Section 368(A)(1) outlines a format for US tax treatment of corporate reorganizations, as described in the Internal Revenue Code of 1986. The reorganization transactions, however, must meet certain legal requirements to classify for the favorable treatment. Additionally, there has been further precedent outside of the codified requirements that have developed in case law.
A variety of transactions can be tax-free reorganizations for federal income tax purposes. To qualify as a tax-free reorganization, a transaction must meet the statutory requirements for one of the types of tax-free reorganizations. In addition, a tax-free reorganization generally must also satisfy the three judicial requirements (continuity of interest, continuity of business enterprise, and business purpose) that apply to all tax-free reorganizations.
Identification of the Tax-Free Reorganization Structures
The various types of tax-free reorganizations are defined in IRC Section 368(a). They include the following:
Section 368 Subsection
Type of Restructuring
Tax-free mergers and consolidations
Changes in place or form of organization
The reorganizations are further described below, but for brevity’s sake, the above can be split into five main types of reorganizations. Subsections A, B, and C are classified as acquisitive reorganizations, wherein the use of a subsidiary structure is required. Subsection D through G are all categories of their own, forming the four other types of reorganizations discussed further below.
IRC Section 368(a)(1) Subsections A through C
The first three acquisitions outlined above are categorized as acquisitive reorganizations, wherein they are constituted by the acquisition of a subsidiary.
A tax-free merger and consolidation as outlined IRC Section 368(a)(1)(A) is fairly cut and dry. In a merger-type of reorganization, a subsidiary corporation is absorbed into a parent company, following any applicable state law or merger statute. A consolidation, on the other hand, involves a combination of two equally grounded companies. In terms of business organization, these two companies may actually dissolve and band together as a new corporation.
IRC Section 368(a)(2)(D) outlines a different type of merger, known as a forward triangular merger. In this reorganization, a target corporation is acquired by the subsidiary of a parent company, as opposed to acquisition from the parent company directly. IRC Section 368(a)(2)(E) outlines a reverse triangular merger, wherein a subsidiary of the parent acquiring company is absorbed into the target corporation.
Subsection B of Section 368(a)(1) defines astock-for-stock exchange, which results in a parenthetical B reorganization (as dictated by the subsection). This type of transaction involves trading all target company stock for a portion of the stock of the acquiring parent corporation. This removes ownership of the target company from target company shareholders and gives it to the acquiring company. In exchange, target company shareholders become minority shareholders of the acquiring company.
As opposed to an acquisitive reorganization, a divisive reorganization involves divestiture of a portion of a group’s holdings, or division of that corporation into smaller subsidiaries. This results in a tax-free reorganization, which can be described as the reverse of an acquisition.
IRC Section 368(a)(1)(D) defines that a division of assets by a parent company can constitute as a binding and legal reorganization if the holders of each divided part admit control immediately after the transfer, and these holders were a shareholder of the previous parent company. Section 354 further outlines a supporting structure where replacement shares can be received in this type of reorganization in a tax-free manner.
IRC Section 368(a)(1)(E)
A recapitalization occurs when a company restructures the proportion of debt and equity within the company. This may be due to adverse economic environments that lead the company to a restructure, but not insofar as to require a merger or deconsolidation.
There are two types of recapitalization – a downstream recap and an upstream recap. An upstream recapitalization results in common shareholders scaling up into preferred shareholders. A downstream recapitalization removes debt by turning debt holders into shareholders, however diluting the ownership of previously existing shareholders.
IRC Section 368(a)(1)(F)
A relocation or organizational structure change may result in a reorganization for federal tax purposes. This movement may be accomplished by merging an old entity with a shell corporate entity in a new location or holding the desired organizational structure. Subsection F simply states that this type of restructuring, which includes “a mere change in identity, form, or place” is considered a reorganization for tax purposes.
IRC Section 368(a)(1)(G)
The final sub-section outlines the reorganization classification in the event of bankruptcy or insolvency proceedings. Divestiture of equity stakes in a liquidating corporation may constitute a reorganization and become income tax recognition events.
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