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New Rules for Qualifying a Transaction as a Statutory Merger or Consolidation Under Section 368(a)(1)(A) of the Internal Revenue Code

Tax

Section 368(a)(1)(A) of the Internal Revenue Code1 provides that a statutory merger or consolidation qualifies as a reorganization. In a merger, one corporation acquires the assets and liabilities of another corporation that ceases to exist after the merger. In contrast, a consolidation occurs when two or more corporations combine to form a new corporation.2 Generally, if a transaction qualifies as a statutory merger or consolidation and certain additional conditions are satisfied, gain or loss is not recognized for federal income tax purposes.

The Internal Revenue Code does not explain when a transaction qualifies as a statutory merger or consolidation. Instead, regulations promulgated under §368 give guidance relative to making that determination.3 Until recently, those regulations provided that a merger or consolidation must comply with the “corporation laws of the United States or a State or Territory or the District of Columbia.”4 Despite this broad language, it was not clear whether a transaction between a target corporation and a disregarded entity of an acquiring corporation would qualify under §368(a)(1)(A).

The Internal Revenue Service and Department of the Treasury issued temporary regulations under §368 on January 24, 2003, that clarify which types of transactions qualify as statutory mergers or consolidations under §368(a)(1)(A).5 Under the temporary regulations, §368(a)(1)(A) may be satisfied if a target corporation merges, or consolidates, with an acquiring corporation or a disregarded entity of an acquiring corporation.6 This conclusion is consistent with proposed regulations that were issued in November 2001.7

Accordingly, in a merger between a target corporation and a disregarded entity of an acquiring corporation, the acquiring corporation will obtain the tax benefits of the merger, and the disregarded entity will receive the detriments ( i.e., the liabilities of the target corporation). Hence, because §368(a)(1)(A) contains the least restrictive criteria of the tax-free reorganization provisions, taxpayers will be more inclined to engage in those types of reorganizations.

Section 1.368-2T Requirements & Examples
The temporary regulations contain two rules that explain when a transaction qualifies as a statutory merger or consolidation. Each rule is discussed below.

The First Rule: The General Rule for Statutory Mergers or Consolidations

The first rule is described in §1.368-2T(b)(1)(ii) of the temporary regulations. This article refers to that rule as the “general rule.”

The general rule considers whether a transaction qualifies as a statutory merger under §368(a)(1)(A) when a target corporation (in a state law merger) transfers its assets and liabilities, and the assets and liabilities attributed to any disregarded entity that the target owns, to an acquiring corporation or any disregarded entity that the acquiring corporation owns. Additionally, the general rule applies to a consolidation.8

A corporation is defined in the temporary regulations by reference to §301.7701-2(b) of the Treasury Regulations.9 That regulation provides eight different definitions for a corporation.10 For the purpose of this article, only the first definition is relevant. Under that definition, an entity is a corporation if a statute so provides.11

A disregarded entity is a business entity12 that is not treated as an entity that is separate from its owner for federal income tax purposes.13 The temporary regulations list three examples of disregarded entities.14

A domestic limited liability company (LLC) that has one owner and that is not classified as a corporation for federal income tax purposes is the first example.15 State law imposes the requirements for the formation of an LLC.16 For example, Florida law provides that one or more persons may form an LLC.17 Under Florida law, the definition of a “person” includes not only an individual, but an entity18 such as a corporation.19 Accordingly, Florida law provides that a corporation may own an LLC.

A qualified real estate investment trust subsidiary (QRS) that is a corporation is the second example.20 A corporation is a QRS if 100 percent of its stock is owned by a real estate investment trust (REIT) that does not elect to treat its subsidiary as a taxable entity.21 All of the assets, liabilities, and items of income, deduction and credit of a QRS are treated as items that belong to the REIT.22

A qualified subchapter S subsidiary (QSub) is the third example.23 A QSub is a corporation that is a wholly owned subsidiary of a subchapter S corporation that elects to treat the subsidiary as a QSub.24 A QSub cannot be an ineligible corporation for purposes of subchapter S.25 All of the assets, liabilities, and items of income, deduction and credit of a QSub are treated as items that belong to the subchapter S corporation.26

a) The Four Requirements.

The general rule (of the temporary regulations) imposes the four requirements described below. A taxpayer must satisfy the “all assets/liabilities test” and ceasing to exist requirements simultaneously.27

1) The Law Requirement. The general rule provides that a statutory merger or consolidation is a transaction that is effected pursuant to either the “laws” of a state, the U.S., or the District of Columbia.28 In contrast, the final regulations that were in effect before the temporary regulations were issued29 indicated that the “corporation laws” of either a state, the U.S., or the District of Columbia determine whether a transaction qualifies as a statutory merger or consolidation under §368(a)(1)(A).30 The Service eliminated the “corporation law” requirement because a merger or consolidation may occur pursuant to a state statute, for example, that is not part of a state’s corporation laws.31

Moreover, the final regulations provided that a merger or consolidation could occur pursuant to the laws of a “territory” of the U.S.32 The Service removed the word “territory” from the list of jurisdictions in the general rule because the definition of “domestic” under §7701(a)(4) does not include a “territory.”33

2) The “All Assets/Liability Test.”

The rule and definitions of key terms. The “all assets/liability test” is the second requirement.34 The general rule provides that a target corporation must transfer all of its assets and liabilities to a transferee unit. In addition, a target corporation also must transfer all of the assets and liabilities attributed to any disregarded entity that it owns.35 If the target corporation retains any assets or liabilities, then the “all assets/liabilities test” is not satisfied.36

The temporary regulations refer to the target corporation as the combining entity of the transferor unit.37 A combining entity is a corporation that is not a disregarded entity.38 A transferor unit is a combining unit.39 A combining unit consists of a combining entity and any disregarded entity that the combining entity owns.40

Moreover, the temporary regulations refer to the acquiring corporation as the combining entity of the transferee unit.41 A transferee unit also is a combining unit.42

The exception to the rule. An exception to the “all assets/liabilities test” requirement exists. The combining entity of the transferor unit may distribute assets to its shareholders, and satisfy and discharge liabilities, “in the transaction.”43 Accordingly, only those remaining assets and liabilities are transferred to the combining unit of the transferee.44

The eighth example in the temporary regulations illustrates this exception.45 In that example, a corporation operates two unrelated businesses. Each business represents 50 percent of the value of the corporation’s assets. The corporation intends to merge into another corporation. The acquiring corporation (i.e., the combining entity of the transferee unit) does not want the assets associated with one of the businesses. Thus, the target corporation (i.e., the combining entity of the transferor unit) sells the unwanted business for cash and then distributes the proceeds to its shareholders. Subsequently, the combining entity of the transferor unit merges into the combining entity of the transferee unit. The transaction qualifies as a reorganization under §368(a)(1)(A). Accordingly, in the example, the “all assets/liabilities test” is satisfied because all of the assets and liabilities of the combining entity of the transferor unit become the assets and liabilities of the transferee unit at the time of the merger.

3) Ceasing to Exist. The separate legal existence of the combining entity of the transferor unit must cease to exist at the time of the statutory merger or consolidation.46 The general rule imposes this condition as the third requirement. An exception to this rule also exists. After the separate legal existence of the combining entity of the transferor unit ceases to exist, the combining entity of the transferor unit, the combining entity of the transferee unit or any officer, director, or agent of either unit may bring, or defend against, a lawsuit on behalf of the combining entity of the transferor unit. This exception relates, however, to litigation that arises from activities conducted by the combining entity of the transferor unit before the effective date of the statutory merger or consolidation.47

4) Domestic Entity Requirement. Even though the text of the general rule does not so provide, the eighth example in the temporary regulations suggests that the combining entity of the transferor unit and the combining entity of the transferee unit are required to be organized under either the laws of a state, the U.S., or the District of Columbia.48 This requirement is the domestic entity requirement and is the fourth condition of the general rule.

b) An Example of the General Rule.

The following example illustrates the general rule. X and Y each are incorporated in the State of Florida. Under Florida law, X merges into Y.49 X, the target, is the combining entity of the transferor unit. X also is the only member of the combining unit of the transferor. Y, the acquiring corporation, is the combining entity of the transferee unit and is the only member of the combining unit of the transferee.

The following events occur simultaneously at the time of the merger. All of the assets and liabilities of X become the assets and liabilities of Y. X’s separate legal existence ceases to exist.50 X’s shareholders exchange their stock in X for stock in Y.

The merger satisfies the requirements of the general rule. First, the merger is undertaken pursuant to the law of a state (i.e., Florida). Second, all of the assets and liabilities of X become the assets and liabilities of Y. Third, X’s separate legal existence ceases to exist when X transfers its assets and liabilities to Y. Fourth, the domestic entity requirement is satisfied because X and Y each are domestic entities (incorporated in Florida). Accordingly, the transaction qualifies as a statutory merger and, thus, as a reorganization under §368(a)(1)(A).

The Second Rule: Statutory Mergers or Consolidations That Involve Disregarded Entities That are Owned by the Acquiring Corporation

The second rule is described in §1.368-2T(b)(1)(iii) of the temporary regulations. That rule applies only when the combining entity of the transferor unit merges, or consolidates, with a disregarded entity that is a member of the combining unit of the transferee. This article refers to that rule as the “disregarded entity rule.”51

If the disregarded entity rule applies, a taxpayer must follow the general rule and disregarded entity rule. Otherwise, a transaction will not qualify under §368(a)(1)(A).52 The following paragraphs of this section examine the domestic entity requirement and the “all assets/liabilities test” in the context of both rules.

a) The Domestic Entity Requirement. The disregarded entity rule imposes an explicit domestic entity requirement. That rule provides that the combining entity of the transferor unit and the combining entity of the transferee unit that owns a disregarded entity are required to be organized under either the laws of a state, the U.S., or the District of Columbia.53 In addition, an entity through which the combining entity of the transferee unit owns a disregarded entity must satisfy the domestic entity requirement.

Finally, most disregarded entities are subject to this requirement. The domestic entity requirement does not apply, however, to disregarded entities of the combining entity of the transferor unit that become disregarded entities of the combining entity of the transferee unit.54

b) The “All Assets/Liabilities Test” and Examples. The disregarded entity rule provides that the combining entity of the transferor unit must transfer all of its assets and liabilities to a disregarded entity that is a member of the combining unit of the transferee.55 If the combining entity of the transferor unit owns any disregarded entities, the general rule provides that those assets and liabilities also must become the assets and liabilities of the combining unit of the transferee.56

1) Example: A Merger Involving an LLC That is a Disregarded Entity. X and Y each are incorporated in the State of Florida. Z is an LLC that is formed under Florida law. Y owns the sole membership interest in Z, and Z is disregarded as an entity that is separate from Y.57 Under Florida law, X (the combining entity of the transferor unit) merges into Z (an LLC that is a member of the combining unit of the transferee).58 All of the assets and liabilities of X become the assets and liabilities of Z, and X’s separate legal existence ceases to exist at the time of the merger.

The merger satisfies the requirements of the general rule and disregarded entity rule. First, the merger is undertaken pursuant to the law of a state (i.e., Florida).59 Second, all of the assets and liabilities of X become the assets and liabilities of Z (an LLC), which Y owns. Third, X’s separate legal existence ceases to exist when Z obtains the assets and liabilities of X. Finally, the domestic entity requirement is satisfied because X, Y, and Z are domestic entities.60

2) Example: A Merger Involving a QSub. This example differs from the preceding example to the extent that X (the combining entity of the transferor unit) is a subchapter S corporation, and V is a QSub that X owns. As in the preceding example, X intends to merge into Z, an LLC, and Y is a subchapter C corporation that owns the sole membership interest in Z.

The proposed regulations that were promulgated in 2001 did not address whether a QSub is a member of the combining unit of the transferor.61 Likewise, the proposed regulations did not examine whether the assets and liabilities that were attributed to a QSub are transferred to the combining unit of the transferee.62 These issues are relevant because a QSub is treated as a new corporation when its status terminates.63 A QSub’s status terminates if it merges into another entity and no longer is owned by a subchapter S corporation.64 Accordingly, if a former QSub is a corporation that is not a disregarded entity of a subchapter S corporation, the former QSub may not qualify as a member of the combining unit of the transferor.65 If that is so, then the former QSub’s assets and liabilities are not relevant for determining whether the “all assets/liabilities test” requirement is satisfied.66

On the other hand, if a former QSub is a member of the combining unit of the transferor and the assets and liabilities that are attributed to the former QSub are not transferred to the combining unit of the transferee, then the transaction may not qualify as a statutory merger under §368(a)(1)(A) because the “all assets/liabilities test” may not be satisfied.67 Accordingly, the Service and Treasury Department added the third example to the temporary regulations to clarify whether a merger involving a QSub would satisfy the “all assets/liabilities test” requirement.68

In the third example of the temporary regulations, the government resolved the problem described in the preceding paragraphs by adopting the rationale contained in the ninth example of §1.1361-5(b)(3) of the Treasury Regulations.69 In that example, a QSub is treated as having transferred its assets to a subchapter C corporation, the acquiring corporation.70 The subchapter C corporation then is deemed to have transferred the assets to a new corporation in exchange for stock in that new corporation.71

The government applied this approach in the third example of §1.368-2T(b)(1)(iv) of the temporary regulations and concluded as follows. First, a QSub is a member of the combining unit of the transferor at the time of a statutory merger or consolidation. Second, the assets and liabilities that are attributed to the QSub are deemed to be transferred to the combining unit of the transferee. Thus, the “all assets/liabilities test” is satisfied at the time of the statutory merger or consolidation.72

In light of the foregoing discussion, the transaction that is described in the above fact pattern qualifies as a statutory merger under §368(a)(1)(A) because the general rule and disregarded entity rule are satisfied. First, the merger is undertaken pursuant to the law of a state (i.e., Florida).73 Second, all of the assets and liabilities of X (the combining entity of the transferor unit) and the assets and liabilities of V (the former QSub that is a member of the transferor unit) become the assets and liabilities of Z (an LLC), which Y (the combining entity of the transferee unit) owns. In turn, Z is deemed to have transferred to a new corporation (i.e., V) all of the assets and liabilities attributed to V in exchange for stock in the new corporation.74 Third, X’s separate legal existence ceases to exist at the time of the merger. Finally, the domestic entity requirement is satisfied because X, Y, and Z are domestic entities (formed in Florida).75

Conclusion
The temporary regulations clarify whether a transaction qualifies as a statutory merger or consolidation and, thus, as a reorganization under §368(a)(1)(A). Accordingly, these regulations permit taxpayers to structure transactions in order to minimize adverse tax consequences.

1 For the balance of this article, all references to a code section shall be a reference to the Internal Revenue Code of 1986, as amended.
2 See Bittker & Eustice, Federal Income Taxation of Corporations & Shareholders §12.22[1] (7th ed. 2000).
3 See Treas. Reg. §1.368-2(b)(1), as in effect before January 24, 2003 (see 26 CFR part 1, revised April 1, 2002). See also Temp. Treas. Reg. §1.368-2T(b)(1).
4 Treas. Reg. §1.368-2(b)(1), as in effect before January 24, 2003.
5 See Temp. Treas. Reg. §1.368-2T(b)(1).
6 Temp. Treas. Reg. §§1.368-2T(b)(1)(ii), (iii).
7 The proposed regulations were issued on November 15, 2001. 66 Fed. Reg. 57,400. The 2001 proposed regulations replaced proposed regulations that were issued on May 16, 2000. 65 Fed. Reg. 31,115.
8 See Temp. Treas. Reg. §1.368-2T(b)(1)(ii).
9 See Temp. Treas. Reg. §§1.368-2T(b)(1)(i)(A), (B).
10 Treas. Reg. §301.7701-2(b).
11 Treas. Reg. §301.7701-2(b)(1).
12 A business entity is an entity that is recognized for federal income tax purposes. See Treas. Reg. §301.7701-2(a). A disregarded entity that has one owner is included in that definition. Id.
13 See Temp. Treas. Reg. §1.368-2T(b)(1)(i)(A); Treas. Reg. §301.7701-2(a).
14 Temp. Treas. Reg. §1.368-2T(b)(1)(i)(A).
15 See id.
16 See, e.g., Fla. Stat. Ann. §608.401 et seq. (the “Florida Limited Liability Company Act”).
17 Fla. Stat. Ann. §608.405.
18 Fla. Stat. Ann. §608.402(25).
19 Fla. Stat. Ann. §608.402(11).
20 Temp. Treas. Reg. §1.368-2T(b)(1)(i)(A).
21 Id.
22 I.R.C. §856(i)(1)(B).
23 Temp. Treas. Reg. §1.368-2T(b)(1)(i)(A).
24 I.R.C. §§1361(b)(3)(B)(i), (ii).
25 An ineligible corporation includes a financial institution that uses the reserve method of accounting for bad debts described in §585, an insurance company that is subject to tax under subchapter L, a corporation to which an election under §936 applies, or a DISC or former DISC. See I.R.C. §1361(b)(2).
26 I.R.C. §1361(b)(3)(A)(ii).
27 Temp. Treas. Reg. §1.368-2T(b)(1)(ii).
28 Id.
29 Treas. Reg. §1.368-2(b)(1), as in effect before January 24, 2003.
30 Id.
31 Prop. Treas. Reg. §1.368-2(b) (Nov. 15, 2001) (preamble).
32 Treas. Reg. §1.368-2(b)(1), as in effect before January 24, 2003.
33 Prop. Treas. Reg. §1.368-2(b) (Nov. 15, 2001) (preamble). A domestic corporation is “created or organized in the United States or under the law of the United States or of any State.” Section 7701(a)(4).
34 Temp. Treas. Reg. §1.368-2T(b)(ii)(A).
35 Id.
36 See Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 1.
37 See Temp. Treas. Reg. §1.368-2T(b)(1)(ii)(B).
38 Temp. Treas. Reg. §1.368-2T(b)(1)(i)(B).
39 See Temp. Treas. Reg. §1.368-2T(b)(1)(ii)(A).
40 Temp. Treas. Reg. §1.368-2T(b)(1)(i)(C).
41 See, e.g., Temp. Treas. Reg. §1.368-2T(b)(1)(iii).
42 See Temp. Treas. Reg. §1.368-2T(b)(1)(ii)(A).
43 Id.
44 Id. See also Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 8.
45 Id.
46 Temp. Treas. Reg. §1.368-2T(b)(1)(ii)(B).
47 Id.
48 See Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 8. See also Temp. Treas. Reg. §1.368-2T(b)(1)(iii).
49 See Fla. Stat. Ann. §607.1101.
50 See Fla. Stat. Ann. §607.11101(1).
51 Temp. Treas. Reg. §1.368-2T(b)(1)(iii).
52 Id.
53 Id.
54 Id.
55 Id.
56 Temp. Treas. Reg. §1.368-2T(b)(1)(ii).
57 See Treas. Reg. §301.7701-2(a).
58 Fla. Stat. Ann. §607.1108(1), (2).
59 Id.
60 Temp. Treas. Reg. §1.368-2T(b)(1)(iii).
61 Temp. Treas. Reg. §1.368-2T (preamble).
62 Id.
63 See §1361(b)(3)(C); Treas. Reg. §1.1361-5(b)(1).
64 See Temp. Treas. Reg. §1.368-2T (preamble).
65 See Temp. Treas. Reg. §1.368-2T(b)(1)(i)(C).
66 Temp. Treas. Reg. §1.368-2T (preamble).
67 Temp. Treas. Reg. §§1.368-2T(b)(1)(ii), (iii).
68 See Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 3.
69 See Temp. Treas. Reg. §1.368-2T (preamble); §1.368-2T(b)(1)(iv), ex. 3.
70 See Treas. Reg. §1.1361-5(b)(3), ex. 9.
71 Id.
72 Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 3.
73 Fla. Stat. Ann. §§607.1108(1), (2).
74 Temp. Treas. Reg. §1.368-2T(b)(1)(iv), ex. 3.
75 Temp. Treas. Reg. §1.368-2T(b)(1)(iii).

Jeffrey B. Fienberg is an assistant branch chief with the Office of Chief Counsel (Corporate), U.S. Internal Revenue Service. He received his LL.M. in tax from the University of Florida in 2001. Mr. Fienberg is a member of the Florida, New Jersey, and Pennsylvania bars. The opinions stated in this article are those of Mr. Fienberg and do not necessarily represent the views of the Internal Revenue Service or the Department of Treasury.
This column is submitted on behalf of the Tax Section, William D. Townsend, chair, and Michael D. Miller, BenjaminA. Jablow, and Normarie Segurola, editors.

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