Tax-Free Reorganization

IRC Section 368 explained further

What is a Tax-Free Reorganization?

A corporation may undergo restructuring or reorganization for various strategic reasons, whether for increased operational efficiency or for cutting costs. That reorganization may be conducted to increase profits. A tax-free reorganization is often implemented to find efficiencies within the law that allow for reduced tax. These types of reorganizations can be triggered by certain tactical actions, such as takeovers, buyouts, new acquisitions, or even the threat of Chapter 11. 

These techniques are generally implemented with the mindset that the seller looks to avoid income tax on any realized gains, such as the gain on trading shares in another corporation. While there are other occurrences in which a seller would want to avoid income tax recognition, income tax deferral is often accomplished through using a proper reorganization that follows federal income tax recognition laws.

Tax Rules

Managing a tax-free reorganization is entirely dependent on the tax jurisdiction a company is in. A tax-free reorganization is done not necessarily to grant a tax exemption and thereby put the company in a better position. It is done to reduce any tax consequences of an already impending reorganization.

In other words, a business reorganization is not triggered by the need to conduct a tax-free reorganization. Rather, the tax-free reorganization is triggered when a business reorganization is expected. With the incoming restructuring, the business hopes to neither incur a tax advantage nor a disadvantage.

In essence, the term “tax-free” is misleading because the expense is not entirely mitigated but may be deferred, transferred, or minimized.

Two Factors

To reduce tax concerns in a business reorganization, there are two factors to consider. The reorganization implies that:

  1. After reorganizing, taxable profits in the company joining the parent company (hence known as the transferee) are calculated using the metrics of the parent company prior to the reorganizing; and,
  2. No tax is immediately incurred during the restructuring.

This results in a deferred tax on unrealized gains rather than an exemption to these taxes. So, in essence, the reorganization is tax-free because the tax is not immediately due. The proper term, however, should instead be a tax-deferred reorganization.

Types of Reorganizations

Tax-free reorganizations can be divided into the following four types:

  • Acquisitive Reorganizations
  • Divisive Reorganizations
  • Corporate Restructuring Reorganizations
  • Bankruptcy Reorganizations

Tax-Free Reorganization

1. Acquisitive Reorganizations

Acquisitive reorganizations, as the name implies, involve a restructuring where one corporation acquires another corporation. This can happen via a stock acquisition or asset deal. These reorganizations can be further divided into four sub-categories. The letters attached to each type of category are based on their subsection clause as found in IRC Section 368.

  • Type A reorganization: A merger or consolidation, all privy to the relevant state or federal tax laws. In a Type A reorganization, the target corporation dissolves after the merging. All of the target’s balance sheet is absorbed by the acquiring or parent company (IRC § 368(a)(1)(A)).
  • Type B reorganization: A form of corporate restructuring where the acquiree exchanges its stock for voting stock in the acquirer’s corporation. The sole requirement here is that the acquiring/parent company own above and beyond majority ownership of the acquiree after the transaction. This requires that the target corporation exchange around 75-85% ownership to the acquiring company (IRC § 368(a)(1)(B)).
  • Type C reorganization: A stock-for-asset deal, where the target company “sells” all of its targets to the parent company in exchange for voting stock. Included in this transaction is a necessary amount of consideration that is not equity. This is known as a boot. The target company then liquidates (IRC § 368(a)(1)(C)).
  • Type D acquisitive 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)). There is also a type D divisive reorganization, as described further below.

These types of reorganizations can also be classified as triangular reorganizations (excluding reorganization type D). Types A, B, and C can be used in conjunction with the three parties, involving a target corporation, a parent, and a subsidiary.

2. Divisive Reorganizations

As the name implies, a divisive reorganization involves a corporation dividing into smaller corporations. This results in two or more companies and must qualify under the rules as set out in the divisive Type D reorganization under IRC 368(a)(1)(D). Divisive reorganizations take three different forms:

  • Split-offs: A subsidiary “splits-off.” The parent company’s shareholders then offer parent stock in exchange for some controlling shares in the subsidiary.
  • Spin-offs: The parent corporation “spins-off” some of its assets into a new subsidiary. This spin-off can typically include a specific line of business or divisional assets and is spun-off sometimes for better divisional control. The parent company trades these assets or lines of business to the subsidiary in exchange for stock and dividends in the new subsidiary.
  • Split-ups: A transfer of the assets of the parent corporation to two or more newly formed corporations and dividends 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.

3. Restructuring Reorganizations

Restructuring, though sometimes used synonymously with reorganization, is another form of reorganization. This involves keeping the current corporate entity structure intact but perhaps moving around the organization chart. There are two main types of restructurings:

  • Type E Restructuring: A restructuring involving not the organizational structure but rather the existing corporation’s capital structure. As such, this is classified as a recapitalization under IRC § 368(a)(1)(E)). This can occur when the corporation issues a new class of stock in exchange for existing common stock or preferred stock. 
  • Type F restructuring: A simple formality change to the corporation. This involves a change in identity, form, or location of the corporation under  IRC § 368(a)(1)(F). For example, changes in the state or jurisdiction of incorporation generally qualify as Type F reorganizations.

4. 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).

Additional Resources

Thank you for reading CFI’s guide to Tax-Free Reorganization. To keep learning and developing your knowledge base, please explore the additional relevant resources below:

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