Variations on a D reorganization theme.
In general, an acquisitive D reorganization is a transfer of the assets of one corporation (a target) to another (an acquirer) in exchange for the latter's stock; thereafter, the target liquidates and distributes the acquirer's stock received in the exchange to its shareholders. In an acquisitive D reorganization, the distribution of acquirer stock must satisfy Sec. 354 requirements. In a divisive D reorganization, the distribution of acquirer stock has to satisfy the Sec. 355 requirements.
In general, Sec. 368(a)(2)(C) permits an acquirer to transfer assets to a corporation it controls (within the meaning of Sec. 368(c)) following an A, B, C or G reorganization, without disqualifying the reorganization. Why did Congress blatantly exclude D reorganizations from this provision? For many years, tax advisers were concerned that the omission could be interpreted as signaling Congress's intent to invalidate a D reorganization that is followed by a transfer of the target's assets to the acquirer's subsidiary.
In Rev. Rul. 2002-85, the Service declined to draw this negative inference. Reasoning that Sec. 368(a)(2)(C) provides a permissive (and nonexclusive list), the IRS resolved that a transfer of a target's assets to an acquirer's wholly owned subsidiary does not disqualify an otherwise qualifying D reorganization.
Rev. Rul. 2002-85
In the ruling, an individual owns all of a target (a state X corporation) and all of an acquiring corporation (a state Y corporation). For valid business reasons and pursuant to a reorganization plan, the target transfers all of its assets to the acquirer in exchange for 70% of the latter's voting stock and 30% cash. Following the exchange, the target liquidates, distributing the acquirer's voting stock and cash to the individual.
Under the reorganization plan, the acquirer subsequently contributes all of the target's assets to a pre-existing wholly owned subsidiary in exchange for additional subsidiary stock. The subsidiary will continue the target's historical business after the transfer and the acquirer will maintain its ownership of the subsidiary's stock. The Service ruled that the acquirer's contribution of the target assets to the subsidiary does not prevent the transaction from qualifying as a D reorganization, provided the transaction otherwise satisfies applicable D reorganization requirements.
Variations of Rev. Rul. 2002-85
Rev. Rul. 2002-85 provides helpful guidance to taxpayers and tax advisers and can be applied together with existing published guidance for greater tax-planning flexibility. One such opportunity and two limitations are explored below.
"Cause to Be Directed" D Reorganization
Example 1: An individual, I, owns all of the stock of target T. B, an individual, owns all of the stock of corporation A, which owns all of the stock of corporation S. I and B are unrelated. I, B, A and T enter into a plan of reorganization and agreement providing that A will acquire all of T's assets in exchange for A stock, cash and A's assumption of all of T's liabilities. Pursuant to the plan and the agreement, A causes the T assets to be transferred directly from T to S. After T transfers all of its assets, it liquidates, distributing the A stock and cash to I. After the transaction, I owns more than 50% of A's outstanding stock (by value). Because of the amount of cash paid and the liabilities assumed, the transaction does not meet the "solely for voting stock requirement" of a C reorganization.
In this fact pattern, the issue is whether the transaction should be viewed a direct acquisition by A of all of T's assets, followed by A's transfer of those assets to S. Because A exercises dominion and control over the T assets, it should be treated as acquiring the assets directly from T; see Rev. Rul. 70224 (holding that A is treated as acquiring the T assets directly from T). Because A is viewed as the acquirer, Rev. Rul. 2002-85 should apply to ensure that A's transfer of the assets to S does not disqualify the D reorganization, provided that the reorganization meets all the other requirements of a D reorganization.
Triangular D Reorganization
Example 2: The facts are the same as in Example 1, except A contributes its own stock and cash to S. T transfers all of its assets to S in exchange for the A stock, cash and S's assumption of all of T's liabilities. T liquidates, distributing the A stock and cash to I. After the transaction, I owns more than 50% of A's outstanding stock (by value). Because of the amount of cash paid and the liabilities assumed, the transaction does not meet the "solely for voting stock requirement" of a C reorganization.
In this variation on Rev. Rul. 2002-85, S, not A, should be treated as the acquirer in the reorganization. However, unlike Example 1, no published guidance appears to support Sec. 368 treatment of this transaction. Although Sec. 368 (a) (1) (A) (by reason of Sec. 368(a)(2)(D)), (B) and (C) explicitly permit the use of A stock (i.e., parent stock) in such reorganizations, Sec. 368(a)(1)(D) does not. Also, Rev. Rul. 2002-85 does not, by its terms, approve "triangular" D reorganizations. As a result, Example 2 appears to be a taxable acquisition of T's assets by S, even though it is economically equivalent to Example 1.
Divisive D Reorganization
Example 3: An individual, I, owns all of the stock of corporation D. D operates two separate and distinct businesses--A and B. D owns all of the stock of corporation C. As part of a reorganization plan, D contributes B to C in exchange for C stock. After the contribution, D distributes the C stock to I. After the distribution, I holds all of the D and C stock. Immediately thereafter, C contributes 50% of the value of the B assets to S, a newly formed wholly owned C subsidiary, in exchange for S stock.
In Example 3, if the transaction meets the D reorganization requirements, C's contribution of assets to S should not disqualify it under Rev. Rul. 2002-85. However, is the transaction, in its entirety, necessarily tax free? The answer is "no." To ensure that I obtains tax-free treatment, the transaction must also meet all the Sec. 355 requirements, including the active trade or business requirement.
Generally, to qualify as a divisive tax-free reorganization, D and C each must be engaged in the active conduct of a trade or business immediately after the distribution. These trades or businesses must have been actively conducted throughout the five-year period immediately preceding the distribution, and generally must not have been acquired by D or C in a taxable transaction within the five-year period immediately preceding the distribution; see Sec. 355(b). Further, a trade or business is a specific group of activities carried on by the corporation for the purpose of earning income or profit. These activities must include every operation that forms a part of the process of earning income, including the collection of income and payment of expenses; see Begs. Sec. 1.355-3(b)(2)(ii).
In Example 3, C contributed 50% of the value of the B assets to S. Whether the transaction meets the Sec. 355 requirements will most likely depend on the nature of those assets. If C contributes all of the B assets necessary to the conduct of B's business, and only passive assets remain with C, the active trade or business requirement will likely be violated, because C will not be engaged in an active trade or business (i.e., C will not operate B) immediately after the transaction. On the other hand, if C retains sufficient B assets to continue to actively conduct B, its contribution of some of the assets to S should not prevent C from satisfying the active trade or business requirement.
In Rev. Rul. 2002-85, the Service has finally resolved the longstanding issue on the transfer of assets to a controlled corporation following a D reorganization. The ruling provides helpful guidance and greater tax-planning flexibility if, for example, a transaction cannot be structured to satisfy the C reorganization "solely for voting stock" requirement.
Notwithstanding the ruling's helpful guidance, a transaction's form continues to have extreme importance, because economically similar transactions can potentially have drastically different tax consequences, as the examples here suggest. Also, although Rev. Rul. 2002-85 applies equally to acquisitive and divisive D reorganizations, the ruling, by its terms, does not apply for purposes of determining whether the Sec. 355 requirements are met. Accordingly, absent further guidance, advisers should ensure that divisive D reorganizations conform to the separate requirements of Sec. 355, including the active trade or business requirement.
FROM JAMES W. STANLEY, J.D., LL.M., WASHINGTON, DC
David Madden, J.D., LL.M.
Washington National Tax Service
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|Publication:||The Tax Adviser|
|Date:||Jun 1, 2003|
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