution. (13) This definition of control still exists for all of the types of reorganizations, except for an acquisitive D reorganization, according to Sec. 368(c). For such a reorganization, control is defined in Sec. 304(c); the 80% threshold is reduced to 50%, with modified ownership attribution determined under Secs. 318 and 304(c)(3). (14)

Reorganizations

Use of Tax-Free Forms

While Sec. 332 may not apply when all or part of a liquidating subsidiary's assets are transferred to another subsidiary, the merger could be a tax-free A, C, D or F reorganization.

A reorganizations: Sec. 368(a)(1)(A) defines an A reorganization as a statutory merger or consolidation. For a merger to be tax free, it must be effected in accordance with state law. (Mergers of corporations formed outside of the U.S. do not qualify as A reorganizations.) The regulations set out certain additional requirements:

1. The reorganization must have a significant non-Federal-tax business purpose.

2. There must be continuity of business enterprise (COBE): the merged company's historic business must be continued or a significant portion of the historic business assets must be used by the successor-in-interest (Regs. Sec. 1.368-1(d)).

3. There must be continuity of interest (COI): a substantial part (at least 50% for IRS ruling purposes, although the courts have allowed less (15)) of the consideration that the merged corporation's shareholders receive must be stock in the surviving corporation or its parent (Regs. Sec. 1.368-1(e)).

In addition, Prop. Regs. Sec. 1.3682 (b) (1) (i) (A), while allowing a merger of a domestic corporation into a disregarded LLC wholly owned by a corporation, requires all involved entities to be domestic entities. The proposed regulation bars an A reorganization of a disregarded LLC wholly owned by a corporation into another corporation, because all of the assets of the transferor unit (both the LLC and its sole corporate owner) do not become the transferee's assets and liabilities. A disregarded LLC that is not a corporation cannot merge in an A reorganization, according to Prop. Regs. Sec. 1.368-2(b)(i).

C reorganizations: Sec. 368(a)(1)(C) defines a C reorganization as the acquisition by one corporation, solely in exchange for all or part of its voting stock (or that of a corporation in control of the acquirer), of substantially all of the properties of another corporation. The acquirer's assumption of target liabilities does not violate the requirements, but the target must liquidate.

The COBE and COI requirements of A reorganizations must also be met. Like an A reorganization, a C reorganization is an acquisition of a target's assets, but not necessarily by statutory merger or consolidation. The transaction can be accomplished by transfer documents (e.g., bills of sale and deeds). The consideration used by the acquirer (with the exception of the assumption of the target's debt) must be solely voting stock of the acquirer or its parent. (Sec. 368(a)(2)(B) slightly relaxes this requirement.)

In Bausch & Lomb Optical Co., (16) an acquirer obtained 79% of a target's stock. Later, in an unrelated transaction, the acquirer issued its voting stock to the target for target assets; the target then liquidated. The Second Circuit, using the step-transaction doctrine, combined the liquidation with the asset-stock exchange and concluded that the assets were not acquired solely for acquirer voting stock; rather, they were acquired in part for cancellation of the acquirer's interest in the target, impermissible consideration. Consequently, the Bausch & Lomb doctrine stood for the proposition that if an acquirer held a pre-existing stock interest in a target, the transaction could not qualify as a C reorganization. Regs. Sec. 1.368-2(d)(4)(i) eliminated the Bausch & Lomb doctrine; an acquirer's prior ownership of target stock will not, by itself, prevent the solely for voting stock requirement from being met.

In a C reorganization, the acquirer must obtain substantially all of the target's assets. Thus, there is no C reorganization if a target has two businesses, sells one and distributes the cash to its shareholders and, as part of the same plan, the acquirer obtains the target's remaining business in exchange for voting stock. The acquirer has not obtained substantially all of the target's assets. (The transaction might qualify as an A reorganization, however.)

Moreover, in a C reorganization, only the acquirer can assume the target's liabilities; thus, if the acquirer is a subsidiary, it (not the parent) must assume the target's liabilities. There is no such rule for an A reorganization. For both A and C reorganizations, Sec. 368(a)(2)(C) specifically allows the acquirer to transfer all or part of the target's assets to a subsidiary.

Finally, for a valid C reorganization, Sec. 368(a)(2)(G) requires the transferor to liquidate. (In an A reorganization, there must be a merger under state law; thus, the transferor's separate existence automatically terminates by operation of law).

D reorganizations: Sec. 368(a)(1)(D) defines a D reorganization as a transfer by one corporation of all or part of its assets to another if, immediately after the transfer, the transferor (or one or more of its shareholders) is in control of the transferee corporation. In pursuance of the reorganization plan, stock or securities of the transferee corporation must be distributed in a transaction qualifying under Sec. 354, 355 or 356.

D reorganizations are categorized as acquisitive or divisive. In an acquisitive D, the acquirer obtains substantially all of the transferor's assets and the transferor liquidates, thereby meeting Sec. 354(b). In a divisive D, the distribution meets Sec. 355's complex requirements.

C reorganizations and acquisitive D reorganizations sometimes overlap, as both require an acquirer to obtain substantially all of a target's assets. In such a case, the transaction is a D reorganization, under Sec. 368(a)(2)(A). Although the Code is silent on the overlap of A and D reorganizations, if a transaction meets both sets of requirements, it will be both an A and a D reorganization. A major concern in D reorganizations is that, if the transferor's liabilities exceed the total adjusted basis of the property transferred, Sec. 357(c) treats the excess of such liabilities over asset basis as gain from an asset sale. Restructurings of controlled groups often take the form of a D reorganization; substantially all of a corporation's assets are transferred to a sister corporation.

Example 1: P Corp. wholly owns S Corp. and S1 Corp. S merges into S1 under state law; as a result, S transfers all of its assets to S1, which assumes all of S's liabilities. The transaction is an A reorganization. In addition, because there is a transfer of substantially all of the assets, and the transferor's shareholder (P) is in control of the transferee, the transaction is also a D reorganization. Thus, if the S liabilities assumed by S1 exceed the basis of the S assets S1 received, S will recognize gain. (If the controlled group fries a consolidated return, Regs. Sec. 1.1502-13 will control the timing of gain recognition.)

Structuring the above transaction as a merger of S into P, followed by P's dropdown of S's assets to S1, may not solve S's liabilities-in-excess-of-basis problem. The form of the transaction (if respected) would be an A and a C reorganization, as both of these types of reorganizations allow asset dropdowns, under Sec. 368(a)(2)(C). Sec. 332 tax-free liquidation treatment would not apply, however, as the liquidation is incomplete; the step-transaction doctrine would apply. However, the Service might try to recast the transaction as a direct transfer from S to S1, a D reorganization.

F reorganizations: Sec. 368 (a)(1)(F) defines an F reorganization as a mere change in identity, form or place of organization of one corporation, however effected. Although an F reorganization is limited to one corporation, more than one corporation can be used to accomplish the reorganization. Thus, if a Pennsylvania corporation merged into a new Delaware corporation, the transaction that changes the place of organization is an F reorganization. Similarly, if an LLC treated as a corporation is merged into a new corporation, the transaction that changes the LLC's form is an F reorganization.

F reorganizations that involve mergers also involve asset transfers, and thus may be A and D reorganizations. In an F and a D reorganization, there is no Sec. 357(c) gain recognition if the transferor's liabilities exceed the transferred property's basis. (17) (In a statutory merger that qualifies as both an A and a D reorganization, but not an F reorganization, Sec. 357(c) will apply. (18))

Another F reorganization advantage is that the corporation's tax year does not end and it can carry back its net operating losses to the transferor's tax year. Thus, even if an F reorganization also qualifies as another type, Regs. Sec. 1.381(b)-1(a)(2) provides that Sec. 381 (dealing with tax attributes) treats the acquirer as the transferor would have been treated had there been no reorganization.

Restructuring Opportunities

The following examples illustrate various ways to restructure controlled groups.

Sec. 332 Liquidations

According to Regs. Sec. 1.332-2(d), if Sec. 332 applies to a transaction that also qualifies as a reorganization, it overrides the reorganization provision.

Example 2: P Corp. owns S Corp., a solvent subsidiary, and wants to combine S's operations with its own. If S merges into P, the merger will be a tax-free Secs. 332 and 337 liquidation, not a reorganization (Sec. 332 overrides the reorganization provisions, to the extent applicable). Thus, S's transfer of assets would be tax free to S under Sec. 337 and tax free to P (the recipient) under Sec. 332. S's asset basis would carry over to P; P would lose its basis in S stock, but would inherit S's tax attributes under Sec. 381.

Disregarded entities: What if a wholly owned subsidiary merges into a disregarded LLC wholly owned by the same parent?

Example 3: P Corp. owns S Corp., a solvent subsidiary. For state income tax reasons, P wants to combine its operations, without exposing its assets to S's potential future liabilities. P forms a disregarded LLC into which S merges. The Federal income tax results are the same as in Example 2.

Upstream Merger/A and C Reorganizations

What if a less-than-80%-owned subsidiary merges into its parent?

Example 4: P Corp. owns 79% of S Corp., and wants to combine S's operations with its own. S merges into P; P gives S's minority shareholders P voting stock. Because P does not own at least 80% of S, Sec. 332 does not apply. This transaction has historically qualified as an A reorganization. (19) It also qualifies as a C reorganization; according to Regs. Sec. 1.368-2(d)(4), prior stock ownership of the target does not prevent the solely-for-voting-stock requirement from being met. (Before the regulation was issued, the Bausch & Lomb doctrine would have prevented this transaction from being a C reorganization, because of P's prior ownership of S stock.)

The preamble to Prop. Regs. Sec. 1.368-2(d)(4) (20) states that an upstream C reorganization should not be treated differently from an upstream A reorganization solely because the acquirer already owns target stock. Further, the IRS and Treasury have concluded that a transaction in which the acquirer converts an indirect ownership interest in assets to a direct interest is not a sale; Congress did not intend to disqualify a transaction as a C reorganization merely because the acquirer has prior ownership of a portion of a target's stock. Thus, the merger in Example 4 above would be an A and a C reorganization. S's transfer of assets to P would be tax free to S under Sec. 361 and tax free to P. P would inherit S's tax attributes under Sec. 381; S's minority shareholders would receive P stock in exchange for S stock tax free under Sec. 354.

Upstream Merger into Disregarded Entity/A and C Reorganizations

Example 5 illustrates that a merger of a corporation into a disregarded LLC can be an A and a C reorganization.

Example 5: P Corp. owns 79% of S Corp. and wants to combine S's operations with its own for state income tax purposes, but wants to keep S's liabilities separate from its operations. P forms a disregarded LLC into which S merges.

This transaction cannot be a Sec. 332 liquidation, because the 80%-ownership test is not met. It can be an A reorganization under Prop. Regs. Sec. 1.368-2(b)(1) if all of the entities involved are domestic entities. This transaction should qualify as a C reorganization, even if P, S or the LLC are foreign entities; S's liabilities would be in the LLC.

Upstream Merger/Asset Dropdown

Although a taxpayer may not be able to use Sec. 332 when a subsidiary merges into a parent and the latter transfers part of the liquidated subsidiary's assets to another subsidiary, the transaction may be an A or a C reorganization.

Example 6: P Corp. owns and directly operates business A and wholly owns subsidiaries S Corp. and S1 Corp. S has two businesses, B and C; S1 owns business D. For business reasons, P wants to combine A with B and C with D. Thus, S merges into P; P retains B and transfers C to S1.

The merger of S into P is not a Sec. 332 liquidation. P's transfer of C to S1 should prevent Sec. 332 from applying, as the liquidation is incomplete. In Rev. Rul. 76-429, (21) the Service ruled that a wholly owned subsidiary's sale of one of two businesses, followed by an immediate distribution (under a plan of complete liquidation) of all of its assets to the parent who reincorporated the retained business, was not a complete liquidation. According to the Service, "[a] genuine complete liquidation of a corporation contemplates that the assets will no longer remain in their present form of corporate solution and that the activities will cease to be carried on in corporate form with the same shareholders."

If Sec. 332 does not apply to P, then Sec. 337 will not apply to S. Sec. 311(b) will apply to S, causing it to recognize built-in gain on its assets unless another nonrecognition provision applies. P will also have tax consequences. Although the transaction cannot qualify as a tax-free liquidation, it could qualify as an A or a C reorganization. According to Sec. 368(a)(2)(C), if a transaction otherwise qualifies as an A or C reorganization, it will not be disqualified merely because the acquirer transfers part (or all) of the assets received to a subsidiary.

In Rev. Rul. 69-617, (22) a parent owned a greater-than-80% interest in a subsidiary; the subsidiary's remaining stock was publicly held. The parent wanted the subsidiary's business to be conducted by another subsidiary. The subsidiary merged into its parent; the subsidiary's minority shareholders received parent stock in the merger. The parent then transferred all of the subsidiary's assets and liabilities to the parent's new wholly owned subsidiary.

The Service ruled that the transaction could not be a tax-free Sec. 332 liquidation, because the parent immediately transferred the subsidiary's assets to another subsidiary. The transaction was an A reorganization. After the elimination of the Bausch & Lomb doctrine, the transaction in Example 6 may also be a C reorganization.

If in Example 6, P had transferred substantially all of S's assets to S1, the IRS might restructure the transaction as a D reorganization under the liquidation-reincorporation doctrine, treating the transaction as if S had transferred substantially all of its assets to S1 in exchange for stock and then liquidated, transferring the S1 stock and the S assets not held by S1 to P. However, Sec. 357(c) would apply if the total transferor liabilities assumed by the transferee exceeded the total basis of the assets transferred to the transferee. Further, the assets P retained would be deemed transferred from S in a transaction taxable to S under Secs. 311 and 1001 (if P assumes and retains S's liabilities). P will also be deemed to have received the assets as a dividend, purchase or both, depending on the proportion of liabilities it assumed versus the value of the assets it retained.

Upstream Merger into Disregarded Entity/Asset Dropdown

After the elimination of the Bausch & Lomb doctrine, a transaction that does not qualify as a tax-free Sec. 332 liquidation because of an asset reincorporation can qualify as a C reorganization--and as an A reorganization under Prop. Regs. Sec. 1.368-2(b)(1)--if all involved entities are domestic.

Example 7: P Corp. conducts business A and wholly owns S Corp., which conducts businesses B and C, and S1 Corp., which conducts business D. For state income tax reasons, P wants to align B with A and C with D. P does not want to expose itself or S1 to S's potential liabilities.

P and S1 each form a disregarded LLC. S merges into P's LLC; P's LLC retains B and transfers C to S1's LLC.

According to Rev. Rul. 76-429, this transaction may not be a tax-free Sec. 332 liquidation, because of P's transfer of C to S1. However, it is an A reorganization under Prop. Regs. Sec. 1.368-2(b)(1), if all of the entities involved are domestic and the merger is valid under state law. The transaction should also be a valid C reorganization, even if all or none of the entities involved are domestic. P initially changed its indirect ownership in S's assets for a direct ownership and followed this transformation with a dropdown of part of the assets to its wholly owned subsidiary (as permitted by Sec. 368(a)(2)(C)).

Upstream Merger of a Disregarded Entity into a Corporation

A merger of a disregarded LLC of a transferor group cannot be an A reorganization if the transferor group's parent does not merge into the transferee group. The transaction does not qualify as a C reorganization either, even if the LLC owns substantially all of the transferor group's assets, because the transferor's parent does not liquidate.

Example 8: P Corp. conducts business A; its wholly owned subsidiary, S Corp., conducts business B and owns LLC-1, a disregarded entity that owns business C. If S's and LLC-1's assets and liabilities are combined, LLC-1 will own sufficient assets to meet the Sec. 368(a)(1)(C) substantially all requirement. P owns LLC-2, a disregarded entity that owns business D. P wants to merge LLC-1 into LLC-2.

This transaction cannot be an A reorganization under Prop. Regs. Sec. 1.368-2(b)(1), because S remains in existence. For the same reason, the transaction cannot be a C reorganization. The transaction is merely a dividend from S to P. The result would be the same if, instead, LLC-2 were owned by S1 Corp. (another of P's wholly owned subsidiaries), and it could not qualify as a D reorganization.

If, however, S received stock in another P subsidiary (e.g., S1) in exchange for the transfer of LLC-1 to LLC-2, and the group filed a consolidated Federal return, the transaction could be tax free under Sec. 351; S would be deemed in control of S1 under Regs. Sec. 1.1502-34.

The previous examples have all dealt with the consequences of realigning or restructuring the operations of S, a subsidiary existing for valid non-Federal income tax reasons. What if S stock were acquired in a Sec. 338(d)(3) qualified stock purchase (QSP)? (23) Could some of the same realigning or restructuring be accomplished for a newly acquired subsidiary?

QSP of New Subsidiary/ Upstream Merger

Sec. 338 overrides the Kimbell-Diamond (24) doctrine. This doctrine permitted a corporation to acquire a subsidiary's stock, liquidate the subsidiary without gain or loss, and take a basis in its assets equal to the cost of the stock plus the subsidiary's liabilities. It changed a stock purchase into an asset purchase by use of the step-transaction doctrine.

Example 9: P Corp. acquires 100% of S Corp.'s stock for cash in a QSP. S merges into P as part of the acquisition plan. P's acquisition of S is not converted into an asset acquisition because of the liquidation; Sec. 338 overrides Kimbell-Diamond.

According to Kev. Rul. 90-95, (25) Congress intended Sec. 338 to replace any treatment of a taxable stock purchase as an asset purchase under the Kimbell-Diamond doctrine. Thus, P's liquidation of S will result in no basis step-up in S's assets; P will take a carryover basis, unless it makes a Sec. 338 election. The liquidation will be tax free to P under Sec. 332 and tax free to S under Sec. 337.

QSP of New Subsidiary/ Upstream Merger/Asset Dropdown

One of the reorganization requirements is the existence of COI. In a QSP, the corporation making the purchase is treated as a historic shareholder for COI purposes.

Example 10: P Corp. conducts business A directly, but conducts business B through S1 Corp., its wholly owned subsidiary. In a QSP, P acquires all of the stock of S Corp., which conducts businesses A and B. For valid nontax business reasons, S merges into P. P retains A, but transfers B to S1.

As was previously discussed, the transaction is not a tax-free Sec. 332 liquidation. Because there is a statutory merger of S into P, the transaction is an A reorganization, despite the dropdown of part of S's assets from P to S1, if there is COI. Regs. Sec. 1.338-3(d)(2) provides that, in meeting COI on the transfer of assets from a target to a transferee, the purchasing corporation's target stock acquired in the QSP represents an interest on the part of a person who was an owner of the target's business prior to the transfer, which can be continued in a reorganization.

The example in Kegs. Sec. 1.338-3(c)(5) clarifies that the purchaser in a QSP is a historic shareholder for COI purposes; thus, the merger in Example 10 should qualify as an A reorganization (and, after the elimination of the Bausch & Lomb doctrine, as a valid C reorganization as well). Kegs. Sec. 1.368-2(d) (4)(i) states that prior ownership of target stock by an acquirer will not prevent the voting stock requirements from being met. Because Sec. 338 makes P a historic shareholder, P is merely substituting an indirect interest in a business in which it has COI for a direct interest in the same business.

QSP of New Subsidiary/ Upstream Merger into Disregarded Entity/Asset Dropdown

A QSP makes the purchasing corporation a historic shareholder, even if the restructuring is accomplished through the use of LLCs.

Example 11: The facts are the same as in Example 10, except that P Corp. conducts business B through wholly owned subsidiary S1 Corp. In a QSP, p acquires all of S Corp.'s stock. P wants to align S's business A with its business A and S's business B with S1's business B, but does not want to expose itself or S1 to S's contingent liabilities. P and S1 each form a disregarded LLC. S merges into P's LLC. P's LLC retains A, but transfers B to S1's LLC.

As was discussed, this transaction cannot be a Sec. 332 tax-free liquidation, because of the dropdown of B. It can be an A reorganization under Prop. Regs. Sec. 1.368-2(b)(1), if all of the entities are domestic; and could also qualify as a C reorganization, if there is a valid business reason for the transaction.

As a result of making a QSP of S, p is a historical shareholder for COI purpose; thus, P is merely substituting its indirect interest in S's assets for a direct interest. Sec. 368(a)(2)(C) permits P to retain one business and contribute the other business to a wholly owned subsidiary.

Conclusion

As a result of the elimination of the Bausch & Lomb doctrine, C reorganizations will become more important in restructuring businesses within a controlled group, even if the entities involved are not all domestic. As a result of Prop. Kegs. Sec. 1.368-2(b)(1), A reorganizations will also be useful in restructuring domestic entities. These reorganizations will be especially important if a parent seeks to isolate a subsidiary's liabilities from the parent's (or another subsidiary's) operations and disregarded LLCs are the vehicle of choice to hold such operations.

(1) See Sec. 368(a)(2)(C) and Rev. Rul. 69-617, 1969-2 CB 57; all of the types of reorganizations discussed in this article are explained in the text under "Reorganizations," infra.

(2) REG-126485-01 (11/15/01). Treasury and the IRS are considering further revisions to the Sec.368(a)(1)(A) regulations to address statutory mergers involving foreign corporations.

(3) Under Rev. Rul. 76-429, 1976-2 CB 97, whether the assets are transferred to a new subsidiary before or after the liquidation is irrelevant.

(4) See Telephone Answering Service Co., 63 TC 423 (1974).

(5) Rev. Proc. 2002-3, IRB 2002-1, 117.

(6) Rev. Proc. 90-52, 1990-2 CB 626.

(7) The ownership test should be determined immediately after the spinoff; see, e.g., IRS Letter Ruling 200045025 (8/11/01).

(8) Compare, however, IRS Letter Ruling 200137042 (6/20/01), in which a subsidiary, prior to its liquidation (but apparently not as part of its liquidation plan), transferred approximately 50% by fair market value of its assets to another subsidiary of the parent. The parent retained the latter subsidiary and did not spin it off.

(9) See Rev. Rul. 84-2, 1984-1 CB 92; see also IRS Letter Ruling 9253027 (10/2/92), in which the IRS applied a less-than-5%-of-gross-and-net-assets test.

(10) General Utilities and Operating Co., 296 US 200 (1935).

(11) See, e.g., Louis F. Viereck, Cls. Ct., 11/3/83. In that case, the dissolution of a corporation that conducted a floral business was a D reorganization (rather than a liquidation) when the sole shareholder transferred the business to a new corporation, but retained 80% of the dissolved corporation's assets (including title to certain real property used in the business). The corporation obtained beneficial use of substantially all of the dissolved corporation's operating assets; even though the new corporation did not have actual title to certain operating assets, the beneficial use met the D reorganization substantially all of the assets requirement.

(12) See, e.g., Rev. Rul. 70-240, 1970-1 CB 81.

(13) In this situation, the Service may have tried to recast the transaction as an F reorganization; see Rev. Rul. 61-156, 1961-2 CB 62.

(14) Rev. Proc. 2002-3, note 5 supra, adopts the same attribution rules.

(15) See Rev. Proc. 77-37, 1977-2 CB 568; see also, e.g., John A. Nelson Co., 296 US 374 (1935)(38% held sufficient to meet COI).

(16) Bausch & Lomb Optical Co., 267 F2d 75 (2d Cir. 1959), cert. den.

(17) See Rev. Ruls. 79-289, 1-979-2 CB 145, and 87-27, 1987-1 CB 134.

(18) See Rev. Rul. 75-161, 1975-1 CB 114.

(19) See Rev. Rul. 58-93, 1958-1 CB 18.

(20) REG-115086-98 (6/14/99).

(21) Rev. Rul. 76-429; note 3 supra.

(22) Rev. Rul. 69-617, 1969-2 CB 57, note 1 supra; see also Rev. Rul. 58-93, note 19 supra (A reorganization occurred when a 79%-owned subsidiary transferred all of its assets to a new corporation for all of its stock, then merged into the parent).

(23) A QSP is any transaction (or series of transactions) in which one corporation purchases 80% of the vote and value of stock of another corporation within a 12-month period.

(24) Kimbell-Diamond Milling Co., 187 F2d 718 (5th Cir. 1951), cert. den.

(25) Rev. Rul. 90-95, 1990-2 CB 67.
Gregory W. Walkauskas, J.D., LL.M.
Of Counsel
Rose, Schmidt, Hasley & DiSalle, P.C.
Pittsburgh, PA
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Author:Walkauskas, Gregory W.
Publication:The Tax Adviser
Date:Oct 1, 2002
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