Tax Free Reorganization

IRC Section 368 explained further

What is a Tax-Free Reorganization?

Corporations reorganize and restructure for various reasons and in numerous ways. Companies reorganize to increase profits and improve efficiency. The reorganization of a company typically addresses the efficiency component in an attempt to increase profits. Corporate reorganization normally occurs following new acquisitions, buyouts, takeovers, other forms of new ownership, or even the threat of filing for bankruptcy.

These transactions often involve sellers wanting to avoid income tax on the gain realized upon the disposition of their share interests in one corporation for shares in another corporation. A corporation transferring its assets would also like to avoid gain recognition. Income tax deferral can ordinarily be accomplished through the use of a qualifying corporate “reorganization” (as this term is defined for federal income tax purposes).

Countries typically have specific rules for tax-free reorganization in their tax laws. The objective of these rules is not to grant a tax exemption to the companies or shareholders involved, but to “neutralize” the tax consequences of the business reorganization, so that the reorganization involves neither a tax advantage nor a tax disadvantage. The term “tax-free” is a misnomer because the tax is not eliminated, but will be realized when a later taxable transaction occurs.

The principle of tax neutrality in business reorganization has two aspects. It implies (1) that no tax is levied at the time of the reorganization and (2) that, after the reorganization, the taxable profits of the transferee company and its shareholders are calculated on the basis of tax elements that were present in the transferor company and its shares immediately before the reorganization. The principle is one of deferral of tax on unrealized gains that exist at the time of the reorganization, no exemption of tax on these gains.

Below is a brief overview of types of reorganizations from the U.S. income tax perspective. This overview is by no means intended to be a comprehensive treatment of each structure, but rather, is intended to merely highlight some of the important characteristics of each.

Tax-free reorganizations can be divided into four basic categories:

  • Acquisitive reorganizations
  • Divisive reorganizations
  • Corporate restructuring reorganizations
  • Bankruptcy reorganizations

Acquisitive Reorganizations

Acquisitive reorganizations are transactions where one corporation acquires the stock or assets of another corporation. Included in this category are the following types of reorganizations:

Type A reorganization. A merger or consolidation that is effected under state or foreign statutes. In a typical A reorganization, the target corporation’s assets and liabilities become assets and liabilities of the acquiring corporation and the target corporation ceases to exist (IRC § 368(a)(1)(A)).

Type B reorganization. An acquisition of stock of the target corporation in exchange solely for voting stock of the acquiring corporation, provided that the acquiring corporation has “control” (generally 80% ownership) of the target corporation immediately after the transaction (IRC § 368(a)(1)(B)).

Type C reorganization. An acquisition of “substantially all” the assets of the target corporation in exchange for voting stock of the acquiring corporation (and a limited amount of consideration other than qualifying stock, also known as boot) followed by a liquidation of the target (IRC § 368(a)(1)(C)).

Acquisitive D reorganization. The transfer of “substantially all” of the target corporation’s assets to an acquiring corporation, provided that the target corporation or its stockholders (or a combination of the two) has “control” (generally 80% ownership) of the acquiring corporation immediately after the transfer. The target corporation also must liquidate and distribute to its stockholders the acquiring corporation stock and any other consideration received by the target corporation from the acquiring corporation (as well as the target’s other properties, if any) in a transaction that qualifies under IRC § 354 (IRC § 368(a)(1)(D)).

Triangular reorganizations. Types A, B and C acquisitive reorganizations can often also be structured as triangular tax-free reorganizations. Unlike a direct reorganization which involves two parties (the target corporation and the acquiring corporation), a triangular reorganization generally involves three parties: the target corporation on the seller side and a parent corporation and a subsidiary on the buyer side.

Divisive Reorganizations

Divisive reorganizations are transactions where one corporation divides into two or more corporations and that qualify as a divisive Type D reorganization under IRC § 368(a)(1)(D).

Divisive reorganizations take three different forms:

Spin-offs: A transfer of the assets of the parent corporation (typically the assets of a division or line of business) to a newly formed corporation and dividend of the stock of the newly formed corporation to the parent corporation’s stockholders.

Split-offs: An exchange offer in which the stockholders of the parent corporation exchange their stock in the parent for stock in a new entity.

Split-ups: A transfer of the assets of the parent corporation to two or more newly formed corporations and dividend of the stock of the newly formed corporations to the parent corporation’s stockholders. The parent corporation liquidates and the stockholders hold shares in the two or more newly formed companies.

Restructuring Reorganizations

Restructuring reorganizations are adjustments to the corporate structure of an existing (and continuing) corporation. Included in this category are the following types of reorganizations:

E reorganization. A recapitalization under IRC § 368(a)(1)(E)). A recapitalization is a reshuffling of an existing corporation’s capital structure. For example, a corporation’s issuance of common stock for outstanding preferred stock (or an issuance of preferred stock for outstanding common stock) generally qualifies as a recapitalization (Treas. Reg. (§ 1.368-2(e)).

F reorganization. A mere change in identity, form or place of organization of a corporation under IRC § 368(a)(1)(F). For example, changes in the state or jurisdiction of incorporation generally qualify as Type F reorganizations. In addition, if a corporation converts from one type of organization to another, it may qualify as a Type F reorganization (Rev. Rul. 67-376).

Bankruptcy Reorganizations

Bankruptcy reorganizations are transactions that involve the transfer of assets from one corporation to another corporation in a bankruptcy or similar case and that qualify as Type G reorganizations under IRC § 368(a)(1)(G).