Proposed IRS Changes Ease Income Tax Regulations for Corporate Mergers
The Internal Revenue Service recently reversed its course in a direction favorable to taxpayers regarding the proposed regulations on the income tax consequences of corporate mergers or consolidations involving entities that are disregarded for federal tax purposes. The regulations are important to commercial real estate professionals who directly or indirectly own property through a disregarded entity or who may be consolidating their companies with an acquiring entity that makes use of disregarded entities.
For federal tax purposes disregarded entities are treated as branches of their sole owners, such as single-member limited liability companies that are not treated as corporations for federal tax purposes, qualified real estate investment trust subsidiaries that are wholly owned subsidiaries of REITs, and qualified subchapter S subsidiaries that are wholly owned subsidiaries of S corporations.
Although for federal tax purposes disregarded entities are nonexistent and their assets and liabilities are treated as those of their sole owners, they exist as separate legal entities under state law. This divergence of legal and tax status has created questions about the proper treatment of these entities under tax rules related to corporate reorganizations. Specifically, the proposed regulations consider the consequences of a merger of a target corporation into an entity disregarded for tax purposes or the merger of a disregarded entity into a recognized tax entity.
Target Corporation Into Disregarded Entity
The proposed regulations consider whether the merger of a target corporation into a disregarded entity would be treated as a type A reorganization under Section 368(a)(1)(A) of the Internal Revenue Code or a type C reorganization under Section 386(a)(1)(C). Type A and type C reorganizations are two of the methods available by which shareholders can effect a fully or partially tax-deferred merger of companies wherein the acquiring company gains the assets and liabilities of the target company and the target company ceases to exist.
Generally, type A reorganizations are defined as statutory mergers or consolidations that are effectuated pursuant to state law. In type A reorganizations, all of the assets and liabilities of the target are acquired. Type C reorganizations generally dictate that the acquiring entity gains “substantially all” of the assets of the target company, primarily in exchange for its stock. Type C reorganizations might be used if the parties are prevented from merging under state law or the acquiring company does not want to gain all of the assets and liabilities of the target.
However, when companies intend a complete consolidation of their businesses, there are advantages to qualifying for a type A reorganization. In particular, type A reorganizations allow greater flexibility in terms of the consideration that the target company shareholders may receive while continuing to qualify for a partially tax-deferred transaction.
When first released, the proposed IRS regulations provided that a merger of a tax-recognized entity into a disregarded entity would not be eligible for a type A reorganization and only would be considered under the more restrictive type C reorganization requirements. That conclusion was based on the view that parties to the reorganization for tax purposes — the acquiring company and the owner of the disregarded entity — would not be the parties that consolidated under state law (the acquiring company and the disregarded entity). This position reflected a reversal of authority previously issued by the IRS. The reissued proposed regulations reverse this conclusion and provide that a merger of a target real estate company into a disregarded entity would be eligible for a type A reorganization.
The effect of the IRS decision for target shareholders will be the ability to test their transactions against the more flexible rules of type A reorganization. In particular, it allows more flexibility in the nature of the consideration paid to those target shareholders. Under both types of reorganizations, the target corporation's shareholders may defer recognition of gain if they receive only the stock of the acquiring company and the applicable statutory and judicial requirements for a qualifying reorganization are satisfied. Also, both types stipulate that target shareholders always are taxable on the value of any cash or other property that they receive in connection with the reorganization.
However, an important difference exists between the reorganizations with respect to the amount of cash or other property that target shareholders may receive before the transaction is considered a fully taxable sale. Type A reorganizations allow target shareholders to receive a greater amount of boot without causing the merger to be considered an outright sale. Generally, in type A reorganizations, tax is deferred with respect to the value received in stock for target shareholders so long as they receive at least 50 percent or more of the consideration in the form of the acquiring entity's stock. Thus, 50 percent or less can be in the form of cash or other boot. Case law permits the stock to be as little as 38 percent of the total consideration received.
Under more-restrictive type C reorganizations, target shareholders must receive at least 80 percent of the gross fair market value of all transferred property in voting stock of the acquiring entity to defer gain on the value of the acquiring company stock they receive. Importantly, for purposes of the 80 percent test, any liabilities of the target entity that are assumed by the acquiring entity must be included with any cash or other property transferred to the target shareholders. If assumed debt aggregated with any cash and other property given to the target shareholders equals at least 20 percent of the value of the target corporation's assets, the transaction does not qualify as a type C reorganization and all target shareholders' consideration (including stock) would be taxable.
Disregarded Entity Into Acquiring Corporation
The proposed regulations also consider the consequences of the merger of a disregarded entity into a tax-recognized corporation. Consistent with the first release of the proposed regulations, the reissued regulations continue to provide that this type of transaction could not qualify as a type A reorganization unless the owner of the disregarded entity also merged into the acquiring corporation. In a qualifying type A reorganization the target ceases to exist as an operation of law. The IRS has reasoned that because the target entity for tax purposes is the owner of the disregarded entity, the merger of only the disregarded entity into the acquiring corporation could not satisfy the requirement. However, the merger of only the disregarded entity into the acquiring corporation might qualify as a non-recognition transaction under other provisions of the code — for example, as a type C reorganization or as a tax-free contribution of property under Section 351.