Many companies will, at some point, decide that it makes sense to make some changes to its business structure to better align with its business purpose. Certain changes will trigger tax consequences, while other changes may not. With proper analysis and planning, a company may be able to take advantage of one of several types of tax-free reorganizations offered under the U.S. federal income tax code and regulations to defer (or at least minimize) the recognition of any immediate taxes.
Tax-free reorganizations can be classified into four distinctive groups:
· Group 1 includes four types of reorganizations where one entity can merge into, consolidate with, or acquire another entity, and are commonly referred to as Type A, Type B, Type C, and Type D reorganizations.
· Group 2 consists of three different occasions when part of a parent corporation’s assets or stock are used to form a new subsidiary or subsidiaries. Reorganizations under this group also fall under a Type D reorganization.
· Group 3 focuses on maintaining the overall organizational structure, while changing an entity’s capital structure, or moving an entity around the organizational chart. Reorganizations under this group fall under either a Type E or Type F reorganization.
· Group 4 involves the transfer of assets by a corporation to another corporation in a bankruptcy (or similar) case. A reorganization under this group is referred to as a Type G reorganization.
The focus of this discussion is on a Type F reorganization, which falls under Group 3, above. A Type F reorganization typically involves “mere” or simple formality changes to a corporation. Such changes include a change in identity, in form, or in the location of the corporation. In 2015, the IRS issued final regulations to provide the public with clearer guidance and to clarify what qualifies as a “mere change” under an (F) reorganization.
Under the final regulations, a corporation will have undergone a “mere change” if it meets the following six requirements:
1. All stock of the resulting corporation must be distributed in exchange for stock of the transferor corporation;
2. The same person or persons own all the stock of the transferor corporation at the beginning of the potential F reorganization and all of the stock of the resulting corporation at the end, in identical proportions;
3. The resulting corporation does not hold any property or have any tax attributes immediately before the potential F reorganization;
4. The transferor corporation must completely liquidate in the reorganization;
5. No corporation other than the resulting corporation may hold property that was held by the transferor corporation immediately before the potential F reorganization; and
6. Immediately after the potential F reorganization, the resulting corporation may not hold property acquired from a corporation other than the transferor corporation if the resulting corporation would, as a result, succeed to and take into account the tax attributes of such other corporation.
A simple illustration will tie together the above six requirements. P1 and P2 are unrelated individuals that each hold a 50% membership interest in LLC, a limited liability company treated as a partnership for federal income tax purposes. LLC, in turn, owns 100% of USCO, a U.S. C corporation. P1 and P2 want to re-align the current business structure by moving the corporation from under LLC and instead hold the C corporation directly, in the same proportion as the partners currently hold their indirect interests in the corporation, namely, 50/50.
On January 1, 2018, USCO transfers all of its assets to NEWCO in exchange for NEWCO stock. USCO then transfers all of the NEWCO stock to LLC in exchange for USCO stock. USCO subsequently liquidates completely. P1 and P2 each continue to hold 50% membership interest in LLC, which in turn now owns 100% of NEWCO.
The above sequence of events should qualify as a tax-free reorganization, as follows: Under Code Section 361, there is no gain or loss to USCO on the transfer of its assets to NEWCO in exchange for stock of NEWCO in an F reorganization. Under Code Section 354, there is typically no gain or loss to LLC upon the exchange of USCO’s stock for NEWCO stock.
Requirements #1 and #2 under the regulations are satisfied because all of NEWCO’s stock are distributed to LLC in exchange for USCO stock, and LLC is the same shareholder that owns all the stock of USCO at the beginning of transaction, and all of the stock of NEWCO at the end, and owns such stock in identical proportions (i.e. 100%).
#3 is satisfied because NEWCO does not hold any property or have any tax attributes immediately before the transaction, and #4 is satisfied because USCO completely liquidates in the reorganization.
#5 is satisfied because only NEWCO holds property that was held by USCO immediately before the transaction.
Lastly, #6 is satisfied because immediately after the transaction, NEWCO does not hold any property acquired from any other corporation that would result in NEWCO taking into account the tax attributes of such other corporation.