Section 368 outlines and defines seven types of corporate reorganizations.
Section 368 outlines and defines seven types of corporate reorganizations.
The Internal Revenue Code of 1986, as amended, generally provides favorable tax treatment to reorganizations described in Section 368(a)(1). In order to receive such favorable treatment, transactions must satisfy several statutory requirements as well as non-statutory 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.
The various types of tax-free reorganizations are defined in IRC § 368(a). They include the following:
|Section 368 Subsection||Type of Restructuring|
|§ 368(a)(1)(A)||Tax-free mergers and consolidations|
|§ 368(a)(1)(B)||Stock-for-stock exchanges|
|§ 368(a)(1)(C)||Stock-for-asset exchanges|
|§ 368(a)(1)(D)||Divisive reorganizations|
|§ 368(a)(1)(F)||Changes in place or form of organization|
|§ 368(a)(1)(G)||Insolvency reorganizations|
The acquisitive reorganizations (particularly those identified in IRC §§ 368(a)(1)(A), 368(a)(1)(B), and 368(a)(1)(C)) are permitted in some situations to be accomplished through the use of acquisition subsidiaries, a situation that is described in various segments below.
A tax-free corporate acquisition can be accomplished through a variety of structural arrangements, including the following:
For tax purposes, various statutory requirements apply to these acquisitive reorganizations, including (1) the amount of stock that must be received by the selling shareholders, (2) the type of stock that must be received by them (e.g., voting stock), and (3) whether any other non-stock consideration can be received. These requirements are not consistent for each type of reorganization.
As the name suggests, a divisive reorganization entails a corporation being divided into several components on a tax-free basis. IRC § 368(a)(1)(D) provides that the term “reorganization” includes 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. However, this treatment applies “only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.” IRC § 354 permits the tax-free receipt of the replacement shares by the shareholders in a reorganization.
If a corporation is suffering from adverse economic circumstances, it may restructure its debt and equity, which is known as a recapitalization. In a downstream recapitalization, debt holders become shareholders and the corporate equity interests of existing shareholders become diluted or eliminated. In an upstream recapitalization, some common shareholders may become preferred shareholders. This latter recapitalization will often occur in closely held corporations where the equity ownership is restructured to facilitate estate planning (i.e., ownership of common stock by older family members is shifted to younger members and the older family members become preferred shareholders). IRC § 368(a)(1)(E) specifies that the term “reorganization” includes a recapitalization.
A corporation may change its place of organization or its form of organization, assuming the replacement entity is a corporation for federal tax purposes. Often, but not always, this is accomplished by the merger of the old entity into a new corporate entity, with ownership rights and shareholder percentages being unaffected. IRC § 368(a)(1)(F) specifies that the term “reorganization” includes “a mere change in identity, form, or place of organization of one corporation, however effected.”
A corporation may need to reorganize itself to facilitate the completion of a bankruptcy or an insolvency proceeding. When the equity interests in the corporation are shifted, the exchange of some corporate interests for others could become income tax recognition events. IRC § 368(a)(1)(G) specifies that the term “reorganization” includes “a transfer by a corporation of all or part of its assets to another corporation in a [U.S. Code] title 11 [i.e., bankruptcy] or similar case; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.”
A tax-free corporate reorganization must ordinarily satisfy certain common-law tax requirements, including the following:
Although Reg. § 1.368-1(b) specifies that a reorganization must have a “continuity of the business enterprise” under the modified corporate form (described in Reg. § 1.368-1(d)) and, except as provided in IRC § 368(a)(1)(D), a “continuity of interest” (described in Reg. § 1.368-1(e)), these requirements have evolved outside the statutory definition of “reorganization” through tax litigation. For this reason they are often described as the “common-law” tax requirements applicable to tax-free corporate reorganizations.
The “continuity of interest” and the “continuity of business enterprise” tests have undergone significant changes during the past twenty years. The statutory definitions for certain types of reorganizations effectively mandate the satisfaction of one or more of these requirements. For example, in a stock-for-stock exchange (i.e., a B reorganization), the only type of consideration permitted to be received by the seller is voting stock, which satisfies the “continuity of interest” mandate. This “common-law” tax requirement is applicable where much greater flexibility is permitted (e.g., for a corporate merger).
These requirements are inapplicable to certain types of reorganizations. For example, notwithstanding the requirements of Reg. § 1.368-1(b), “continuity of interest” and “continuity of business enterprise” are not required for reorganizations under IRC §§ 368(a)(1)(E) and 368(a)(1)(F). In these reorganizations, the shareholders do not change, and, consequently, these requirements are not relevant.
A tax-free reorganization must have a “business purpose,” and not just a tax purpose. Reg. § 1.368-1(b) specifies that a reorganization must be “required by business exigencies.” Even though the continuity of interest and continuity of business enterprise requirements may not apply to all forms of corporate reorganizations, the business purpose requirement will generally be applicable. A corporate tax planner can ordinarily assure compliance with this requirement by having the reorganization documents recite the business and economic purposes of the corporation reorganization (e.g., to facilitate greater economic efficiency of the combined enterprises, to comply with changes in local law, and a variety of other objectives).
Continuity of Shareholder Interest
Reg. § 1.368-1(e) notes that the purpose of the continuity of interest requirement is to prevent transactions that resemble sales from qualifying for non-recognition of gain or loss available to reorganizations. Reg. § 1.368-1(b) specifies that the merger of two enterprises under a single corporate structure is a reorganization if the new corporation maintains a continuity of interest with the shareholders of the old corporation. However, a reorganization does not occur if the shareholders of the old corporation are merely holding short-term notes in the new corporation. The reorganization provisions are detailed and precise, and their specifications, underlying assumptions, and purposes must be satisfied in order for a taxpayer to enjoy the benefit of the exception from the general rule of taxation of a gain realization transaction. Accordingly, under the Code, a short-term purchase money note is not a security of a party to a reorganization, an ordinary dividend is to be treated as an ordinary dividend, and a sale is nevertheless to be treated as a sale even though the mechanics of a reorganization have been satisfied (this latter observation being relevant, for example, to a cash merger).
Under Reg. § 1.368-1(e)(1)(i), a reorganization must preserve a substantial part of the value of the proprietary interests in the target corporation. A proprietary interest in the target corporation is preserved if it is exchanged for a proprietary interest in the issuing corporation, it is exchanged by the acquiring corporation for a direct interest in the target corporation, or it otherwise continues as a proprietary interest in the target corporation. However, a proprietary interest in the target corporation is not preserved if the target is acquired by the issuing corporation for consideration other than stock of the issuing corporation or stock of the issuing corporation furnished in exchange for a proprietary interest in the target is redeemed. All facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. However, a mere disposition of target corporation stock prior to a potential reorganization to persons unrelated to the target or the issuing corporation is disregarded, and a mere disposition of issuing corporation stock prior to a potential reorganization to persons unrelated to the issuing corporation is disregarded. This allows the stock of the target to be traded on a stock exchange without impacting the continuity of interest rule applicable at the time the target is acquired.
Continuity of Business Enterprise
The continuity of business enterprise requirement specifies that the “issuing corporation” (defined in Reg. § 1.368-1(b) as meaning the acquiring corporation) must either continue the target corporation’s business or use a significant portion of target’s assets in the new business. The fact that the purchaser is in the same line of business as the target tends to establish the requisite continuity, but is not alone sufficient. If the target has more than one line of business, the purchaser needs only to continue the most significant line of business. In general, a target’s historic business is the one conducted most recently. However, a business entered into as part of a plan of reorganization is not a historic business. All facts and circumstances are considered in determining when the plan of reorganization comes into existence and whether a line of business is significant. (Reg. § 1.368-1(d))
After completion of the reorganization, the acquired assets can be transferred by the acquiring corporation to certain other corporations and partnerships without violating the continuity of business enterprise requirement if specified ownership conditions are satisfied. (Reg. §§ 1.368-1(d)(3) and 1.368-1(d)(4))