An Introduction to Basic Tax-Free Corporate Reorganization Principles

There are a number of reasons as to why corporations enter into tax-free reorganizations. This article provides a very basic overview of tax-free corporate reorganizations. The term “reorganization” is used in the internal Revenue Code to describe a variety of transactions that result in a fundamental change in the ownership or structure of one or more corporations. Transactions that qualify as reorganizations under Section 368 are wholly or partially tax-free to the corporations and their shareholders. The rationale for nonrecognition is that a reorganization is merely a readjustment of a continuing corporate enterprise, resulting in a continuity of investment. In keeping with nonrecognition principles, the gain or loss is not permanently forgiven but merely deferred through transferred and exchanged bases for the corporation’s assets and the shareholder’s stock.

The basic types of reorganization found in Section 368 of the Internal Revenue Code are:

• Type A reorganization. In a Type A reorganization, the assets and liabilities of a target corporation are transferred to an acquiring corporation in a statutory merger or consolidation, and the target corporation is dissolved. The consideration received by the target’s shareholders is determined by the merger agreement. Internal Revenue Code Section 368(a)(1)(A) does not expressly limit the permissible consideration in a merger or consolidation. The IRS requires that at least 50% of the consideration paid must consist of stock. In the context of international corporate acquisitions, tax-free mergers may take the form of forward triangular mergers, in which the acquired corporation is merged into a subsidiary of the acquiring corporation.
• Type B reorganization. A Type B reorganization takes place when a purchaser acquires the stock of a target corporation solely in exchange for the purchaser’s voting stock, provided that the purchaser is in “control” of the target immediately after the acquisition. See IRC Section 368(a)(1)(B). For this purpose, “control” is ownership of 80% or more of the target’s voting power and 80% or more of the total shares of each class of the target’s nonvoting stock.
• Type C reorganization. A Type C reorganization generally takes place when the purchaser acquires substantially all of the target’s assets solely in exchange for the purchaser’s voting stock (or voting stock of the purchaser’s parent).
• Type D reorganization. A Type D reorganization takes place when there is a transfer by a corporation of part or all of its assets to another corporation if immediately after the transfer the transferor and/or its shareholders are in control of the transferee corporation and if the stock of the transferred corporation are distributed in transaction qualifying under Section 354, 355, or 356.
• Type E reorganization. A Type E reorganization is recapitalization of a corporation.
• Type F reorganization. A Type F reorganization is a mere change in identity, form, or place of organization of one corporation, however affected.
• Type G reorganization. A Type G reorganization is a transfer by one corporation of all or part of its assets to another corporation in a bankruptcy proceeding or a similar proceeding.

Corporate reorganizations fall into three broad categories:

Acquisitive Reorganizations

Acquisitive reorganizations are transactions where one corporation (the “acquiring corporation,” hereafter referred to as “P”) acquires the assets or stock of another corporation (“the target corporation,” hereafter “T”). Included in this category are statutory mergers or consolidations (Type A), stock-for-stock acquisitions (Type B), stock-for-assets acquisitions (Type C), and variations, known as “triangular reorganizations,” which involve the use of a subsidiary.

Nonacquisitive, Nondivisive Reorganizations

Nonacquisitive, nondivisive reorganizations are adjustments to the corporate structure of a single, continuing corporate enterprise. This category includes recapitalizations (Type E); change in the identity, form or place of incorporation (Type F); certain transfers of substantially all of the assets of one corporation to another commonly controlled corporation followed by a liquidation of the first corporation (nondivisive Type D); and transfers of corporation’s assets to another corporation in connection with a bankruptcy reorganization plan (Type G).

Divisive Reorganizations

Divisive reorganizations are divisions of a single corporation into two or more separate corporate entities.

Basics of Reorganizations

Simply fitting within one of the categories of a reorganization discussed in Section 368 will not be enough to classify a transaction as a tax-free reorganization. The transaction must also satisfy the continuity of proprietary interest, continuity of business enterprise, and business purpose doctrines.

Continuity of Proprietary Interest

The continuity of interest doctrine requires that the shareholders of T retain a continuing proprietary interest (i.e., as shareholders) in P. Treas. Reg. Section 1.368-1(b). Put differently, P must provide consideration to T shareholders that represents a proprietary interest in P’s affairs- i.e., stock- and that stock must be a substantial part of the value of the consideration received in the reorganization. Prop. Reg. Section 1.368-2(e). Debt instruments, including convertible debt, do not confer the requisite proprietary interest.

Continuity of Business Enterprise

To qualify as a tax-free acquisitive reorganization, the Income Tax Regulations require a “continuity of business enterprise.” See Treas. Reg. Section 1.368-1(b). P either must continue T’s historic business or continue to use a “significant portion” of T’s “historic business assets” in a business. Treas. Reg. Section 1.368-1(d)(2). The fact that P and T are in the same line of business tends to establish the requisite continuity. If T has more than one business, P only must continue a “significant” line of T’s business. Treas. Reg. Section 1.368-1(d)(3). T’s “historic business assets” are the assets used in its historic business; the portion of those assets that are considered “significant” is based on their relative importance to the operation of the business. Treas. Reg. Section 1.368-1(d)(4).

Business Purpose

A transaction will not qualify as a tax-free reorganization unless it is motivated by a business purpose apart from tax avoidance. Treas. Reg. 1.368-1(c). The business purpose requirement will be satisfied if the distribution is motivated, in whole or in part, by one or more corporate business purposes. Such a purpose is a non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group of which the distributing corporation is a member. Treasury regulations also provide that, if a corporate business purpose can be achieved through a non-taxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then the distribution is not carried out for that corporate business purpose. See Treas. Reg. Section 1.355-2(d)(3). See, e.g., Treas. Reg. Section 1.368-2(b)(5), Example (3), which provides “Corporation X is engaged in the manufacture and sale of toys and the manufacture and sale of candy. The shareholders of X wish to protect the candy business from the risks and vicissitudes of the toy business. Accordingly, X transfers the toy business to new corporation Y and distributes the stock of Y to X’s shareholders. Under applicable law, the purpose of protecting the candy business from the risks and vicissitudes of the toy business is achieved as soon as X transfers the toy business to Y. Therefore, the distribution is not carried out for a corporation business purpose.

The business requirement is an independent requirement, so that even if a reorganization is not used for a tax avoidance purpose (e.g., it was not a “device” for the distribution of earnings), the transaction will not qualify if there was no business purpose for the transaction. Moreover, a corporate business purpose will not be treated as sufficient if the corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of controlled corporate stock and which is neither impractical nor unduly expensive. Treas. Reg. Section 1.355-2(b)(3)-2(b)(5).

The Income Tax regulations include a number of examples of valid corporate business purposes, including a pro rata distribution motivated by a desire to comply with legal requirements (e.g., a court anti-trust order), a non-pro rata distribution permitting different shareholder groups to focus on different business lines and thereby resolve shareholder conflicts, the separation of a regulated business from an unregulated business where it is impossible to achieve the separation without distributing the stock of the regulated business, and a pro rata distribution to enable a key employee to invest in the business of either the distributing or controlled entities. The regulations also identify corporate business purposes that are not sufficient for a tax-free reorganization, or including limitation of liability where liability protection could be achieved without a reorganization. Treas. Reg. Section 1.355-2(b)(5).

In addition to the regulations promulgated under Section 355, Rev. Proc. 96-30, Appendix A, prior to its amendment in Rev. Proc. 2003-48, provided a non-exclusive list of business purposes for a tax-free reorganization transaction, which include: to facilitate the retention of a key employee, to facilitate a stock offering, to facilitate borrowing, to reduce costs, to enhance the fit and focus of the distributing and controlled corporation’s respective business, to reduce the competition between the businesses, to facilitate an acquisition of the distributing corporation, to facilitate an acquisition by the distributing or controlled corporation, and to reduce the risks by separating a risky business from a less risky business. Over the course of time, however, cases and published rulings have acknowledged other valid purposes such as the reduction of state of foreign tax liability, a desire to resolve or reduce the impact of chronic labor union problems, and decreasing competition between the businesses for capital. See Rev. Rul. 89-101, 1989-2 C.B. 67; Rev. Rul. 76-187, 1976-1 C.B. 97; Priv. Ltr. Rul. 9823052 (Mar. 11, 1998).

The Treasury Regulation provides that a shareholder purpose is not a corporate business purpose for purposes of a tax-free reorganization. However, in cases where the shareholder purpose is closely aligned with a corporate business purpose, the business purpose requirement should be satisfied. This  is supported by treasury regulation Section 1.355-2(b)(5), Example 2, which provides:

Corporation X is engaged in two businesses: The manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B anticipate that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

The IRS addressed a similar case in Rev. Rul. 2003-52. In the Revenue Ruling, a family farm corporation was divided with two motives in mind. First, the two shareholders, who were siblings, were in disagreement as to whether the corporation should focus more on the livestock or grain aspects of the business going forward. Thus, dividing the business would allow the siblings to devote their undivided attention and apply a consistent business strategy to the particular business of his or her interest. Second, the parents had estate planning goals in mind and wanted to promote family harmony. The IRS found the first motive to be a corporate business purpose and the second motive to be a shareholder purpose. Despite the second motive being a shareholder purpose, the IRS held that the distribution satisfied the business purpose requirement because it was “motivated in substantial part by a real and substantial non-federal tax purpose that is germane to that purpose.”

Plan of Reorganization

A reorganization must occur pursuant to a plan in order to qualify as a reorganization under Section 368. Treas. Reg. Section 1.368-1(c), 1.368-2(g). Prior to implementing a reorganization, a written plan should be entered into by all shareholders.

Conclusion

This article is intended to provide the reader with a basic understanding of basic tax-free corporate reorganization principles. It should be evident from this article that this is a complicated area of tax law that requires advance planning. If you are considering utilizing a tax-free corporate reorganization as a planning option, it is crucial that you consult with a qualified tax attorney to review your particular circumstances.

Anthony Diosdi is an international tax attorney at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.