Non-Recognition Exchanges
Under the Code and the Regulations issued thereunder, the gain or loss arising from the conversion of property into cash is treated as income realized or as loss sustained by the owner of the converted property,[i] which the owner must generally account for in determining their federal income tax liability for the year of the conversion.[ii]
Likewise, the gain or loss arising from a property owner’s exchange of such property for other property that differs “materially in kind” from the property exchanged should, as in the case of a sale for cash, be treated as a taxable event, the gain or loss from which must be accounted for in determining the owner’s gross income for the year of the exchange.[iii]
Unliquidated, Continuing Interests
However, Congress decided long ago that certain gains or losses that are realized on the sale or exchange of property should not be recognized; that is, they should not be included in, or deducted from, gross income at the time the sale or exchange occurs.
These exceptions to the general rule of gain or loss recognition involve circumstances in which Congress has determined it may be inappropriate to treat a property owner’s exchange of such property for other property as a taxable event; specifically, where the owner has not liquidated their investment and the exchange effects only a readjustment of the owner’s continuing interest in the property exchanged under a modified form.[iv]
Reorganizations
The purpose of the corporate “reorganization” provisions of the Code is to except from the general recognition rule certain specifically described exchanges that are incident to such readjustments of corporate structures that are made in one of the particular ways specified in the Code, as are required by business exigencies, and which effect only a readjustment of the shareholders’ continuing interest in the property under modified corporate forms.[v]
In order for the reorganization of a corporation (for our purposes, the “target”) and of its shareholders’ interests therein to qualify for nonrecognition treatment under the Code, (i) the transaction must entered into for a valid business purpose, (ii) the reorganized corporation’s historic business must be continued or a significant portion of its historic business assets must be used in a business, through the issuing (the acquiring) corporation, and (iii) a substantial part of the value of the target shareholders’ proprietary interests in the target corporation is preserved in the reorganization as a proprietary (equity) interest in the issuing corporation.[vi]
Strict Application of Requirements
In order to exclude transactions not intended to be included, the specifications of the reorganization provisions of the law are precise. Both the terms of these specifications and their underlying assumptions and purposes must be satisfied in order to entitle the exchanging taxpayer to the benefit of the non-recognition exception from the general rule requiring recognition.
Thus, the application of the term “reorganization” is strictly limited to the specific transactions set forth in the Code.[vii] In determining whether a transaction qualifies as a reorganization, the transaction must be evaluated under relevant provisions of law,[viii] including the step transaction doctrine, which is a subset of the substance over form doctrine; i.e., an examination of economic reality.[ix]
Types of Reorgs
Setting aside transactions in the context of a bankruptcy[x] and those that involve only one corporation,[xi] the Code limits the definition of the term “reorganization” to two kinds of stock acquisitions[xii] and three kinds of asset acquisitions. All other transactions are excluded.
Of the three asset-acquisition reorganizations,[xiii] this post will consider a transaction with respect to which the IRS issued a private letter ruling[xiv] in which the agency determined the transaction qualified as a “C reorganization” (a “C Reorg”). To better understand the IRS’s ruling, let’s first briefly consider the requirements for treatment as a C Reorg.
The C Reorg
According to the Code, a C Reorg involves the acquisition by one corporation, in exchange solely for shares of its voting stock (or in exchange solely for shares of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties[xv] of another corporation (the target).
Following the foregoing exchange, and pursuant to the plan of reorganization, the target corporation must distribute to its shareholders (i) the stock (and any other properties) it received from the acquiring corporation, as well as (ii) its other properties that were not transferred as part of the exchange.[xvi]
In determining whether the exchange is solely for stock, the assumption by the acquiring corporation of liabilities of the transferor corporation, or the fact that property acquired from the transferor corporation is subject to a liability, is generally disregarded.
Under an exception to the “solely for stock” requirement, if (i) one corporation acquires substantially all of the properties of another corporation, (ii) the acquisition would qualify as a C Reorg but for the fact that the acquiring corporation exchanges money or other property in addition to voting stock,[xvii] and (iii) the acquiring corporation acquires, solely for voting stock, property of the target corporation having a fair market value which is at least 80 percent of the fair market value of the target, then such acquisition will be treated as a C Reorg.[xviii] However, solely for the purpose of determining whether the 80 percent test is satisfied, the amount of any liability assumed by the acquiring corporation is treated as money paid for the property.[xix]
With this foundation, now let’s consider the above-referenced ruling.
The PLR
Target was a corporation treated as an S corporation for federal income tax purposes;[xx] thus, its shareholders, who were not otherwise identified, were U.S. individuals and/or qualifying trusts. Target owned an interest in Partnership, which was Target’s primary asset. Target’s other assets consisted of cash and cash equivalents.
Partnership was a general partnership and was treated as a partnership for federal income tax purposes; thus, there was at least one other partner aside from Target.[xxi] Partnership owned shares of stock in Corp,[xxii] which was a C corporation. The Corp shares were Partnership’s primary asset.
Partnership Distribution
In preparation for the reorganization of Target (the Reorg), Partnership distributed to Target all its shares of Corp stock attributable to Target’s interest in Partnership (the “Corp Shares”). It is not clear that this distribution was in complete liquidation of Target’s interest in Partnership.[xxiii] Target thereby became a direct shareholder of Corp.
Stock for Assets
After the foregoing preparatory transaction, Acquiring acquired all the Corp Shares owned by Target – Target’s assets – solely in exchange for newly issued shares of Acquiring voting common stock (the “Acquiring Shares”).
Target Corp Converts to LLC
Immediately after the transfer of its Corp Shares, Target converted, in accordance with state law, into a limited liability company (LLC) which was treated as a partnership for federal income tax purposes; in other words, as a result of the conversion, the former shareholders of Target (of which there were at least two) became members of the new LLC.
Target used its cash to pay its Reorg expenses, reimburse Acquiring for its Reorg expenses, and distribute pro rata its remaining cash to Target’s shareholders (the “Residual Cash Distribution”; significantly for purposes of the reorganization rules, the cash did not come from Acquiring).
Target represented that it was treated as distributing the Acquiring Shares it received in connection with the Reorg to its shareholders in pursuance of the plan of reorganization, as well as any properties not transferred to Acquiring with respect to its stock or liabilities. Indeed, where an entity classified as a corporation (Target) elects to be classified as a partnership (via a state law conversion into an LLC), the following should be deemed to occur: the corporation distributes all of its assets and liabilities to its shareholders in liquidation of the corporation, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership in exchange for interests therein.[xxiv]
Target Representations[xxv]
Target also represented that: (i) the Reorg was undertaken pursuant to a plan of reorganization;[xxvi] (ii) the Reorg was motivated, in substantial part, by bona fide non-federal income tax purposes; (iii) Acquiring acquired Target’s assets (the Corp Shares) solely in exchange for the Acquiring Shares; (iv) the fair market value of the Acquiring Shares received by Target in the Reorg were approximately equal to the fair market value of the Corp Shares surrendered; (v) there was no plan or intention by Acquiring (or any person related to Acquiring) to acquire any of the Acquiring Shares received by Target shareholders in exchange for their Target stock in connection with the Reorg; (vi) Acquiring acquired from Target assets with a fair market value of at least 90 percent of the fair market value of the net assets and at least 70 percent of the fair market value of the gross assets held by Target immediately prior to the Reorg; (vii) Acquiring would continue the historic business of Target or use a significant portion of Target’s historic business assets in a business;[xxvii] (viii) no liabilities of Target were assumed by Acquiring;[xxviii] and (ix) each party to the Reorg was solvent for federal income tax purposes immediately before and immediately after each relevant step of the Reorg.
The Ruling
Based on the foregoing facts and representations, the IRS ruled that: (i) the Reorg qualified as a C Reorg; (ii) Target and Acquiring were each a party to the reorganization; (iii) Target would not recognize any gain or loss on its transfer of the Corp Shares to Acquiring in exchange for the Acquiring Shares;[xxix] (iv) Target would not recognize any gain or loss on the deemed distribution of the Acquiring Shares to Target’s shareholders;[xxx] and (v) the Target shareholders would not recognize gain or loss on the exchange of their Target shares for Acquiring Shares (as a result of Target’s deemed distribution) except on the receipt of a proportionate share of the Residual Cash Distribution, if any.[xxxi]
Observations
The conversion of Target from a state law corporation to a state law limited liability company was undertaken pursuant to a state law conversion statute.[xxxii] Under such a statute, when an entity has been converted to a limited liability company, for all purposes of the state’s laws, the limited liability company is deemed to be the same entity as the converting entity and the conversion constitutes a continuation of the existence of the converting other entity in the form of a limited liability company.[xxxiii]
From a tax perspective, as described earlier, the converting corporation, Target, should be treated as having made a liquidating distribution to its shareholders. Such a liquidation is required for a successful C Reorg following the asset-for-solely-voting-stock exchange. The fact there was no actual or “physical” liquidating distribution to, and possession by, Target’s shareholders of the Acquiring Shares was not material to the IRS’s ruling. It sufficed that the conversion, from a tax perspective, comprised the necessary steps and produced the same outcome as such a liquidating distribution.
Moreover, the fact that Target’s shareholders, to whom the required liquidating distribution of the Acquiring Shares was deemed to have been made under the C Reorg rules, did not take “physical” possession of such shares but were, instead, treated as having contributed them to a newly formed partnership did not jeopardize the C Reorg. Under the continuity of interest regulations,[xxxiv] the focus is generally on exchanges between the target corporation’s shareholders and the issuing (acquiring) corporation. Under this approach, dispositions of the acquiring corporation’s stock by the former target shareholders generally are disregarded. Thus, the post-Reorg “tax-free” contribution (or deemed contribution pursuant to the conversion described in the PLR) of the Acquiring Shares to Partnership in exchange for a partnership interest[xxxv] did not cause the transaction to fail the continuity of interest test.
Thus, Target corporation, which owned Corp stock, was replaced by LLC, which owned Acquiring Shares, and the former shareholders of Target preserved their indirect equity interest in the latter’s business assets as members of LLC.
The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the firm.
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[i] When used in this context, the term “conversion” typically refers to a sale of the property in question.
Interestingly, late last year, New Zealand’s Inland Revenue proposed that a corporation’s loan to its shareholder should be treated as a taxable dividend if it is not repaid within one year. The proposal has its genesis in the fact that the shareholders of many closely held corporations do not cause their corporation to make dividend distributions or to pay salaries to employee-shareholders.
In the U.S., the subpart F rules treat a loan from a CFC to its U.S. shareholder as an investment in a U.S. obligation and, thus, as a distribution that such shareholder may have to include in gross income under certain circumstances. IRC Sec. 951(a)(1)(B) and Sec. 956.
Some have suggested that this concept be extended for purposes of implementing a wealth tax.
[ii] Reg. Sec. 1.61-6(a) provides: “Gain realized on the sale or exchange of property is included in gross income, unless excluded by law.”
[iii] Reg. Sec. 1.1001-1(a).
[iv] Reg. Sec. 1.61-6(b). Gain or loss from such sales or exchanges is generally recognized at some later time. The prime example is the sale or exchange of real property held for productive use or investment for property of like kind under IRC Sec. 1031, but see also the following: (1) certain formations and liquidations of corporations (IRC Sec. 351, 332 and 337); (2) certain formations and distributions of partnerships (IRC Sec. 721 and 731); (3) a corporation’s exchange of its stock for property (IRC Sec. 1032); (4) certain involuntary conversions of property if replaced (IRC Sec. 1033); and (5) certain exchanges of stock for stock in the same corporation (IRC Sec. 1036).
[v] Reg. Sec. 1.368-1(b).
[vi] Reg. Sec. 1.368-1.
[vii] We are all familiar with the well settled principle of federal tax law that deductions and credits are a matter of legislative grace. INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435 (1934). Unless specifically provided for in the Code, no deduction or credit is allowed.
The non-recognition treatment accorded to exchanges that satisfy the requirements of the reorganization provisions of the Code are subject to a comparable degree of examination.
[viii] Beginning, of course, with IRC Sec. 368.
[ix] For example, a stock for stock exchange that is followed by the liquidation of the acquired corporation may be treated, and tested, instead as the acquisition of the assets of the target in exchange for stock of the acquiring corporation.
[x] IRC Sec. 368(a)(1)(G).
[xi] IRC Sec. 368(a)(1)(E) (involving a recapitalization) and Sec. 368(a)(1)(F) (involving a mere change in identity, form, or place of organization of one corporation).
[xii] IRC Sec. 368(a)(1)(B) and Sec. 368(a)(2)(E).
[xiii] IRC Sec. 368(a)(1)(A) (involving a merger or consolidation under state law); Sec. 368(a)(1)(C) (involving the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in control of the acquiring corporation), of substantially all of the properties of another corporation, but in determining whether the exchange is solely for stock the assumption by the acquiring corporation of a liability of the other shall generally be disregarded; and Sec. 368(a)(1)(D) (involving a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred). See also IRC Sec. 368(a)(2)(D).
[xiv] PLR 202601012.
[xv] For ruling purposes, the “substantially all” requirement is satisfied if there is a transfer of assets representing at least 90 percent of the fair market value of the net assets and at least 70 percent of the fair market value of the gross assets held by the target (transferring) corporation immediately prior to the transfer. Rev. Proc. 77-37, amplified by Rev. Proc. 86-42.
[xvi] IRC Sec. 368(a)(2)(G). For purposes of this rule, any distribution to the acquired corporation’s creditors is treated as made pursuant to the plan of reorganization.
It should be noted that the other two asset-acquisition reorganizations also require the liquidation of the acquired corporation: in an A reorganization (a state law merger), the target corporation is deemed to have been liquidated by operation of law; in a D reorganization, the target is required to make a liquidating distribution to its shareholders of (a) the stock and other properties it received from the acquiring corporation, as well as (b) the other properties of the target. IRC Sec. 354(b)(1)(B).
[xvii] “Boot.”
[xviii] The “boot relaxation” rule.
[xix] IRC Sec. 368(a)(2)(B); Reg. Sec. 1.368-2(d)(3).
[xx] IRC Sec. 1361.
[xxi] How many times can I use the word “partnership” in a single sentence?
[xxii] Actually, shares of Acquiring stock, referred to as the Old Acquiring Shares. We’ll refer to Corp here to avoid confusion.
[xxiii] According to IRC Sec. 731(a)(1), gain shall not be recognized to a partner on a distribution by a partnership except to the extent that any money distributed exceeds the adjusted basis of such partner’s interest in the partnership immediately before the distribution.
We’ll assume that IRC Sec. 731(c), Sec. 707(a), Sec. 704(c)(1)(B), Sec. 737, and Sec. 751 were not an issue with respect to the distribution.
[xxiv] See, for example, Reg. Sec. 301.7701-3(g)(1)(ii).
In most cases, a corporation’s liquidating distribution to its shareholders is treated as a taxable sale of its assets by the corporation (IRC Sec. 336) and a taxable sale of their stock by the shareholders (IRC Sec 331).
[xxv] Recall the earlier discussion regarding the requirements to be satisfied for treatment as a C Reorg.
[xxvi] As described in Reg. Sec. 1.368-1(c).
[xxvii] Within the meaning of Reg. Sec. 1.368-1(d).
[xxviii] Within the meaning of IRC Sec. 357(d).
[xxix] IRC Sec. 361(a).
[xxx] IRC Sec. 361(c)(1).
[xxxi] IRC Sec. 354(a)(1) or Sec. 356(a)(1).
The IRS also ruled that: each Target shareholder’s basis in the Acquiring Shares deemed received in the Reorg would be equal to Target shareholder’s basis in their Target shares immediately before Target’s conversion (adjusted for each Target shareholder’s proportionate share of the Residual Cash Distribution, if any) [IRC Sec. 358(a)(1)]; and each Target shareholder’s holding period in the Acquiring Shares deemed received in the Reorg would include the period during which the stock of Target surrendered in exchange was held, provided that the Target stock was held as a capital asset by the Target shareholder on the date of the exchange. IRC Sec. 1223(1).
[xxxii] New York does not have one. Surprise!
[xxxiii] For example, see Delaware’s LLCA Sec. 18-214(g).
[xxxiv] Reg. Sec. 1.368-1(e).
[xxxv] IRC Sec. 721.