Real Estate Tax Forum

TAX LAW AND ESTATE PLANNING SERIES Tax Law and Practice Course Handbook Series Number D-477 19th Annual Real Estate Tax Forum Volume Two Co-Chairs Leslie H. Loffman Sanford C. Presant Blake D. Rubin To order this book, call (800) 260-4PLI or fax us at (800) 321-0093. Ask our Customer Service Department for PLI Order Number 186465, Dept. BAV5. Practising Law Institute 1177 Avenue of the Americas New York, New York 10036

41 New Proposed Regulations on Mergers Involving Disregarded Entities Blake D. Rubin Andrea Macintosh Whiteway EY Copyright 2002 Blake D. Rubin and Andrea Macintosh Whiteway. All rights reserved. Reprinted from the PLI Course Handbook, 18th Annual Real Estate Tax Forum (Order #144587) If you find this article helpful, you can learn more about the subject by going to www.pli.edu to view the on demand program or segment for which it was written.

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INTRODUCTION On November 15, 2001, the Treasury Department issued new proposed regulations (the Proposed Regulations ) that, when finalized, will allow certain mergers between corporations and disregarded entities to qualify for tax-free merger treatment under Code Sec. 368(a)(1)(A). 1 A disregarded entity for this purpose includes a qualified REIT subsidiary, a qualified subchapter S subsidiary and a business entity that is not classified as a corporation and that has a single owner (for example, a singleowner limited liability company ( LLC )). The Proposed Regulations supersede prior proposed regulations (the Prior Regulations ) issued on May 16, 2000 that would not have allowed such treatment. 2 The Proposed Regulations, which will be effective from the date that they are finalized, 3 represent an important change in position at the Treasury Department. They can be expected to result in increased use of LLCs to facilitate corporate transactions, and ultimately to increase the prevalence of LLCs more generally. This column will first briefly discuss the statutory and regulatory framework for tax-free reorganizations and the adverse consequences that adoption of the Prior Regulations would have had. Thereafter, this column will analyze the Proposed Regulations and the favorable impact that they will have on structuring corporate merger transactions. REQUIREMENTS FOR AN A REORGANIZATION The most flexible and simple form of tax-free reorganization is a statutory merger or consolidation pursuant to Code Sec. 368(a)(1)(A) (an A reorganization ). For a merger or consolidation to be tax-free, it must be effected in accordance with the state laws on the subject. Reg. 1.368-2(b)(1) currently requires that: In order to qualify as a reorganization under section 368(a)(1)(A) the transaction must be a merger or consolidation effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia. [Emphasis added.] 1. Notice of proposed rulemaking and notice of public hearing (REG-126485-01, 2001-49 I.R.B. 555) published in the Federal Register at 66 FR 57400-57404. 2. Withdrawal of notice of proposed rulemaking (REG-106186-00) published in the Federal Register at 66 FR 57400 on November 15, 2001, as corrected on November 19, 2001 to reflect REG-106186-98. 3. Prop. Reg. 1.368-2(b)(1)(v). 3

Thus, under the currently applicable regulations, an A reorganization is limited to mergers or consolidations effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia. In addition, both corporations engaging in the merger must be domestic entities. 4 In a merger, by operation of law the target corporation transfers its assets and liabilities to the acquiring corporation and dissolves, and the shareholders of the target corporation become shareholders of the acquiring corporation. The Code imposes no limitations on the type of consideration that may be received by stockholders of the target corporation in an A reorganization. However, any boot received by the shareholders of the target corporation is taxable to them. Notwithstanding the lack of any statutory limitation on the type of consideration that may be received by a target corporation s shareholders, an A reorganization (like other reorganizations) must have a business purpose and is subject to the continuity of interest and continuity of business enterprise limitations. 5 The continuity of interest doctrine requires that the original owners of the target corporation retain a continuing interest in the reorganized corporation. Reg. 1.368-1(e)(1) provides that [a]ll facts and circumstances must be considered in determining whether, in substance, a proprietary interest in the target corporation is preserved. Examples contained in the regulations conclude that where the target corporation s shareholders receive 50 percent of the consideration in the form of stock of the acquiring corporation, continuity of interest has been satisfied. Reg. 1.368-1(e)(6) Example 1. Moreover, the Supreme Court in John A. Nelson Co. v. Helvering, 296 U.S. 374 (1935), concluded that the requisite continuity of interest existed where the target corporation transferred its assets in exchange for consideration consisting of 38 percent preferred stock of the acquiring corporation and 62 percent cash. Thus, boot consideration in excess of 62 percent of the total merger consideration jeopardizes continuity of interest and therefore status as an A reorganization. 4. See Reg. 1.368-1(c); Code Sec. 367. 5. Reg. 1.368-1. For a comprehensive discussion of these rules, see Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, Seventh Edition (WGL 2000) at 12. 2-806 4

REQUIREMENTS FOR A C REORGANIZATION A tax-free reorganization under Code Sec. 368(a)(1)(C) (a C reorganization ) is an acquisition by an acquiring corporation of substantially all of the properties of a target corporation (the target corporation ) in exchange solely for voting stock of the acquiring corporation (or in a triangular C reorganization, of its parent), subject to the ability in some instances to exchange for voting stock and a limited amount of money or other property. In order to qualify as a C reorganization, the following requirements must be satisfied: 6 The acquiring corporation must acquire substantially all of the properties of the target corporation. 7 The consideration must consist of either solely voting stock of the acquiring corporation (or its parent), or solely voting stock plus, if certain conditions are met, a limited amount of money or other property. 8 The acquiring corporation may contribute part or all of the acquired assets to its controlled corporation. 9 6. Note that if the requirements for a C reorganization are satisfied and the transaction would otherwise meet the requirements of a tax-free reorganization under Code Sec. 368(a)(1)(D), then the transaction must be treated as a reorganization under Code Sec. 368(a)(1)(D). 7. To establish guidelines for determining whether the acquiring corporation has acquired substantially all of the properties, the Service issued Rev. Proc. 77-37, 1977-2 C.B. 586, which provides for advance ruling purposes that the transfer of 70 percent of the gross assets and 90 percent of the net assets will be deemed to constitute a transfer of substantially all of the properties. It is important that the transaction not be viewed as divisive as in the case where the target corporation retains certain assets. See Bittker and Eustice at 12.24[2][b]. 8. There are three exceptions to the requirement that the consideration consist of solely voting stock of the acquiring corporation. The first exception is that voting stock of a corporation that controls the acquiring corporation may be given as an alternative consideration. The second exception is that if no other boot is paid, then the acquiring corporation s assumption of the target corporation s liabilities is disregarded in determining whether the acquisition is solely for voting stock. The third exception allows the use of money or other property as consideration provided that at least 80 percent of the gross fair market value of al of the property of the target corporation is acquired for voting stock (the so-called boot relaxation rule ). Code Sec. 368(a)(2)(B). For purposes of this determination, liabilities assumed or taken subject to by the acquiring corporation are treated as money in determining whether 80 percent of all property was acquired solely for voting stock. 9. The acquiring corporation has the flexibility to drop down the assets to a subsidiary or sub-subsidiary without jeopardizing the tax-free treatment of the reorganization. Code Sec. 368(b). See Bittker and Eustice, at 12.24[2][d]. 5

The target corporation must liquidate. 10 A C reorganization thus imposes requirements that are not applicable to A reorganizations, namely the requirement that the acquiring corporation acquire substantially all of the properties of the target corporation, and that the exchange be solely for voting stock (subject to the boot relaxation rule of Code Sec. 368(a)(2)(B)). 11 An A reorganization is not subject to these restrictive requirements. Most notably, the target s shareholders in an A reorganization can receive up to 62 percent of their consideration in the form of cash without causing the transaction to fail to qualify as a tax-free reorganization. FORWARD TRIANGULAR MERGERS Merger transactions often are structured in a forward triangular format in which the acquiring corporation forms a wholly owned subsidiary to participate in the merger. The target corporation is then merged into the subsidiary in exchange for stock of the acquiring parent corporation in a transaction qualifying under Code Sec. 368(a)(2)(D). There are several advantages to the triangular structure compared to a merger of the target directly into the acquiring parent corporation. These include the ability to insulate the acquiring parent corporation from the liabilities of the target and the possibility of avoiding the need for a vote of the acquiring parent s shareholders to approve the merger. One disadvantage of the triangular format compared to a direct merger into the acquiring corporation is that in order to qualify as tax-free under Code Sec. 368(a)(2)(D), in addition to meeting the requirements for an A reorganization, substantially all of the properties of the target corporation must be acquired. For this purpose, all payments to dissenters and all redemptions and distributions (except for regular, normal distributions ) made by the corporation immediately preceding the transfer and which are part of the plan of reorganization will be considered as assets held by the corporation immediately prior to the transfer. 12 The substantially all requirement thus limits the ability of a target corporation to tailor itself in advance of a forward triangular 10. Unless the Service waives this requirement, which it may do in certain limited circumstances. 11. See footnote 8. 12. See Rev. Proc. 77-37, 1977-2 C.B. 586, which provides for ruling purposes that the transfer of 70 percent of the gross assets and 90 percent of the net assets will be deemed to constitute a transfer of substantially all of the corporation s properties. 2-808 6

merger by distributing to the target shareholders assets not desired by the acquiror. A triangular merger in which the target is merged into an LLC that is wholly-owned by the acquiring corporation would offer the same state law benefits as a traditional forward triangular merger into a subsidiary corporation. Although the wholly owned LLC would be a disregarded entity for Federal tax purposes, its state law existence would shield the parent corporation from the liabilities of the target corporation. In addition, if the merger of the target corporation into the LLC qualifies as a statutory merger under Code Sec. 368(a)(1)(A) rather than as a forward triangular merger under Code Sec. 368(a)(2)(D), the substantially all requirement would be inapplicable. Finally, because the disregarded entity has no separate Federal income tax existence, use of a single-owner LLC rather than a corporation as the merger participant would permit the acquiring corporation to maintain a simple Federal tax structure and avoid the ambit of the consolidated return regulations. THE PRIOR REGULATIONS The Prior Regulations addressed the tax consequences of a merger of a disregarded entity into an acquiring corporation as well as the merger of a target corporation into a disregarded entity. The Prior Regulations concluded that these transactions could not qualify as a statutory merger for purposes of Code Sec. 368(a)(1)(A) or as a forward triangular merger pursuant to Code Sec. 368(a)(2)(D). The preamble to the Prior Regulations stated the Treasury Department s view that [c]ompliance with a corporate law merger statute does not by itself qualify a transaction as a statutory merger for purposes of section 368(a)(1)(A). Prop. Reg. 1.368-2(b)(1) of the Prior Regulations expanded on this view as follows: In order to qualify as a reorganization under section 368(a)(1)(A) the transaction must be a merger or consolidation involving two corporations effected pursuant to the laws of the United States or a State or territory, or the District of Columbia.... Thus, the merger under state or Federal law of an entity that is disregarded as an entity separate from its owner for Federal tax purposes into an acquiring corporation in which the owner exchanges its interest in the disregarded entity for stock in the acquiring corporation and the disregarded entity ceases to exist as a result of the transaction by operation of the state or Federal merger law is not a statutory merger qualifying as a reorganization under section 368(a)(1)(A). Moreover, the merger of a target corporation into an entity that is disregarded as an entity separate from its owner for Federal tax purposes that does not lose its status as a disregarded entity as a result of the transaction is not a statutory merger qualifying as a reorganization under section 368(a)(1)(A). 7

The Prior Regulations did not address whether the aforementioned transactions could qualify as tax-free reorganizations under other provisions of Code Sec. 368. Nevertheless, the preamble stated that the merger of a disregarded entity into an acquiring corporation or the merger of a target corporation into a disregarded entity could qualify as a reorganization under Code Sec. 368(a)(1)((C), (D), or (F) if all applicable requirements were met. 13 Thus, the Prior Regulations left open the possibility that such transactions could qualify as C reorganizations. However, as discussed above, the requirements for qualification as a C reorganization are substantially more onerous than those that apply for A reorganizations. The Prior Regulations would have largely eliminated the use of disregarded entities in mergers, because an acquiring corporation could utilize a corporation instead of a disregarded entity as the merger participant and thereby have the tax-free status of the transaction tested under the rules for A reorganizations rather than the more onerous rules for C reorganizations. The Prior Regulations were roundly criticized as inconsistent with the policies underlying the use of disregarded entities. 14 THE PROPOSED REGULATIONS To its credit, the Treasury Department listened to the comments of taxpayers, re-thought its position in the Prior Regulations and withdrew them, replacing them with the Proposed Regulations. The Treasury Department properly concluded that a disregarded entity should be treated in the reorganization context in the same manner as it is treated in other Federal tax contexts, namely as a division of its owner. Most significantly, the Proposed Regulations permit certain statutory mergers and consolidations involving disregarded entities to qualify as A reorganizations. 13. Notice of proposed rulemaking and notice of public hearing (REG-106186-98, 2000-23 I.R.B. 1226) published in the Federal Register at 65 FR 31115. 14. See, e.g., ABA Tax Section Letter to Commissioner Rossotti regarding Comments Concerning Proposed Regulations on Mergers Involving Disregarded Entities dated October 13, 2000, as supplemented by additional comments submitted on July 23, 2001 (suggesting that the merger of a target corporation into a disregarded entity should qualify as an A reorganization provided that the parent of the disregarded entity is a corporation); AICPA Letter to Commissioner Rossotti and Acting Assistant Secretary (Tax Policy) Jonathan Talisman regarding Comments on Proposed Regulations on Mergers Involving Disregarded Entities dated December 8, 2000 (suggesting that if the merger of a target into the corporate owner of a disregarded entity satisfies the requirements of an A reorganization, then the merger of the target into the disregarded entity owned by the corporate owner should be afforded similar treatment.) 2-810 8

The Proposed Regulations utilize certain defined terms. The term disregarded entity is defined as a business entity (as defined in Reg. 301.7701-2(a)) that is disregarded as an entity separate from its owner for Federal tax purposes. The term combining entity is defined as a business entity that is a corporation (as defined in Reg. 301.7701-2(b)) that is not a disregarded entity. The term combining unit is defined as a combining entity and all disregarded entities, if any, the assets of which are treated as owned by such combining entity for Federal tax purposes. The Proposed Regulations provide that, for purposes of Code Sec. 368(a)(1)(A), a statutory merger or consolidation must be effected pursuant to the laws of the United States or a State or the District of Columbia and that, pursuant to such laws, at the effective time of the transaction the following events must occur simultaneously: all of the assets (other than those distributed in the transaction) and liabilities (except to the extent satisfied or discharged in the transaction) of each member of one or more combining units (each a transferor unit) become the assets and liabilities of one or more members of one other combining unit (the transferee unit); and the combining entity of each transferor unit ceases its separate legal existence for all purposes. 15 The Proposed Regulations provide that such a transaction in which any of the assets and liabilities of a combining entity of a transferor unit become assets and liabilities of one or more disregarded entities of the transferee unit is not a statutory merger or consolidation within the meaning of Code Sec. 368(a)(1)(A) unless such combining entity, the combining entity of the transferee unit, such disregarded entities, and each business entity through which the combining entity of the transferee unit holds its interests in such disregarded entities is organized under the laws of the United States or a State or the District of Columbia. An example in the Proposed Regulations makes clear that a merger of a target corporation into an LLC wholly owned by an acquiring corporation in exchange for stock of the acquiring corporation qualifies as a statutory merger. 16 Likewise, a merger of a target corporation into an LLC 15. Prop. Reg. 1.368-2(b)(1)(ii). Notably, the requirement contained in existing Reg. 1.368-2(b) that the transaction be effected pursuant to the corporation laws of the United States or a State or Territory or the District of Columbia was deleted in both the Proposed Regulations and the Prior Regulations (although the Prior Regulations did not allow mergers with disregarded entities to qualify as A reorganizations). 9

wholly owned by a corporate subsidiary of the acquiring corporation in exchange for stock of the acquiring corporation qualifies as a forward triangular merger under Code Sec. 368(a)(2)(D) if the substantially all requirement is met. 17 On the other hand, like the Prior Regulations, the Proposed Regulations quite properly do not permit a statutory merger of a target LLC wholly owned by a corporation into an acquiring corporation to qualify as an A reorganization. Thus, the Proposed Regulations provide that the merger of a disregarded entity into a member of a transferee unit, where the owner of the disregarded entity does not also merge into a member of the transferee unit, does not qualify as a statutory merger or consolidation under Code Sec. 368(a)(1)(A). In such a transaction, all of the transferor unit s assets may not be transferred to the transferee unit, with the result that the transferor unit s assets may be divided between the transferor unit and the transferee unit. Moreover, the separate legal existence of the combining entity of the transferor unit does not terminate as a matter of law. Although such a transaction cannot qualify as an A reorganization, it may qualify for nonrecognition treatment as a C reorganization or under other provisions of the Code. CONCLUSION The Treasury Department is to be applauded for re-thinking its position in the Prior Regulations and issuing the more liberal Proposed Regulations. The Proposed Regulations are well-supported by logic, are consistent with sound tax policy and are helpful to taxpayers. They can also be expected to result in increased use of LLCs to facilitate corporate transactions, and ultimately to increase the prevalence of LLCs more generally. 16. Prop. Reg. 1.368-2(b)(1)(iv) Example 2. 17. Prop. Reg. 1.368-2(b)(1)(iv) Example 3. 2-812 10

NOTES

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