Editor: Rick Klahsen, CPA
Of all types of acquisitive reorganizations, the Sec. 368(a)(1)(A) merger generally provides the most flexibility. With an A merger, the “substantially all the assets” test is not required, qualifying consideration is not limited to solely voting stock, and up to 60% boot is allowed (Regs. Sec. 1.368-1(e) (2)(v), Examples (1) and (2)). However, a variety of business reasons often make a merger less than ideal (e.g., valuable, nontransferable licenses and contracts or successor liability concerns) and lead taxpayers to look to other Sec. 368(a) transactions.
In such instances, the more stringent requirements of the other transaction forms often cause additional problems. For example, a Sec. 368(a)(1)(B) reorganization is not a viable option if the target shareholders negotiated to receive 50% cash consideration. This item explains how, within the context of a subchapter S corporation target, a Sec. 368(a)(1)(F) reorganization private letter ruling may present a structure that allows the parties to a reorganization to have their cake and eat it, too.
Letter Ruling 200835014 addressed a demutualization merger of a nonprofit target into a for-profit taxable corporation (T), followed by the merger of T with and into a wholly owned disregarded entity of the purchasing corporation (P). In line with existing authority, the IRS ruled that the de-mutualization merger represented an F reorganization and that the merger of T with and into the disregarded entity represented a separate A merger of T into P.
F Reorgs. in General
An F reorganization is “a mere change in identity, form, or place of organization of one corporation, however effected”(Sec. 368(a)(1)(F)). Because Treasury has not finalized regulations defining an F reorganization, taxpayers must analyze historical rulings, case law, and proposed regulations when determining whether an F reorganization has occurred. Proposed regulations under Sec. 368(a)(1)(F) provide that a mere change occurs only if:
- All the stock of the resulting corporation, including stock issued before the transfer, is issued in respect of stock of the transferring corporation;
- There is no change in the ownership of the corporation in the transaction, except a change that has no effect other than that of a redemption of less than all the shares of the corporation;
- The transferring corporation completely liquidates in the transaction; and
- The resulting corporation does not hold any property or have any tax attributes (including those specified in Sec. 381(c)) immediately before the transfer (Prop. Regs. Sec. 1.368-2(m)(1)(i)).
However, a legal dissolution of the transferring corporation is not required (Prop. Regs. Sec. 1.368-2(m)(1)(ii)(A)).
Under Prop. Regs. Sec. 1.368-2(m) (3), the regulations would, for the most part, adopt existing authority when applying the step-transaction doctrine to determine whether an F reorganization has occurred. The IRS has consistently held that application of the step-transaction doctrine should not cause the failure of an F reorganization occurring as part of a larger transaction. (See Rev. Ruls. 200348, 96-29, 79-250, 69-516, 64-250, and 61-156.)
In Rev. Rul. 69-516, the IRS respected an F reorganization that occurred as a step in a series of transactions that ultimately resulted in a Sec. 368(a)(1)(C) reorganization of the target and an acquirer. The IRS did not apply the step-transaction doctrine to collapse the steps into a single C reorganization. In Letter Ruling 200835014, the IRS applied these same principles to a Sec. 368(a)(1)(A) merger following a demutualization F reorganization.
Similarly, in Rev. Rul. 79-250, the IRS held that the step-transaction doctrine should not apply to cause an F reorganization to fail where it occurs as a step in a series of transactions that result in more than a mere change. Ruling on an identical fact pattern in Rev. Rul. 9629, the IRS clarified and emphasized the unique treatment of the step-transaction doctrine as it applies to F reorganizations. These rulings directly correlate to Prop. Regs. Sec. 1.368-2(m)(3)(ii), which states that an F reorganization occurring within a larger transaction that results in more than a mere change will not cause failure of the otherwise qualifying F reorganization.
The courts have similarly separated F reorganizations from other transactions occurring in close proximity to the F reorganization. (See Reef Corp., 368 F.2d 125 (5th Cir. 1966), cert. denied, 386 U.S. 1018 (1967); Aetna Cas. and Sur. Co., 568 F.2d 811 (2d Cir. 1976); see also Casco Prods. Corp., 49 T.C. 32 (1967).)
F Reorgs. and Qualified Subchapter S Subsidiaries
For closely held corporations, a common form of F reorganization involves the contribution of all the stock of a target subchapter S corporation to a newly created domestic corporation in exchange for all the stock of the newly created corporation, followed by an immediate qualified subchapter S subsidiary (QSub) election for the target. The IRS addressed this type of reorganization in Situation 1 of Rev. Rul. 2008-18. While the ruling does not specifically conclude on the transaction’s qualification as an F reorganization, it clearly indicates that such a transaction may represent an F reorganization. Furthermore, the IRS has issued numerous private letter rulings confirming the treatment of such a transaction as an F reorganization (Letter Rulings 200725012, 200701017, and 200542013).
Using an F Reorg. for Pretransaction Restructuring
Example 1: P is a publicly traded C corporation in negotiations to acquire T, an S corporation. The parties intend to accomplish the acquisition via an A merger of T into P, with consideration comprising an equal amount of cash and P stock. However, during the transaction due diligence process, it is determined that the difficulty of transferring valuable T contracts (i.e., government, customer, or supply contracts) to P will require a structural change whereby T will remain in existence. Based on the mix of consideration, neither a B reorganization nor a Sec. 368(a)(2)(E) reorganization is viable, and T is not willing to take less cash.
To accomplish a 50-50 cash and stock transaction allowing P to acquire the T stock, the transaction is structured with the following steps:
- In a transaction intended to qualify as an F reorganization similar to the one described in Situation 1 of Rev. Rul. 2008-18, Newco is created, and T is transferred to Newco. This is followed by an immediate QSub election for T.
- Following the F reorganization, Newco merges with and into P in exchange for merger consideration of equal amounts of cash and stock in a transaction intended to qualify as an A merger.
In this situation, where Newco (an S corporation) merges with and into P (a C corporation), the QSub election for T terminates (see Regs. Sec. 1.1361-5(a) (1)(iii)). P’s acquisition of T is treated as Newco’s transfer of the T assets to P, followed by P’s transfer of the T assets to a newly created C corporation (New T) (see Regs. Sec. 1.1361-5(b)(3), Example (9), and Rev. Rul. 2004-85, Situation 2). Where such deemed transfers occur as part of a Sec. 368(a) reorganization, the deemed transfers do not cause an otherwise qualifying reorganization to be disqualified (see Sec. 368(a)(2)(C) and Regs. Sec. 1.368-2(k)).
Under step-transaction principles for F reorganizations, in particular those applied in Rev. Ruls. 69-516 and 96-29 and most recently by the IRS in Letter Ruling 200835014, assuming that step 1 otherwise meets the requirements of an F reorganization, the transaction should not be disqualified as a result of the merger taking place in step 2.
Following the step 2 merger, the parties end up in a position almost identical to what would have transpired in a direct stock acquisition. However, unlike a B reorganization (or other stock acquisition), any earnings and profits or other tax attributes of Newco (T prior to the step 1 F reorganization) will transfer to P (see Sec. 381(c)).
Example 2: P, an S corporation, is in negotiations to acquire T, also an S corporation. The contract and license issues are the same as in Example 1, causing P to require that T survive the reorganization. The parties intend to accomplish the acquisition via a stock-for-stock B reorganization, with consideration comprising solely P voting stock. P plans to immediately elect to treat T as a QSub. As a result, the acquisition needs to be tested as a C reorganization (see Rev. Ruls. 67-274 and 2004-85). However, in contemplation of the acquisition, T sold a division that had accounted for approximately 35% of T ’s historic value and distributed the proceeds to the T shareholders. As a result, the acquisition would qualify as neither a B reorganization nor a C reorganization (due to failure of the substantially all the assets requirement). To accomplish the acquisition, the transaction is structured using the same two steps used in Example 1.
Business Purpose and Economic Substance of the Step 1 F Reorg.
As with any Sec. 368(a) reorganization, the F reorganizations in the examples above must have a valid business purpose and satisfy additional judicial doctrines such as economic substance. Does the step 1 F reorganization have a valid business purpose? It seems clear that the business purpose of the F reorganization is to allow the parties to consummate the merger of the two corporations while retaining the valuable contracts tied to the T corporate legal entity. If not for the contract transferability issue, a straight A merger without the step 1 F reorganization would have accomplished the intended tax results. Therefore, one could argue that the step 1 F reorganization is consummated solely for nontax business reasons.
Does the Coltec economic substance analysis jeopardize qualification of the reorganizations? (See Coltec Indus., 454 F.3d 1340 (Fed. Cir. 2006).) The Coltec economic substance analysis is generally considered to require a transaction to have both profit potential and a nontax business purpose. Pre-Coltec judicial history suggests that the emphasis on profit potential occurs in transactions triggering large tax losses, and the courts will emphasize profit potential over business purpose or taxpayer motive in such instances. For example, the Eleventh Circuit stated in Kirchman that “[i]t is clear that transactions whose sole function is to produce tax deductions are substantive shams, regardless of the motive of the taxpayer” (Kirch man, 862 F.2d at 1492 (11th Cir. 1989), aff’g Glass, 87 T.C. 1087 (1986)). (See also Mahoney, 808 F.2d 1219 (6th Cir. 1987), aff’g Forseth, 85 T.C. 127 (1985); and Shriver, 899 F.2d 724 (8th Cir. 1990).)
However, other courts have not limited economic substance to profit potential but instead allow for analysis of other economic considerations. In ACM Part nership, the Third Circuit acknowledged that “it is also well established that where a transaction objectively affects the taxpayer’s net economic position, legal relations, or nontax business interests, it will not be disregarded merely because it was motivated by tax considerations” (ACM Partnership, 157 F.3d 231 (3d Cir. 1998), aff’g in part and rev’g in part T.C. Memo. 1997-115). (See also Northern Indiana Pub. Serv. Co., 115 F.3d 506, 510 (7th Cir. 1997); and Kraft Foods Co., 232 F.2d 118 (2d Cir. 1956).)
When considering tax planning and structuring, such as steps 1 and 2 above, the recognition of economic consequences outside of profit potential is extremely important. Though a specific step of a transaction or series of transactions may not contain a clear profit motive, the result of the steps may result in a clear change to the objective economic positions, legal relations, and nontax business interests of the parties. As a result, it would appear reasonable to assume that the Coltec profit potential analysis should be limited to loss-and deduction-generating transactions and that a more general economic substance analysis focusing on nontax business purpose and/or an objective change in the economic position of the parties may apply in other situations.
Conclusion
The use of disregarded entities in the context of F reorganizations has become very common and provides great flexibility for taxpayers. Under the right circ*mstances, a pretransaction F reorganization could help solve significant deal issues for both a buyer and a seller.
EditorNotes
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or rick.klahsen@rsmi.com.
